Many closely-held companies conduct business as an S Corporation because of the numerous tax advantages this structure affords. Less well known, however, is the S Corp. advantage in business continuation planning: the ability to use the corporate redemption to get for surviving shareholders a full increase in basis. This article attempts to explain this concept with a hypothetical case study illustration.
Best practices of a buy-sell agreement
First, let’s look at a key component in business continuation planning, the buy-sell agreement. There are two major types of buy-sell agreements: the entity redemption plan and the cross-purchase plan. With a redemption plan, the business enters into a contract with the owners to purchase each owner’s interest, at a specified time. In the cross-purchase arrangement, the owners establish an agreement among themselves to buy and sell the stock. The business entity is not a party to the arrangement.
Each type of buy-sell agreement holds advantages and disadvantages, depending on the goals and objectives of the business owners. Typically, however, most owners look for a buy-sell agreement that:
o Is easy to understand and administer.
o Affords the surviving owners with a greater percentage ownership in the business.
o Increases the basis in the business for the surviving owners.
o Does not encounter a problem with the transfer for value rule, which converts life insurance proceeds into taxable income.
In addition, if the buy-sell agreement is funded with life insurance, it is typically desirable to acquire one policy per owner.
Pros and cons
A cross-purchase agreement with 3 owners or more will typically be subject to the transfer for value rule. An entity purchase may present a problem in that the arrangement increases the basis of the surviving business owners.
A “C corporation,” as a stand-alone entity, is independent of its shareholders. It is a separate taxpayer, as are its shareholders. Therefore, life insurance proceeds that a C Corp. receives to fund an entity redemption stay with the corporation and do not increase the surviving shareholders’ basis in the business.
The treatment of life insurance proceeds by an S corporation is handled differently. Because the S Corp.’s is not considered a separate taxable entity apart from its shareholders, income and deductions “pass through” to the shareholders. Life insurance proceeds received by an S Corp. increase the basis of all shareholders.