A cost-effective and economical method of providing the cash essential to purchase a deceased shareholder’s business interest is a stock redemption buy-sell plan. An insured stock redemption buy-sell plan words for a corporation by a stock redemption buy-sell agreement paid for with nondeductible life insurance premiums.
The Corporation, Shareholders, and Insurance Company
First, the corporation and shareholders enter into an agreement where the corporation agrees to buy a deceased shareholder’s stock and the deceased shareholder’s executor is directed to sell the stock to the corporation for an agreed-upon price under a stock redemption buy-sell agreement. This protects not only the corporation, but the individual shareholders and the deceased shareholder’s family. With a pre-set price, all parties involved can plan for and know exactly how much money will be needed if a shareholder dies.
Next, the corporation is the owner of an insurance policy on each shareholder’s life. The amount of the policy differs based on the amount approximately equal to each shareholder’s vested interest in the business. The corporation is also responsible for payment of the nondeductible premiums on the insurance policies. The individual shareholders are not listed as the owner or beneficiary on the policy. This would create a delay in payment due to the insurance policy being tied up in the probate process if tied to the deceased shareholder’s estate.
Upon the death of the shareholder, the corporation obtains the income-tax-free death payment from the life insurance policy it owns on the departed shareholder. Then, the corporation uses the proceeds of the life insurance policy to purchase the stock from the deceased shareholder’s estate for the purchase price that was agreed upon in advance and listed in the buy-sell agreement. Finally, after resolving the estate, the executor dispenses the balance of the estate to the deceased shareholder’s heirs.
Other Features of an Insured Stock Redemption Buy-Sell Plan
An insured stock redemption buy-sell plan can serve as a vital source of funding. It can also provide a number of other features, including:
- Prompt and Certain Payment – Since the life insurance proceeds are not subject to the often lengthy and expensive probate process. Funds are available immediately to complete the purchase of any interest held by the deceased shareholder.
- The Need for Cash Created by the Event – The event of the death of a shareholder creates a source of cash in the form of a life insurance death benefit. The immediate need of cash to purchase the corporate stock held by the deceased shareholder’s estate is satisfied with a life insurance policy.
- The Death Benefit Exceeds Premiums Paid – A positive aspect of a corporation paying the nondeductible life insurance premiums is seen when the policy is used and the full policy amount is received. Even if the total of the premiums paid is not as much as the total premium paid out, the gain is generally free from income tax. This aspect can make up for the premiums not being deductible from the corporation’s expenses.
- Avoidance of Financing Problems – Since a life insurance policy is taken out before death and cash is received immediately after death, the need to find other ways to pay for the shareholder’s interest is eliminated. Problems with financing, expensive interest bearing loans, or a drain on a corporation’s cash are eliminated with a life insurance policy.
- Purchase of Business Interest – The cash value of the life insurance policy can be used to help purchase the business interest when a shareholder becomes disabled or retires. Since the shares still need to be purchased, the cash value that has built up in the policy is a convenient way to fund the purchase of these shares. However, withdrawals and loans reduce the policy’s death benefit and cash value available for use.
Insured Stock Redemption Buy-Sell Plan Tax Results
- Beginning with premium payments for life insurance, an insured stock redemption buy-sell plan is funded with payments that are not tax deductible by the corporation.
- Usually, proceeds received from a life insurance policy upon a shareholder’s death are free from federal income tax. However, these same funds may be subject to the corporate alternative minimum tax.
- Since the transfer of a deceased shareholder’s stock is a complicated issue, a professional tax advisor should be consulted.
- The transfer of the deceased shareholder’s stock for the cash received from the life insurance policy is usually treated as the sale of a capital asset. On the date of the shareholder’s death, this capital asset is adjusted to reflect the fair market value. This amount is known as the purchase price. If the purchase price equals the fair market value of the stock at the shareholder’s death, no gain for federal income tax purposes will result.
- When the surviving shareholders receive the increased ownership share of the corporation, there is no increase in their tax basis.
- The policies are arranged properly if each shareholder holds no incidents of ownership in the policy on his or her life. Assuming that these policies are properly arranged, the death proceeds will not be included in the deceased shareholder’s estate.
- If the purchase price that is established in the buy-sell agreement is a realistic representation of the value of the deceased shareholder’s stock, this purchase price is used to set the value of the stock for federal estate tax purposes. However, this rule assumes that the agreement stops the shareholders from selling to another entity without first offering it to the corporation for the same price.
With the many different nuisances involved in a corporate insurance stock redemption buy-sell plan, a financial advisor should be consulted. With the proper plan in place, all parties involved can have a seamless transition period.