Handing a Business Down? Use This Stock Redemption Plan

Business owners who intend to leave their successful business to one or more children should consider an insured Section 303 stock redemption plan for estate tax purposes.  

No one wants to give the government more of their hard-earned money than legally obligated.  If planned correctly, an owner of a closely held corporation can reduce the amount of taxes paid by the estate once the owner is deceased.  For owners of a closely held corporation, several questions arise:

  • When will the transition from owner to a child take place:  before or after death?
  • What is the value of the business?
  • How will the owner ensure that the other heirs are treated fairly?
  • Will the surviving spouse have adequate income?
  • How will surviving family members pay for estate and inheritance taxes, administrative costs, and funeral expenses?

The Answer:  Section 303 Stock Redemption Plan

One solution to many of these questions is a Section 303 stock redemption plan. Surprisingly, Internal Revenue Code (IRC) Section 303 was enacted over 60 years ago in 1954.  Congress wanted to make it easier for small business owners to pass along their business from generation to generation.  Today, Section 303 can be used for owners of closely held corporations (businesses in which there are few stockholders and a majority of the stock is held by the owner) to sell back the stock to the corporation and provide the surviving family members with enough cash to pay for expenses that result from the owner’s death.

If this code were not in place, many of the distributions in redemption of a deceased shareholder’s stock would be treated as a dividend instead of a capital transaction and would be subject to ordinary income tax rates.  However, with Section 303, the qualifying redemption of stock is only taxable to the extent that the redemption exceeds the estate’s basis.

For example, a $2 million distribution, without the protection of Section 303, would be subject to around a $700,000 income tax hit.  However, with a Section 303 in place, there would likely be no tax due. This is good news for survivors who need cash to pay death costs such as funeral expenses, estate taxes, and administrative costs.

Qualifying Amounts

In order for an amount to qualify for favorable tax treatment granted by Section 303 reaches a limit at the sum of:

  • Estate, inheritance, succession, and legacy taxes
  • Funeral and administration expenses that are allowed as deductions to an estate under section 2053

For amounts under the $5 million federal tax exemption limit, Section 303 can still be used to offset state inheritance taxes, estate taxes, funeral expenses, and administrative expenses.

Qualifying Estates

In order to qualify for Section 303 treatment, the decedent’s stock included in the gross estate must be more than 35% of the adjusted gross value of the estate.  The 35% of stock may be combined from up to 3 different corporate stocks. However, the adjusted gross value of an estate is not known until death occurs. Therefore, advanced planning is highly recommended.

Qualifying Distributions

The beneficiary or estate who receives the redeemed stock is not directly liable for the estate taxes, administrative costs, and funeral expenses.  However, in order to adhere to Section 303 rules, the recipient of the interest from the redeemed stock is liable and must directly reduce the amount by paying taxes or expenses, such as estate taxes, administrative costs, and funeral expenses.

The Mechanics of an Insured Section 303 Stock Redemption Plan

An economical and efficient method of providing cash to the family and heirs is with life insurance.  This allows settlement of a deceased owner’s estate while allowing the family to retain controlling interest in the family business.  

Using life insurance, owned by the corporation, allows the business to be named as the beneficiary of the policy.  The corporation is then responsible for payment of the nondeductible insurance premiums on the owner’s life. The amount is an approximation of the required amount necessary to make the partial stock redemption.  The owner and corporation enter into a Section 303 redemption agreement where the corporation agrees, at the owner’s death, to redeem a portion of the owner’s stock that is equal in value to the total estate taxes, funeral costs, and administration expenses.  This stock is given to the executor of the estate and is then sold back to the corporation.

At the death of the owner, the corporation receives an income tax-free death benefit from the insurance company.  The proceeds from the life insurance policy are sued to buy back a particular portion of the owner’s stock to pay estate taxes, funeral expenses, and administrate costs.  Since this amount is not known until the date of death, the amount of life insurance received by the corporation may exceed these costs. If so, the remaining amount is considered as tax-free to the corporation.  Then, the remaining stock is distributed to the family which continues controlling interest in the corporation.

There are many different routes that a business owner can take to protect his or her family after their death.  IRC Section 303 redemption is just one of them. However, for business owners who determine that upon their death a shortage of cash may harm the business or the family, an insured IRC Section 303 redemption can be a lifesaver.  

Even if, at death, the cash is not needed by the estate or the corporation, a Section 303 redemption is a tax-efficient means of removing cash from the business that would have been taxed as a dividend once it was distributed.  Since there are no tracing requirements for funds received in a Section 303 redemption, having this plan in place can automatically save thousands of dollars in taxes.

Since an insured Section 303 stock redemption plan is often an involved and complicated endeavor, discussions with a highly qualified financial advisor is needed.  Preplanning for the unexpected is definitely a way to protect your business, family, and legacy. Contact a financial advisor today to discuss all of the ways you can use life insurance to protect your most precious assets.

RELATED: A Section 303 Redemption Plan Helps Avoid These Obstacles

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