If you have a buy-sell agreement, you may be able to write off the money you paid for the policy that you later sold. Although the rules are very complex, there are certain things you can do to keep the IRS happy.
- Premiums used to fund a buy-sell agreement are not deductible regardless of who (the corporation, shareholders, or a third party) owns the policy. Planners should therefore consider the comparative tax brackets involved in deciding whether to use the stock redemption or cross purchase approaches to funding a buy-sell agreement.
If the corporation is in a higher income tax bracket than the shareholders, it may be wise to make tax-deductible salary payments or bonuses to the shareholders and have them buy and own the insurance on a cross purchase basis. If the corporation is the lower bracket, it may make more sense (other things being equal) to use a stock redemption plan.
- Death proceeds will be received income-tax free regardless of who (the corporation, shareholders, or a third party) owns the policy. However, this favorable general rule is modified where the amount of life insurance is large, the business has substantial revenue, and the proceeds are payable to certain C corporations. Life insurance proceeds received by a C corporation may generate an Alternative Minimum Tax (AMT) liability of up to 15 percent of the amount of the proceeds.The corporate AMT is not a problem where the policy proceeds are received by an S corporation, a partnership, or the individual coshareholders or partners of the insured. Thus, there is no AMT concern with a cross purchase type agreement.
- The general rule that life insurance proceeds are income-tax free may not apply where there has been a transfer for valuable consideration. If a life insurance policy or an interest in a policy is transferred for valuable consideration, proceeds exceeding the consideration paid plus any premiums paid after the transfer may be subject to income tax at ordinary rates.
- For life insurance contracts entered into after August 17, 2006, certain requirements must be met for the death proceeds of an employer-owned life insurance contract to be received income-tax free. One set of requirements is that before an employer-owned life insurance contract is issued the employer must meet certain notice and consent requirements. The insured employee must be notified in writing, at the time the contract is issued, that the employer intends to insure the employee’s life, and the maximum face amount the employee’s life could be insured for. The notice must also state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured must also give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment.
- The payment of premiums by a corporation that is the beneficiary of a policy on the life of a shareholder will not be taxed to the shareholder as either a constructive dividend or as salary.
But if the corporation pays premiums for a policy owned by one shareholder on the life of another, that payment is likely to be considered a distribution of dividends to the policyowner-shareholder. Likewise, if a corporation pays premiums on the life of an insured employee and the proceeds are payable to the estate or personal beneficiary of the employee, the premiums will be includable in the employee’s income.
- Typically, there will be no accumulated earnings tax problem where cash values accumulate in policies used in funding a stock redemption. Amounts accumulated to fund life insurance for stock redemptions are considered to satisfy a reasonable business need and, thus, are not subject to the accumulated earnings penalty tax. But planners should take care to document the business purposes (as contrasted with shareholder) served by the accumulation. The accumulated earnings tax is not a problem when life insurance is owned on a cross purchase basis because no corporate funds are involved.
- Where shareholders own insurance on the life or lives of other shareholders (a cross purchase plan), at the death of one shareholder, the policy or policies owned by the other shareholders on his life will not be includable in his estate. But the cash values (plus premiums paid but unearned on the date of his death) of the policies the decedent owned on the surviving shareholders’ lives will be included in his estate.
There should be no estate tax inclusion of the life insurance proceeds if the corporation (in the case of a stock redemption) is the owner and beneficiary of the policies. However, planners should check the terms of the buy-sell agreement to determine the degree to which policy proceeds are excluded from the price paid to the deceased shareholder’s estate. This is a major decision in drafting a buy-sell plan: if the value of insurance proceeds received under a stock redemption plan is ignored, it can be argued that the surviving shareholders receive a windfall at the expense of the decedent shareholder’s family.
Perhaps the best solution is for the purchase price to include the cash values (but not the death benefits) of the policies on the lives of all shareholders. This is appropriate because the cash values represent a corporate asset to which the insured shareholder had indirectly contributed.
- There appear to be two sets of tests for determining whether the formula price for the stock set forth in a buy-sell agreement will fix the value of the stock for estate tax purposes. The first applies where the buy-sell is between parties other than the “natural objects of the others’ bounty”. The second, more difficult set of tests, applies when the buyer and seller are either family members or the natural objects of each other’s bounty.
When the buyer and seller are not the natural objects of the others’ bounty, courts will generally accept the formula price as the value of stock for estate tax purposes if the sales price in the buy-sell agreement meets the following requirements:
The estate must be obligated to sell the stock at a shareholder’s death.
The price must be fixed by the terms of the agreement or the agreement must contain a formula or method for determining the price.
The agreement must prohibit the owner from selling the stock during lifetime without first offering it to the other party or parties at a price that does not exceed the death time price.
The price must be fair at the time the agreement is entered into.
When the buyer and seller are natural objects of the others’ bounty, courts will generally accept the formula price as the value of stock for estate tax purposes only if the sales price in the buy-sell agreement meets the requirements above and, in addition:
- the document must represent a bona fide business agreement;
- the agreement must not be a device to transfer the stock to the family or other natural objects of the transferor’s bounty for less than full and adequate consideration in money or money’s worth; and
- the agreement’s terms must be comparable to terms that similar businesses would agree to in a similar arm’s length transaction.
