A stock purchase agreement (commonly referred to as a buy sell agreement) is an arrangement for the disposition of stock in the event of certain contingencies such as death, disability, retirement or the withdrawal of a shareholder from the business. Stock purchase agreements are useful when:
There is a need to restrict the transfer of stock to undesirable third parties.
There is a need to "guarantee" a market for stock that is otherwise illiquid in the event of death, disability or retirement.
There is a desire to formalize "continuity" in the family business (rather than relying on revocable will provisions).
Stock purchase agreements commonly take the form of either a stock redemption agreement or a cross purchase agreement.
Under the stock redemption approach, the corporation agrees to purchase the stock of a deceased or withdrawing shareholder. In the case of a life insurance funded stock redemption agreement, the corporation is the payor, owner and beneficiary of insurance on the lives of each stockholder.
Under the cross purchase approach, each stockholder agrees to purchase the stock of the deceased or withdrawing stockholder. In this scenario, each stockholder is the payor, owner and beneficiary of a policy on the lives of each of the other stockholders. The number of policies needed can be calculated by using the following formula: x(x-1) where x = the number of shareholders.
There is no income tax deduction for premium payments on life insurance policies funding any type of buy sell agreement.
Life insurance policy proceeds are ordinarily received income tax-free by the corporation (in a stock redemption plan) or by the surviving shareholder (in a cross purchase agreement). The transfer for value rule must be avoided. Because buy-sell agreements are commonly funded with life insurance, and it is sometimes determined to be advantageous to make changes in the ownership of the policies involved, care must be taken to avoid the transfer for value trap in connection with any such transfers.
Cost Basis
In a cross purchase insurance funded buy sell agreement, there will normally be no taxable gain to the deceased shareholder's estate. At the deceased shareholder's death, his stock receives a step up in basis equal to its fair market value at the date of death. Code §1014. The amount the surviving shareholder pays the estate for the stock becomes his cost basis in the stock.
In a stock redemption insurance funded buy sell agreement, the policy proceeds become part of the general assets of the corporation, thereby increasing the value of the stock of the survivors by an amount equal to the difference between the policy proceeds and the cash surrender value prior to death. The cost basis of the survivor's stock will not be increased.
Generally, an S Corporation buy sell agreement funded with life insurance will tend to more closely even up the income tax treatment of redemption and cross purchase agreements, because the insurance proceeds increase basis (pro rata among the shareholders). For this purpose, the basis increase would be equal to the total proceeds minus cash value. There are still differences though. With a cross purchase agreement, all basis increases are allocated to the surviving shareholders, while in a stock redemption, it is pro rata among all stockholders (including the estate of the deceased stockholder). See example below.
Example of Stock Redemption Plan in a S Corporation:
Mr. A owns 50% of shares (basis of $100,000).
Mr. B owns 50% of shares (basis of $100,000).
Total value of corporation is $2,000,000.
A & B are each insured for $1,000,000, owned by the corporation.
A dies.
Results:
Tax free proceeds are received by corporation--which increases A’s basis by $500,000 and B’s basis by $500,000 (Code §1367).
Corporation redeems A’s shares for $1,000,000.
The $500,000 increase in A’s basis is wasted because A’s estate receives full stepped up basis of $1,000,000 for A’s shares (Code §1014).
B’s basis is now $600,000 ($100,000 plus $500,000).
If B sells his shares during his lifetime for $2,000,000 he will have a taxable gain of $1,400,000.
One possible way to avoid wasting some of the basis increase (i.e., the part that goes to the estate of a deceased shareholder) is to terminate the S Corporation’s tax year under Code §1377(a)(2) at A’s death and shift the basis adjustment attributable to the life insurance proceeds to the following taxable year (when the surviving shareholder does not have to share the basis increase with the deceased shareholder’s estate). Of course, a cross purchase agreement avoids this whole problem to begin with.
Avoiding dividend treatment and "disappearing basis" in C Corporation stock redemption.
The general rule is that any payment by a corporation (other than an S corporation) to a shareholder will be treated as ordinary income (a dividend) rather than a capital transaction (sale or exchange), even if the payment is made to redeem stock.
If a payment is treated as a dividend, the entire amount will be taxed as ordinary income, with no recovery of basis. To avoid this treatment, there must be a qualifying redemption under Internal Revenue Code Section 302 or Section 303.
Estate Tax Issues
Special valuation rules govern the tests for estate tax value recognition of values set out in buy sell agreements. Internal Revenue Code Section 2703.
Attorney Adler focuses his practice on estate planning, wills, trusts and estates. He can be reached at 212-843-4059 or 646-946-8327.