Beat The Drawbacks Of Stock Redemption Plans
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.