For business owners, leaving a legacy behind for their children is often a driving factor. Leaving that legacy to chance is not.
If the owner of a business passes away, often, the family will have to borrow the cash needed to pay for funeral expenses, taxes on the estate, and ordinary income taxation of stock assets. For those whose main goal is to help avoid these expenses on the family, a Section 303 stock redemption arrangement is a viable option.
For many family-owned businesses, if a son or daughter is willing and able to assume responsibility for operating and owning the business, if steps are not taken beforehand, the death of the business owner may cause insurmountable financial obstacles for the family members who are left to continue to business.
Obstacles to Successful Family Retention
A company that has a limited number of shareholders whose stock is traded publically on occasions is known as a closely held corporation. For these types of businesses, the death of one of the primary shareholders can place a financial burden on, not only the business, but the family as well. Establishing a Section 303 stock redemption arrangement funded with life insurance may be the perfect solution for the shareholder, if:
- At least 35% of the estates value is interest in a closely held corporation.
- A spouse, parents, or children own an interest in the corporation.
- The owner desires to keep the closely held corporation in the family after his or her death.
- The owner’s estate lacks sufficient liquid funds to pay the estate/state tax liabilities and administrative expenses that occur at death.
Some financial obstacles for a closely-held corporation at the death of the owner, include:
- Estate Liquidity – Sufficient liquidity in the deceased owner’s estate to pay estate taxes or other administrative costs without the need of liquidating business assets.
- Need for Income – Any family members who are not active in the business may need continued income. If the deceased owners estate does not have sufficient assets to support these family members, the business will have to satisy their income needs.
- Equalizing Inheritances – For any children not receiving a business interest, the estate will need sufficient non-business assets that can be used to equalize inheritances.
- Impact on Business – The business may need sufficient financial reserves for the transition to new management.
Advance planning will help to overcome any of these financial obstacles, leaving the family the ability and assurance of a successful family retention of all business expenses. Without it, there may be no choice but to sell or liquidate the business.
A Potential Solution
One possible solution to an estate liquidity problem is for the corporation to purchase a certain portion of the deceased owner’s stock. This allows the family the much-needed cash to pay an estate settlement bill, while still retaining the important controlling interest in the business.
This would be the perfect solution, except for taxes. When a corporation purchases its own stock, the transaction is treated as dividend income. This means that ordinary income tax would have to be paid by the heirs on all proceeds of the stock redemption. However, there is an exception to this rule that allows a corporation to redeem its own stock with favorable tax conditions.
Section 303 of the Internal Revenue Code (IRC) states that a corporation may purchase enough of its stock from a deceased owner’s estate to pay any estate taxes, funeral costs, and estate administration expenses. In addition, any gain from a Section 303 stock redemption is taxable as a capital gain. However, since the stock’s value takes a step-up in basis to its fair market value on the date of the owner’s death, the gain realized is usually little to none.
Section 303 and Life Insurance
The IRC allows corporate stock from a deceased owners estate to be redeemed. This transaction is now considered a capital transaction when these proceeds are used to pay estate taxes, state death taxes, and any administrative expenses. Otherwise, the transaction would be considered ordinary income and fall under regular income tax guidelines.
Life insurance allows the corporation to buy and own the life insurance on any key owners or shareholders. In a Section 303 stock redemption agreement, life insurance can help facilitate the arrangement by giving the corporation the liquidity needed to purchase the owner or shareholders company stock after their death. This allows the business to be kept in the family and any liquidity issues at the uncertain time of death. Often, this is the exact time when liquid assets are needed.
Potential Benefits of Using Life Insurance
The benefits of using life insurance in a Section 303 stock redemption agreement allow for:
- A predetermined disposition of a business owner’s interest in an orderly manner.
- The foreknowledge and sense of certainty that funeral, tax, and administrative expenses will be there for the business and the owner’s heirs.
- Goodwill among employees, suppliers, and creditors since the business will remain stable during the uncertain time of the owner’s death.
- The uninterrupted running of the business with remaining owners in control with an exact portion of ownership as before the redemption.
- Any cash values built up in the policy may be used by the business during the insured’s life and can potentially help to improve the balance sheet of the business.
Death is an uncertain time no matter the circumstances. Adding life insurance can help ease the burden of paying for funeral expenses, taxes, and other unforeseen costs that may arise. In addition, if the family depends on the deceased members’ income, planning ahead elevates the need for drastic changes in living situations, routine, or even future expenses, such as college.
As with any complex financial matter, discussing your concerns with a highly qualified financial advisor will put you, your family, and your business on a path to stability in the event of death. Planning also allows a company to invest in the future and to build a strong, solid presence in the event of an owner’s death.