You’ve heard it many times: Change is good. Well, maybe that’s true when you’re talking about a new house or a promotion at work, but when it comes to small-business plans, change can have unexpected repercussions.
Consider this scenario: At the urging of one of his advisors, a business owner client calls to tell you that he wants to convert the plan you carefully developed for him–an entity buy-sell arrangement–to a cross-purchase buy-sell arrangement.
The entity arrangement you set up provides cash for the company to purchase business interests through life insurance. And, you’ve periodically reviewed your client’s situation to make sure the death benefit covers the increasing value of the business. But if you’re to fund a new cross purchase buy-sell arrangement using your client’s existing life insurance, you’ll need to change the policy ownership and the beneficiary.
But before responding to your client’s request, you need to determine if there are broader implications.
You check your records and note the business is an “S” corporation with 2 owners: Robert, 62, and Melissa, 58. When you worked with them to set up their buy-sell arrangement several years ago, you convinced them to fund the agreement with life insurance.
After all, you noted, they would need money to make sure the business could afford to purchase the deceased’s stock without impairing the financial stability of the business. (The business would have an obligation to buy the deceased owner’s portion of the business–in essence, a liability. And life insurance offset that liability.)
When you set it up, the entity arrangement made sense, and it probably still makes sense today. However, one of your clients’ other advisors convinced them that a cross-purchase arrangement would better suit their needs. That’s most likely because the step-up to current market value in basis treatment for the surviving owner is not fully available in the entity plan.
In an S corporation, basis is constantly adjusted, increased by income received and decreased by expenses paid and distributions made to shareholders. Life insurance proceeds paid to an S corporation increase a shareholder’s basis in stock. So, at death, the deceased shareholder’s stock receives a proportional increase upon receipt of the life insurance proceeds. Though this doesn’t have the same step-up effect as in a cross-purchase, it softens the impact of a stock redemption on basis for the surviving shareholder.