S-corporations continue to be a popular entity choice for owners of closely held businesses. Based on tax returns filed, more than 3 million S-corporations exist and the numbers continue to grow. In fact, it might surprise some that in the years between 1996 and 2000, the growth in the number of S-corporations exceeded the growth in the number of limited liability companies (LLC).
The key to working in this expanding market is to understand that S-corporation owners have basically the same needs as other business owners. The wrinkle is that standard solutions often need to be tailored to fit the unique characteristics of S-corporations.
By understanding some of these unique characteristics, you can gain access to an underserved market of affluent business owners with sophisticated planning needs. Buy-sell agreements are a prime example of a need common to many closely held business owners, but which hold particular importance to the S-corporation owner.
Buy-Sell Agreements and S-Corp Advantages
Properly drafted buy-sell agreements funded with life insurance and disability insurance enhance the stability of closely held businesses by providing a smooth transition of ownership upon the death or disability of an owner. Additionally, buy-sell agreements usually restrict other transfers to prevent an unqualified or hostile party from acquiring an interest. Buy-sell agreements provide even greater value to S-corporations because the agreement can help prevent the loss of the tax benefits associated with S status.
S-corporations are simply regular C-corporations that have made a valid “S” election with the IRS. Any corporation can elect S status as long as the corporation meets certain requirements of the Internal Revenue Code.
Electing S status is popular because of the tax and legal advantages it offers closely held business owners. Just like C-corporations, S-corporations can protect the personally owned assets of shareholders from legal liabilities of the business.
The primary tax advantage of S-corporations is they generally pay no tax at the entity level. Instead, income, deductions, gains and losses “flow through” to individual shareholders, thus avoiding the “double tax” imposed on C-corporation profits.
Even with the reduction of the dividend tax rate to 15% under the Jobs and Growth Tax Act of 2003, an S-corporation owner still can pay less tax by avoiding the double tax that would be imposed on C-corporation earnings. To illustrate this, consider the example in Figure 1.
An LLC also offers the advantages of limited liability and flow through taxation, but where a C-corporation is involved, the conversion to an LLC taxed as a partnership is treated as a liquidation of the corporation, and gains would be taxed at the corporate and shareholder level. In contrast, S status could be elected without gain recognition. Additionally, because of the large body of case law on corporations, some advisors feel corporations offer greater legal protection than the more recently developed LLC.
Given these advantages, it is likely that a significant number of businesses will continue to choose to operate as S-corporations. In exchange for pass-through taxation, the Internal Revenue Code imposes restrictions on S-corporations to limit possible abuses. Violating these restrictions automatically can terminate a corporations S election. Buy-sell agreements can play an important role in preventing a termination of a corporations S status except when all shareholders agree.
S-corporations may have no more than 75 shareholders and those shareholders must be individuals (other than nonresident aliens), estates or eligible trusts. If stock is transferred to an ineligible shareholder, or if more than 75 people become shareholders, the S election terminates automatically in most cases.
If a shareholder dies and his or her shares pass to an ineligible trust, a nonresident alien or to too many heirs, S status could be terminated. A disgruntled minority shareholder could use as leverage the threat of terminating S status by transferring shares to an impermissible shareholder.
To prevent termination of the S election without the consent of all shareholders, buy-sell agreements often limit transfers. For example, the agreement may require notice to the corporation prior to all transfers and give the corporation or other shareholders a right of first refusal if an impermissible transfer is proposed. Share transfers not in accordance with the buy-sell agreement might trigger an automatic redemption or be considered void.
One Class of Stock Rule
A corporations S status terminates if it has more than one class of outstanding stock. This precludes S-corporations from issuing both common and preferred shares, and any differences in economic rights (e.g., dividend rights) among outstanding S shares may also be deemed to create a second class of stock.
Debt between an S-corporation and its shareholders can be treated as a second class of stock unless the note meets certain safe harbor requirements. Similarly, a buy-sell agreement can create a second class of stock if it provides for differences in dividend rights or liquidation preferences. However, legitimate buy-sell agreements are given broad latitude.
As with shareholder restrictions, buy-sell agreements can prevent issuance of a second class of stock unless all parties agree. The agreement could require that prior to issuance of new stock or debt the corporation must obtain an opinion of counsel that such action will not create a second class of stock.
Common shares with different voting rights are not considered a second class of stock. If the buy-sell agreement permits, nonvoting shares could be gifted to children without transferring control and may be eligible for a gift tax valuation discount.
The Role of Insurance
Life insurance and disability buy-out insurance enhance the ability of the corporation or remaining shareholders to fulfill their obligations under the buy-sell agreement. In the S-corporation context, insurance minimizes the risk that financial pressures might force shareholders into an arrangement that could threaten the corporations S status.
The value of a well-drafted and properly funded buy-sell agreement is increased for S-corporation shareholders because it can help minimize the risk of an unintended termination of S status.
, J.D., CLU, is assistant director-advanced markets for The Principal Financial Group, Des Moines, Iowa. He can be reached at firstname.lastname@example.org.
Reproduced from National Underwriter Life & Health/Financial Services Edition, February 20, 2004. Copyright 2004 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.