Beat The Drawbacks Of Stock Redemption Plans

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Most planners agree that the biggest drawback to a buy-sell redemption plan for an S-corporation is its failure to result in a stepped-up basis for the remaining owner.

This, however, may not always be the case. With a carefully designed plan, the surviving owners of an S-corporation can receive a step up in basis, even when structured as a redemption plan.

The type of buy-sell arrangement that a company chooses is at least, in part, often dictated by shareholder basis considerations. Adjustments to shareholder basis differ depending on whether stock is transferred as a result of a cross-purchase, stock redemption, a dividend, or death. S-corporations traditionally present tax, attribution, and basis buy-sell challenges, which generally preclude consideration of a stock redemption plan.

However, an S-corporation stock redemption buy-sell arrangement funded with life insurance can be structured to produce a step up in basis on the deceased shareholders interest for the remaining shareholders.

The best client profile for this technique is a corporation that has two shareholders, with the business likely to be sold at the death of the first shareholder. It is also better if the shareholders are not first and second-generation family members (fathers/sons; mothers/daughters).

First and second-generation family members who own stock, where one shareholder is included in the will or estate of the other shareholder, will have attribution issues at the death of the shareholder who has included them in the will.

Where an S-corporation was formerly a C-corporation and has substantial Accumulated Earnings and Profits (AE&P), this technique can also result in an AE&P reduction.

For example, lets assume that Bill and Jill are brother and sister. They are equal shareholders of a cash basis S-corporation that used to be a C-corporation. Each has a $50,000 basis. As a result of its previous structure, they also have $250,000 AE&P. The corporation value is “pegged,” in compliance with IRC 2703, for buy-sell purposes, at $1 million. Bill and Jill each need a $500,000 insurance policy to fund their buy-sell arrangement.

Bill is not as healthy as Jill and they are looking for a buy-sell arrangement that can help spread the cost of the insurance more evenly between them. If they use a stock redemption buy-sell, they are concerned that at the death of either of them, there would be no stepped-up basis for the deceased shareholders interest redeemed by the corporation. And, they are concerned about the high AE&P forcing a dividend.

A typical buy-sell solution that allows spreading the cost of insurance evenly and reducing the AE&P is a stock redemption buy-sell. Through the use of IRC 1377, the solution to the step up in basis concern can also be a stock redemption buy-sell. (See Treas. reg. 1.1368–1 for the detailed provisions of the technique described in this article.)

Heres how it works: Bill and Jill enter into a stock redemption buy-sell arrangement. The corporation owns a life policy on each of them with a $500,000 face value. Bill dies. Jill elects under IRC 1377 (a)(2) to close the tax year for the company “before” making the insurance claim and executes the buy-sell by paying Bills estate with a note.

Jill then opens the new tax year, and makes the insurance claim. The death proceeds come into the corporation income tax-free and are allocated pro-rata among the remaining owners (Note: some insurance proceeds for some corporations may trigger the Alternative Minimum Tax). In this case, there is only one remaining owner and 100% of the proceeds are allocated to Jill, thereby increasing Jills basis.

Jills new basis would be $550,000 ($500,000 death proceeds used to pay Bills estate for the stock received plus her original $50,000 basis). The AE&P are in turn reduced by 50% (IRC 312(n)(7)).

This technique is effective because of the income and basis rules for S-Corporations. An S-Corporation shareholders stock basis is constantly changing because all income to the corporation increases shareholder basis. Therefore, income tax-free income from the life insurance policy will increase the shareholders basis pro-rata. When there is only one shareholder the increase is allocated 100% to that shareholder.

If this had been an accrual S-Corporation, a 50% step up in basis would be possible. And a 25% reduction in AE&P would result.

This technique will also be useful where a stock redemption plan is already in place in an S-corporation. It is unadvisable to change the plan to a cross-purchase plan to achieve the stepped-up basis for two reasons:

1. ?Transfer For Value (TFV)–A policy transferred from the corporation to a co-shareholder is a TFV which would subject the proceeds to income tax; and,

?2. IRC 2703–The ability to “peg” the value of the corporation at the inception of the buy-sell arrangement depends on compliance with 2703. A material modification of the arrangement could trigger loss of grandfathering under the statute.

Buy-sell planning generally is one of the first things a business owner will do to provide an orderly and effective transfer of a business upon the death of a co-shareholder. Getting the right type of buy-sell in place in the right circumstances is crucial. At least where basis concerns are coupled with sizable AE&Ps left over from S-elections, and a need to spread the cost of the plan equally among shareholders, planning can be a little easier if stock redemption buy-sell can be included as an alternative in the decision making process.

, Esq. is director of advanced planning for the Individual Insurance Division of Sun Life Financial in Wellesley Hills, Mass. She can be reached at jane.warner@

sunlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 23, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.