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Tax Planning for Business Succession and Stock Purchase Agreements

By Tax Facts Online

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Will sale of a deceased’s stock under a cross-purchase insurance-funded buy-sell agreement result in income tax liability to the deceased’s estate?

Normally, no taxable gain will result to a deceased’s estate if stock is sold to surviving individual shareholders at its full market value under a standard buy-sell agreement. At the stockholder’s death, the stockholder’s stock receives a new tax basis equal to its fair market value at the time of death.   Because the sale price under a properly designed buy-sell agreement usually is accepted as the fair market value of the stock, the basis and sale price normally will be the same. Consequently, there should be no capital gain. Since individuals, rather than the corporation, purchase the stock, the payment cannot be regarded as a dividend However, if the parties to the buy-sell agreement are related, additional caution should be taken to determine that the sale price under the buy-sell agreement is reasonable.

What are the income tax consequences of funding a stock purchase agreement with life insurance?

Premiums: Regardless of whether a stockholder pays premiums on a policy on the life of another stockholder or on a policy on the stockholder’s own life to fund an agreement, the stockholder cannot deduct premium payments.

If stockholders attempt to use company-paid group term life insurance to fund their buy-sell agreement, the company may be denied a deduction for its premium payments. The IRS has held that premium payments under these circumstances are not related to a corporation’s trade or business. Premiums paid by an insured’s associate stockholders are not taxable income to the insured. If a corporation pays premiums on insurance to fund a buy-sell agreement between individual stockholders, premium payments will be taxable dividends to those stockholders.

(Related on ThinkAdvisor: 23 Days of Tax Planning Advice: 2017)

Death Proceeds: When each survivor applies the tax-free proceeds received to purchase stock from a deceased’s estate, .death proceeds are received free of income tax by surviving stockholders

Cost Basis: The amount a survivor pays an estate for stock becomes the survivor’s cost basis in the stock. This cost basis will be used to calculate the survivor’s gain or loss should the survivor dispose of the stock during the survivor’s lifetime. If a survivor holds stock until death, the estate will receive a stepped-up basis in the stock.

A cross-purchase agreement commonly gives each survivor a right to purchase from the deceased’s estate the un-matured policy on the survivor’s own life. If an agreement calls for transfer of a policy without cost to an insured, it would seem that the insured’s cost basis for the stock should be reduced by the value of the policy.  

Compared to a stock redemption agreement, use of a cross-purchase agreement between stockholders provides flexibility to convert to a stock redemption agreement using the same life insurance policies, which provides the surviving stockholders with an increased cost basis, avoids increasing the estate tax value of the decedent’s estateand does not expose death benefits to the alternative minimum tax.

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

Premiums: A corporation cannot deduct premium payments because 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. 

Death proceeds: Funds received from death proceeds are ordinarily tax-free although may be subject to tax under the corporate alternative minimum tax.  In addition, death proceeds may be taxable if requirements for employer-owned life insurance are not met.

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.  

In the case of an S corporation, each shareholder’s basis is increased by the shareholder’s share of the tax-free death proceeds when they are received by the corporation.

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.

Effect on Corporate Earnings and Profits: The IRS takes the position 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 premiumshave been deducted from earnings and profits.

— Related on ThinkAdvisor: 23 Days of Tax Planning Advice: 2017

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