As a practical matter, these rules imply that the buy-sell price must be determined by formula, the formula must be based on currently accepted valuation techniques, and the formula price must approximate the fair market value of the business interest at the date of the triggering event. Further, the formula must be generally recognized as suitable to valuing the type of business involved; at the time the buy-sell is signed, it must be the result of good faith arm’s length bargaining.
If all of the requirements above are met, the price at which a deceased stockholder’s shares must be sold under a buy-sell agreement will bind the IRS and the courts as the estate tax value of the stock.
No taxable gift occurs upon the execution of a buy-sell agreement. Likewise, sales required under the agreement should not be taxable gifts because adequate consideration is given to all parties through their mutual promises, and because the agreement and sales are transactions in the ordinary course of business.
A buy-sell agreement will not usually fix the gift tax value of stock because most agreements either prohibit gifts without the written consent of the other shareholders or permit gifts only after the shareholder first offers to sell the shares to the other shareholders. But, in the authors’ opinion, a well drafted buy-sell agreement (i.e., one which meets the requirements for binding the IRS to the value set where the parties are the natural objects of the others’ bounty) should be considered highly relevant and will probably succeed in establishing a gift tax value.
The nonexcercise of a favorable purchase right under a buy-sell may have gift tax implications. It is possible that the IRS could argue that the waiver of an option to buy stock under a buy-sell agreement is, itself, a taxable gift to the extent the holder of the right to buy chooses not to require the sale and a family member benefits by this inaction.
Cross Purchase Agreements
When a cross purchase form of buy-sell is used, upon a sale triggering event (such as death, long-term disability, or retirement), the seller is required to sell shares to the other shareholders at the price and conditions set in the agreement. Any gain on the sale is a capital gain (regardless of the character of the corporation’s underlying assets).
If the seller is the shareholder’s estate, and the stock is sold shortly after the shareholder’s death, there is usually little or no gain realized by the estate. This is because the estate’s income tax basis is the federal estate tax (fair market) value of the stock on the date of death.
A cross purchase is advantageous from the perspective of the purchasing shareholders. They increase the income tax basis in their total stock interests by the price they pay for the stock bought under the agreement (even if tax-free life insurance proceeds provided the cash for the purchase). So if a surviving shareholder decides at some later date to sell his interest, because of the increase in basis, his gain on the sale will be lower.
Example. If a shareholder paid $500,000 to the estate of a deceased co-shareholder, the stock he just purchased would now have a $500,000 basis. If that stock was later sold by the surviving shareholder for $700,000, only the $200,000 gain would be taxable. Contrast this with a stock redemption where the survivor gets no increase in basis no matter how much the corporation pays for the deceased shareholder’s stock.
Stock Redemptions
As discussed below, a stock redemption has several potential disadvantages when used with a C corporation. However, it should be noted that these disadvantages can be eliminated or mitigated when used with a pass-through entity, such as a partnership, limited liability company (LLC), or S corporation.
Tax Disadvantages:
Lack of step up in basis – when the business interest of a departing or deceased owner is purchased by the business, the pro rata interest of the remaining owners is increased. However, their basis in the business remains the same. This means that if they later sell their interest in the business during their lifetime, there may be adverse capital gain consequences. This is especially the case with C corporations.
In the case of an entity purchase arrangement involving a pass-through entity that is funded with life insurance, the remaining owners will receive a basis increase to the extent of the receipt of the tax-free death proceeds by the business. This basis increase can be fully allocated to the surviving owners by putting such a provision in the partnership or LLC operating agreement, or in the case of a S corporation, by electing to terminate the tax year and causing the death proceeds to be received in the next tax year. If it is a lifetime buy-out of an owner, then no death proceeds are paid to the entity and there is no basis increase. Thus, lifetime entity purchase buy-outs result in a lack of step up in basis to the remaining owners of pass-through entities.
Alternative Minimum Tax (AMT) – the receipt of the income tax-free life insurance death proceeds by the business may trigger the AMT. This should only be an issue for C corporations. It should not be an issue for entity purchase arrangement involving pass-through entities, as pass-through entities are not subject to a separate AMT (the individual AMT may apply to the owners).
Dividend treatment of sales proceeds – For entity purchase arrangements involving C corporations, the IRS may treat the redemption price amount as a dividend to the shareholder selling the stock. Once again, this should not be an issue for entity purchase arrangements involving pass-through entities (with the possible exception of an S corporation that was formerly a C corporation). Unless the transaction meets certain tests, a corporate distribution in redemption of its stock is classified and taxed as a dividend. That means every cent paid to the seller (not just the gain) is taxable in full, generally at capital gains rates, to the extent of the shareholder’s share of corporate current and accumulated earnings and profits. No credit or offset is allowed for the selling shareholder’s basis, no matter how large it may have been or how that basis was obtained. The result when the redemption occurs during lifetime may not be so dramatic but in comparison to the typically favorable tax implications when the sale occurs after a shareholder’s death, dividend treatment is a tax misfortune.
