Sometimes it’s difficult to decide which type of buy-sell agreement to recommend when dealing with C Corporations. Should it be a stock redemption plan funded with employer owned insurance or a cross-purchase plan funded by cross-owned insurance?
We know the surviving shareholder gets a 100 percent cost basis increase when purchasing the shares from the estate of the deceased shareholder using a cross-purchase plan. On the other hand, the surviving shareholder gets a 0 percent cost basis increase using a stock redemption.
Many retail, wholesale, and manufacturing C Corps retain significant earnings and profits (E&P) on their balance sheets for business purposes. These E&P can normally be reduced only by a taxable dividend to the shareholders.
However, these accumulated E&P can be distributed tax-free as part of a proportional stock redemption under IRC Section 312(n)(7). This transaction would be a desirable tax accounting strategy if it can be accomplished.
Given a choice between both positive results, is there a way we can get both a 100 percent cost basis increase for the surviving shareholder and a tax-free reduction of E&P under IRC Section 312(n)(7)? The answer is yes, and the strategy to accomplish both is a “Wait and See” optional buy-sell agreement coupled with cross-ownership of the life insurance policies. In a “wait and see” plan, option 1 is cross-purchase, option 2 is stock redemption, and mandatory option 3 is back to cross-purchase.
Let’s take a look at a simple case study to illustrate the effectiveness of this “wait and see” plan.
The facts of the case:
For example: Assume the C Corp is owned 50-50 by A and B and has a fair market value for buy-sell purposes of $4,000,000 ($2,000,000 each for A and B). The C Corp has a book value of $3,000,000 which consists of $2,800,000 of retained E&P and $200,000 of original cost basis contributed equally by A and B when they formed the company many years ago.
The shareholders and the corporation enter into a “Wait and See” Optional Buy-Sell Agreement. They purchase $2,000,000 of life insurance each with A as the owner and beneficiary on B’s life and B as the owner and beneficiary on A’s life (cross-ownership). The company provides taxable bonus compensation to the shareholder-employees to pay the annual premium.
At B’s death, the transaction sequence could proceed as follows for a 50-50 shareholder case:
1) A collects the $2,000,000 income tax free life insurance death proceeds on B’s life (cross ownership).
2) C Corp and A waive option 1 (cross-purchase) and select option 2 (stock redemption). The corporation redeems B’s stock in exchange for a short term note payable to B’s estate using the short term AFR rate as the interest rate.