Insurance Funded S Corporation Stock Redemption Plan with Short Tax Year Election
by Russell E. Towers, JD, CLU, ChFCMr. Towers is vice-president, business and estate planning with Brokers’ Service Marketing Group in Providence, RI. Connect with him by e-mail: firstname.lastname@example.org
Successful S Corp shareholders typically have a need to create a business transfer plan to guarantee that their family will receive the fair value of their S Corp shares upon death. Given this need to provide a legal framework to accomplish this desire, it then becomes necessary to decide two important questions:
- What type of written buy sell agreement offers good tax and legal advantages?
- Where will the dollars be found to allow the buyer to finance the purchase of the shares from the estate of the seller?
Sometimes it’s difficult to decide which type of buy sell agreement to recommend when dealing with S Corp owners. Should it be a stock redemption plan funded by corporate owned insurance? Or should it be a cross purchase plan funded by cross-owned insurance on the lives of each owner? Which method offers both tax efficiency and premium payment flexibility?
We know the surviving S Corp owners would get a 100% cost basis increase in the shares purchased from the estate of the deceased using a cross purchase plan. However, there would only be a partial cost basis increase for the surviving S Corp owners using a stock redemption plan. In other words, a stock redemption plan for an S Corp will have some “wasted basis” that cannot accrue for the surviving owners.
We know that a corporate owned insurance to fund a stock redemption plan provides a “pass-through” of non-deductible premiums proportional to each S Corp shareholder’s interest. So the question becomes “Can a plan be recommended that can accomplish a 100% cost basis increase for the survivor AND a proportional “pass-through” of the life insurance premiums equal to each S Corp owner’s interest in the business”? The answer is yes! The plan is known as an S Corp Stock Redemption Plan with an S Corp “Short Tax Year Election”.
Case Example of S Corp Stock Redemption with Short Tax Year Election
Assume the following simple fact pattern: A (age 60/standard) and B (age 45/preferred) each own 50% of the shares of a “cash basis” S Corp with an agreed upon fair market value of $4,000,000. They want to share the cost of an insurance funded buy sell agreement equally. And they want the survivor to have the highest cost basis possible when the first one dies so that the survivor can minimize capital gains taxes upon the future sale of the shares to any third party.
The client’s attorney, CPA, and financial professionals agree that a life insurance funded “S Corp Stock Redemption with Short Tax Year Election” language would accomplish the objectives of this plan design.
The S Corp will be the owner and beneficiary of a $2,000,000 insurance policy on A’s life and a $2,000,000 insurance policy on B. The non-deductible premiums will be part of the K-1 “pass-through” profit that will be reported 50-50 as personal ordinary income on Schedule E of each owner’s respective Form 1040 U.S. Income Tax returns. Since the insurance will be employer-owned, the corporation will provide written Notice and Consent to each insured to assure that any death proceeds received are income tax free. Also, the CPA will file a Form 8925 each year with IRS as part of the Form 1120S U.S. Income Tax Return for S Corps.
Given the plan design stated above, what will be the sequence of the transaction at death to accomplish the transfer of the shares and provide a 100% cost basis increase to the survivor?
- Assume A dies
- First, corporation buys (redeems) A’s shares from A’s estate in exchange for a short-term interest bearing note payable to A’s estate for $2,000,000. B now owns 100% of the stock of the S Corp. after this step is completed.
- Then, the CPA of the S Corp elects a “short tax year” under IRC Section 1377(a)(2) and closes the books for tax accounting purposes
- Finally, the corporation collects the $2,000,000 death benefit from the insurance carrier and allocates 100% of these proceeds to B’s cost basis is the S Corp shares
- The corporation uses this cash from the insurance proceeds to pay off the note plus minimal interest to A’s estate
- A’s estate distributes this cash to A’s family according to the provisions of A’s will or trust documents.
In summary, everyone involved should be happy with the outcome of this transaction. The $2,000,000 of death proceeds are received income tax free. B now owns 100% of the shares of the S Corp with a $2,000,000 cost basis increase to minimize capital gains taxes upon future sale of the company to a third party. And A’s family has received $2,000,000 of income tax free cash to continue the lifestyle to which they are accustomed.