307 / What are the income tax consequences of funding a stock redemption agreement with life insurance?

The IRS does not consider premiums paid by a corporation under a stock redemption agreement to be ordinary and necessary business expenses. Furthermore, regardless of whether a corporation, trust, or insured’s spouse or estate is named beneficiary in a policy, the corporation either directly or indirectly is a beneficiary under the policy because the proceeds will be used to discharge its obligation to redeem the stock. Consequently, the corporation cannot deduct the premium payments ( Q 264).¹

Moreover, regardless of who is named beneficiary, premium payments are not taxable income to stockholders if a corporation owns the policy and the right of a beneficiary to receive proceeds is conditioned on the transfer of stock to the corporation ( Q 8768).

Death Proceeds

Death proceeds ordinarily are received tax-free.² Prior to 2018, death proceeds may have been subject to tax under the corporate alternative minimum tax ( Q 316), which was repealed by the 2017 tax reform legislation.³ In addition, death proceeds are taxable unless a status exception exists and notice and consent requirements for employer-owned life insurance are met ( Q 8776).

Cost Basis

Because proceeds become part of a corporation’s general assets, the value of stock owned by each surviving stockholder will be increased by a share, proportionate to his or her stock interest, of the difference between the death proceeds and the cash surrender value prior to death. The cost basis of a survivor’s stock will not be increased. Consequently, the increase in value due to the insurance may result in some additional gain if a survivor sells the stock during the survivor’s lifetime. If a survivor holds the stock until death, the stock will receive a new tax basis equal to its fair market value at the time of the survivor’s death, thus eliminating this effect. Decedents who died in 2010, however, may not receive a full step up in basis.⁴

For the result under a stock purchase plan, see Q 299.

In the case of an S corporation, each shareholder’s basis is increased by the shareholder’s share of the death proceeds, whether taxable or not, when they are received by the corporation.⁵

A corporation has no income tax basis problem; even if redeemed stock is carried as treasury stock and subsequently is resold, the corporation realizes no gain regardless of basis.⁶

Effect on Corporate Earnings and Profits

Revenue Ruling 54-230⁷ states that earnings and profits will be increased by the excess of insurance proceeds over aggregate premiums paid, apparently on the assumption that no part of premiums have been deducted from earnings and profits. For taxable years beginning after July 18,
1984, if a corporation distributes amounts in a redemption under IRC Sections 302(a) or 303, the part of the distribution properly chargeable to earnings and profits is an amount not in excess of the ratable share of the earnings and profits of the corporation accumulated after February 28, 1913, attributable to the stock redeemed.⁸ The Conference Committee Reports from TRA 1984 indicate that priorities between different classes of stock may be taken into account in allocating earnings between classes and that redemption of preferred stock that is not convertible or participating to any significant extent in corporate growth should be charged to the capital account only.⁹

See also discussion of accumulated earnings tax in Q 308.