Example. Assume the following:
The client’s stock is to be purchased at his death for $1,000,000 ($1,000 per share for 1,000 shares).
The corporation has accumulated earnings and profits far in excess of the distribution.
At the client’s death, if the redemption is taxed under sale or exchange rules, the estate realizes $1,000,000, its income tax basis is $1,000,000, and it recognizes no gain because the amount it has realized does not exceed its basis. So the tax is zero.
But if the redemption is taxed as a dividend, the estate realizes $1,000,000 of ordinary income and its basis does not reduce that income. State and federal taxes would likely exceed $150,000.
Safe Harbor
Code section 302 provides that a redemption will be treated as a sale or exchange if the redemption meets any of the three following tests:
The redemption is not equivalent to a dividend.
The redemption is substantially disproportionate with respect to the shareholder (the shareholder’s interest in the corporation after the redemption is less than 80 percent of his or her interest before the redemption, and the shareholder’s interest after the redemption is less than 50 percent of the total combined voting power of all shares).
The redemption completely terminates the shareholder’s interest in the corporation.
Planners cannot rely on the first test because it is one that can be determined only after the fact. And, as with much of the tax law, neither the substantially disproportionate nor the complete termination test is as easily met as it would appear when there are certain relationships between the seller and other parties who own (or who are deemed to own) stock.
Meeting either of these tests when the corporation is family-owned is extremely difficult because of the attribution (constructive ownership) rules of Code section 318. In a nutshell, stock is owned constructively by (treated as if owned by) the seller if it is actually owned by certain family members or entities in which the shareholder holds an interest.
So in the typical family-owned business in which all stock is held by parents and their children, the sale of stock back to the corporation—even if it is all the stock the seller actually owns—may be neither substantially disproportionate nor a complete termination of the selling shareholder’s interest because the seller is deemed to own stock actually owned by others.
Example. Assume the following:
1. Out of 1,000 shares outstanding, the client and his wife each own 250 shares of their family corporation’s stock.
2. The client’s son and daughter each own 250 shares.
3. At the death of a shareholder, the buy-sell agreement requires the corporation to purchase all the shares the decedent owned from his estate.
4. The purchase price is $1,000 a share.
5. The client dies and leaves his entire estate to his wife.
6. His executor receives the 250 shares at the client’s death and under the agreement sells the stock to the corporation which pays the estate $250,000 in return.
The $250,000 payment the corporation makes to the executor in return for the stock is treated as a dividend rather than a sale or exchange. Why? Because the estate is deemed to own—both before and after the transaction—100 percent of the corporation’s stock.
Under the attribution rules, the client’s widow is deemed to own the 500 shares of stock actually owned by her two children. Of course, the widow also actually owns her own 250 shares. The client’s estate is deemed to own the stock owned by its beneficiary, the client’s widow. So, due to the attribution rules, before the redemption the estate is deemed to own 100 percent (1,000) of the 1,000 outstanding shares of the corporation. After the redemption, the estate is still deemed to own 100 percent of the 750 shares still outstanding.
There is a limited way to break this link between family members called a “waiver of family attribution.”5 The selling shareholder can waive (cut the string on) the family attribution rules and treat the transaction as a substantially disproportionate or complete termination of interest—but only if all three of the following additional requirements are met:
During ten years prior to the redemption, the selling shareholder must not have transferred any stock to or received any stock from someone from whom the stock would have been attributed to the seller (unless the seller can prove that the transfer did not have avoiding federal income taxes as one of its principal purposes).
Immediately after the redemption, the seller must have no interest in the corporation (other than as a creditor), including interests as an employee, officer, or director.
The seller must agree not to acquire any interest in the corporation (other than as a creditor) during the next ten years and to notify the IRS if a prohibited interest is acquired during this period.
Sale or Exchange by the Selling Shareholder
This last resort safe harbor is known as “Section 303 redemption.” It applies only if the sale of stock occurs after a shareholder’s death and thus will not protect the seller in a lifetime redemption. In general terms, to qualify for a Section 303 redemption and its protection against dividend treatment, the stock owned by the deceased shareholder must have comprised a substantial portion of his or her estate.
More specifically, Code section 303 allows sale or exchange treatment on the redemption of closely-held stock to the extent of the estate’s federal and state death taxes, administrative expenses, funeral expenses and generation-skipping transfer taxes.
To qualify for this favorable treatment, the stock owned by the decedent must comprise more than 35 percent of the adjusted gross estate (defined as the decedent’s gross estate less deductible losses and expenses).
Stock can be redeemed under the umbrella of section 303 only to the extent it generates an estate tax. So in many clients’ estates, because of the unlimited marital deduction and the unified credit, the amount of stock that can be redeemed is minimal. Further limiting the usefulness of section 303 is the requirement that it applies only to the extent that the redeemed shareholder’s interest is reduced directly (or through a binding obligation to contribute to the tax) by any payment of estate taxes or expenses. This makes it impossible for the trustee of the client’s marital trust to safely sell stock back to the corporation under section 303 because such trusts specifically forbid the payment of taxes.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM