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.
3) This tax-free redemption reduces the corporation’s balance sheet E&P by 50 percent ($1,400,000) for tax accounting purposes under IRC Section 312(n)(7).
4) A uses the tax-free life insurance proceeds to make a capital contribution (“paid-in” capital on balance sheet) to the corporation of $2,000,000. This capital contribution increases A’s cost basis in the shares by 100 percent of the contribution. A’s cost basis is now $100,000 (original basis) plus $2,000,000 (paid-in capital) = $2,100,000.
5) The corporation uses the $2,000,000 capital contribution to pay off the note and minimal interest to B’s estate.
6) B’s estate transfers this cash payoff through the estate to the surviving spouse and family of B to maintain their lifestyle.
7) A is now the 100 percent owner of the C Corp with a cost basis of $2,100,000 for purposes of any future lifetime sale of the business to a third party. The potential capital gain on this future sale is reduced significantly because A’s cost basis was increased to $2,100,000 rather than only $100,000 if a stock redemption using employer owned life insurance had been utilized.
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