“Wait & See” Buy Sell Agreement Strategy

Sometimes it’s difficult to decide which type of buy sell agreement to recommend when dealing with business succession planning for C Corporations. Should it be a stock redemption plan funded with employer owned insurance or a cross purchase plan funded by cross owned insurance?

 

Using a cross purchase plan, the surviving shareholder gets a 100% cost basis increase when purchasing the shares from the estate of the deceased shareholder. On the other hand, the surviving shareholder gets a 0% cost basis increase when using a stock redemption agreement.

 

Many retail, wholesale, and manufacturing C Corps retain significant earnings and profits (E&P) on their balance sheets for business purposes. These E&P can normally be reduced only by a taxable dividend to the shareholders. However, these accumulated E&P can be distributed tax-free as part of a proportional stock redemption under IRC Section 312(n)(7). This transaction would be a desirable tax accounting strategy if it could be accomplished.

 

Given a choice between both positive results, is there a way we can get BOTH a 100% cost basis increase for the surviving shareholder AND a tax-free reduction of E&P under IRC Section 312(n)(7)? The answer is YES, and the strategy to accomplish both is a “Wait and See” Optional Buy Sell Agreement ( Click to learn about Buy-Sell Planning for QPSC, S Corp, and LLC Professional Practice Owners) coupled with cross ownership of the life insurance policies. In a “wait and see” plan Option #1 is cross purchase, Option #2 is stock redemption, and mandatory Option 3# is back to cross purchase.

 

Let’s take a look at a simple case study to illustrate the effectiveness of this “wait and see” plan…

 

Facts of case: Assume a C Corp is owned 50-50 by Albert and Barbara and has a fair market value for buy sell purposes of $4,000,000 ($2,000,000 each for Albert and Barbara). The C Corp has a book value of $3,000,000 which consists of $2,800,000 of retained E&P and $200,000 of original cost basis contributed equally by Albert and Barbara when they formed the company many years ago.

 

The shareholders and the corporation enter into a “Wait and See” Optional Buy Sell Agreement. They purchase $2,000,000 of life insurance each with Albert as the owner and beneficiary on Barbara’s life and Barbara as the owner and beneficiary on Albert’s life (cross-ownership). The company provides taxable bonus compensation to the shareholder-employees to pay the annual premium.

At Barbara’s death, the transaction sequence could proceed as follows for a 50-50 shareholder case:

 

  1. Albert collects the $2,000,000 income tax-free life insurance death proceeds on Barbara’s life (cross ownership).
  2. C Corp and Albert waive Option #1 (cross purchase) and select Option #2 (stock redemption). The corporation redeems Barbara’s stock in exchange for a short-term NOTE PAYABLE to Barbara’s estate using the short term Applicable Federal Rate (AFR) as the interest rate.
  3. This tax-free redemption reduces the corporation’s balance sheet E&P by 50% ($1,400,000) for tax accounting purposes under IRC Section 312(n)(7).
  4. A uses the tax-free life insurance proceeds to make a CAPITAL CONTRIBUTION (“paid-in” capital on the balance sheet) to the corporation of $2,000,000. This capital contribution increases Albert’s cost basis in the shares by 100% of the contribution. Albert’s cost basis is now $100,000 (original basis) plus $2,000,000 (paid-in capital) = $2,100,000.
  5.  The corporation uses the $2,000,000 capital contribution to pay off the note and minimal interest to Barbara’s estate.
  6. Barbara’s estate transfers this cash payoff through the estate to the surviving spouse and family of Barbara to maintain their lifestyle.
  7. Albert is now the 100% owner of the C Corp with a cost basis of $2,100,000 for purposes of any future lifetime sale of the business to a third party. The potential capital gain on this future sale is reduced significantly because Albert’s cost basis was increased to $2,100,000 rather than only $100,000 if a stock redemption using employer-owned life insurance had been utilized.

 


 

BEFORE STOCK REDEMPTION
(Albert 50% Shareholder, Barbara 50% Shareholder)

Illustration 1

AFTER STOCK REDEMPTION
(Albert 100% Shareholder)
After Stock Redemption

SURVIVING STOCKHOLDER (ALBERT) COST BASIS

Total New Cost Basis

 

 

Contact BSMG Advanced Sales for a discussion of this ‘Wait and See” concept for your C Corp clients. We can provide a buy sell agreement template and sample buy sell agreement that the client’s attorney can use as a guide to draft the actual document.

 

Russell E. Towers JD, CLU, ChFC
Vice President-Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net