What was once considered a cutting edge type of business organization has now become mainstream: S corporations dominate the choice of tax entities. This is true in spite of the explosion of pass-through entities taxed as partnerships.

One motivation for forming an S corporation is the ability to secure both the limited liability of a C corporation and the conduit tax treatment of a partnership. Also, selling an S corporation is often tax-efficient, and losses from riskier ventures can be passed through to offset income earned outside the business. Thirdly, owners are often motivated to save payroll taxes through corporate distributions rather than take income as wages.

There are, too, estate and business exit planning opportunities for S corporations. It follows advocates of solutions that address S corp owners’ needs will get the “leg-up” on the competition. The proliferation of S corps has brought forth techniques tailored to achieve the owners’ financial goals. The remainder of this article discusses how these stratagems can be leveraged with life insurance.

S Corporation opportunities just below the surface

Two concerns quickly dominate every discussion regarding transferring a family business: taxes and control. Too often, these issues threaten the existence of a business while undermining a successful transition to junior family members. This modern Scylla and Charybdis represent twin challenges that even the best financial professionals may be hard-pressed to successfully navigate.

Financial professionals who capitalize on smart solutions just below the surface will successfully plot a course through these troubled waters. The sale of an S corporation to an intentionally defective irrevocable trust (IDIT) may represent just such an opportunity.

Selling an S Corp to an IDIT: taxes and control

An intentionally defective irrevocable trust may be the perfect device to transfer a family-owned S corporation to the next generation. With a properly drafted trust, considerable tax and control leverage may be achieved. The parents are considered owners of the business for income tax purposes while the trust is treated as a separate entity for transfer taxes. Establishing an accurate initial valuation through a certified business appraiser is vital to prevent unwelcome IRS scrutiny.

Initially, the trust is established and funded with “seed money” to ensure the trust is deemed a bona-fide purchaser of the transferred asset. Typically, 10% of the transferred asset is sufficient for funding; a portion of the parent’s respective $1 million gift tax exemption can be used for this purpose. The parents can then recapitalize the business into voting and nonvoting stock. This does not create a prohibited second class of stock as long as the difference in voting rights does not create unequal distribution and liquidation preferences.

The parents then sell a large portion of the nonvoting shares to the IDIT in return for a promissory note. Because the IDIT is made defective, the parents recognize no gain or loss on the sale. Further, the payment of income taxes attributable to the trust are not considered gifts to the trust beneficiaries.

The parents can spend down the estate without using their annual gift tax exclusion or gift tax exemption. Consequently, the trust can accumulate more wealth for the beneficiaries than would be possible if the trust were responsible for payment of taxes. The result is a highly effective “estate freeze,” as all income and appreciation within the trust enhances the inheritance for the grantors heirs.

Further goals can be accomplished if an interest only note is used to purchase the stock. With interest rates at historic lows–the long-term applicable federal rate is currently 4.6%–the estate freeze can be maximized because the interest obligation can be funded with business profits rather than purchased assets.

Most importantly, sufficient cash flow exists to purchase a life insurance policy on the parents equal to the approximate value of the loan principal due the parents. Additional gifts to the trust can be avoided, as the assets to make premium payments exist within the irrevocable trust. This is an extraordinarily powerful technique to pay off the balloon payment without spending down trust assets.

The real value of selling nonvoting S corporation stock is this: The measure of the purchase price for the installment note is based on the post-discount value after applying marketability and minority discounts. In other words, the interest-only note is based on the lower discounted value (often 20%-30%) while the non-discounted value of the shares grows within the trust.

This further enhances the estate freeze as the pre-discount value of the transferred shares appreciates outside the parent’s estate. All the while they remain in practical control through their voting shares. In fact, they can often control their own taxable income by strategic adjustments of dividend distributions.

At death, life insurance purchased within the trust pays off the note while business assets pass through the trust to the adult children. The parents’ voting shares, accompanied by any remaining business interests, can pass outside the trust through a will. The result? The twin dangers, taxes and control, have been successfully navigated by employing a smart opportunity just under the surface.

The S Corporation stock redemption: landmine or undiscovered opportunity?

Transferring a business during life presents its own challenges. Cross-purchase agreements are often favored because surviving owners receive a step-up in tax basis. However, this arrangement quickly becomes unwieldy as each owner must possess a policy on every other owner.

On the other hand, entity agreements present distinct advantages that are difficult to overlook. Only one life insurance policy per owner is necessary and any disparity in premium due to age or health is borne by all the owners through corporate ownership. Although a lack of full step-up in basis appears to be the Achilles’ heel of an entity agreement, a look beneath the surface reveals an S corporation buy-sell can avoid such a pitfall.

The unique pass-through nature of an S corporation allows the tax-exempt life insurance death benefit to increase the basis of the surviving shareholders on a pro-rata basis. Unfortunately, when life insurance proceeds are received in the same tax year as redemption, a portion of this basis increase is allocated to the estate of the deceased owner. Since this shareholder already receives a step-up in basis to fair market value under existing rules, this portion of the proceeds is arguably wasted for tax purposes. A solution lies just below the surface.

The buy-sell agreement can be structured so the basis increase from the insurance proceeds fully accrues only to the surviving shareholders. The entire deceased shareholder’s stock is redeemed through a promissory note prior to filing the insurance claim and receiving the insurance proceeds. The remaining shareholders can elect to close the corporation’s books using a short-year election.

According to the Internal Revenue Code, if any shareholder terminates an owner’s interest during the tax year, the taxable year will be deemed to consist of 2 taxable years, the first of which ends on the date of termination. The insurance claim can then be filed and the S corporation can collect the proceeds. All the basis increase is allocated to the surviving shareholders by virtue of the termination of the deceased interest prior to filing the insurance claim.

Ascertaining the ideal arrangement for a buy-sell agreement requires a careful balancing between tax and practical issues. Life insurance can be an effective tool to leverage a step-up in basis. A strategically timed short-year election may enable the owners to further reduce their future tax exposure while retaining the traditional advantages of an entity buy-sell agreement.

The sheer number of S corporations demands innovative and valuable strategies for business owners seeking to preserve and protect their business. Fortunately, estate and business transfer opportunities with S corporations are readily available for those seeking solutions. Just take a look beneath the surface.