Changes to S-Corporation Redemption Buy & Sell Agreements
Treasury Release
A new PLR has been issued which will have the potential to affect the thinking of structuring Buy and Sell agreements in S-Corporations. The ruling has effectually confirmed the method of splitting the tax year in S-Corporations to gain shareholder basis when configuring buy and sell agreements will not work in accrual based corporations. The timing of the death benefit proceeds is of the utmost importance for stock redemption plans in an S-Corporation. When the death benefit must be “booked” and counted determines when the basis of a policy is considered received. As you may be aware after tax cash into an S-Corp increases the basis to the shareholders. As after tax cash is removed from the corporation the basis decreases, hence increasing the potential capital gains liability when the corporation is sold. Since life insurance is typically receipted as tax free, i.e. after tax, the death benefit increases the basis of the corporation. This letter ruling provides the taxpayer with a very important piece of the puzzle, mainly when is the death benefit considered receipted. The options are 1) upon death of the insured or 2) when the actual proceeds are received. It is obviously not practical to predict the timing of death, but it is certainly possible to manipulate the timing of when the death proceeds are received by delaying the submission of death claims to the carrier. On the surface this may not mean much to you. It is my aspiration by the time you finish reading the following you will have a better understanding of the influence of the ruling and the impact it creates. Before we can proceed to the rest of the PLR a short refresher course may help. Note: This PLR applies to S-Corporation which utilizes accrual based accounting method only. Cash based S-Corporations should still be able to make use of the split tax year election. This has been the conservative approach anyway, but is now confirmed.
When considering the impact of structuring Buy & Sell Agreements for closely held business entities several important factors must be taken into consideration. Some of the concerns are who will redeem the stock, at what value, the timing of the purchase, the available funding, and the income and estate tax implications of the deceased and surviving shareholder. We will explore each of these concerns. The following is not intended to be a fully encompassing characterization of the previous topics, but rather a quick reference to important aspects to consider when contemplating the design of a buy and sell agreement. 1. When stock is redeemed the entity or individual who purchases the stock from the decedent’s estate will determine the income tax liability for the surviving shareholder. If a surviving shareholder purchases the stock then the shareholders basis will be adjusted by the purchase price of the stock. If the corporation redeems the stock then the surviving shareholder may receive no or partial step up in basis depending on the type of corporation or business entity. This is a compelling reason for shareholders to purchase the stock. 2. Timing of the purchase is normally determined by the agreement and may be over a period of time, such as an amortization schedule covering a 10 year interval or
may require payment immediately. These characteristics my dramatically effect the ability of the corporation and the decedent’s family to endure the financial hardship. 3. Funding may be handled in several various ways. As already mentioned an amortization schedule could be arranged to provide a stream of income to the decedent’s family or estate. An analysis must be undertaken to determine the viability of the business entity’s capability to provide the necessary funding for several years. If the stream of income is determined to be severance or deferred compensation adverse tax implications could occur. (i.e. ordinary income tax opposed to capital gains treatment) The business entity could create and fund a sinking fund to provide the necessary funds for purchase. While this approach is perhaps suitable for minority interest holders the additional funds created will only increase the value of the corporation and could generate needless tax liabilities to surviving shareholders in the event a premature death doesn’t occur prior to the sale of the business entity. The obvious shortfall in this method is the time required to create an adequate fund. If funds are needed immediately due to unexpected events the account balance will almost certainly be insufficient. For the following reasons, in most but not all cases, life insurance becomes a cost efficient alternative for funding depending on the insurability of the shareholders. 4. Valuing a closely held business entity is perhaps one of the most complex and complicated procedures in completing the process. The following IRC code provides factors which should be represented in any buy and sell agreement. “Pegging” the value of a business for estate tax purposes reduces the opportunity administrative delays in settling the estate. Additional information outlining IRS procedures for the valuation of a business entity is provided in an attached document. IRC Code Section 2703 (a) General rule. -For purposes of this subtitle, the value of any property shall be determined without regard to -(1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or (2) any restriction on the right to sell or use such property. (b) Exceptions. -Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: (1) It is a bona fide business arrangement. (2) It is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth. (3) Its terms are comparable to similar arrangements entered into by persons in an arms' length transaction.
Now back to the PLR. The method employed to increase the basis to the surviving shareholders when facilitating the buy and sell is found under IRC Sec. 1377(a)(2). In the event of the termination of a shareholder’s interest, i.e. the death of a shareholder for example, the corporation is allowed to terminate its tax year and treat the year as consisting of 2 taxable years. The reason
this becomes important is because the payment of the death proceeds will increase the basis of the corporation as mentioned above. If the proceeds are considered paid in the tax year currently established and not the new one, then the basis of the policy is provided on a pro rata basis to all shareholders, including the decedent. IRC Sec. 1014 allows the basis of the decedent’s stock to step up at death. Allocating basis from the life insurance death benefit is redundant and not necessary. If the death benefit can be delayed until after the company has elected the new tax year, then only the surviving shareholders will received the advantage of the increased basis. Effectually this procedure presents the surviving shareholders with the same tax results as a cross purchase buy and sell agreement. Mechanically speaking the procedure works as follows: 1. The buy and sell agreement is written to automatically split the tax year with all shareholders consisting. (a requirement for splitting) 2. Upon the death of the shareholder a promissory note is given to the decedent’s estate. 3. The corporation elects the IRC Sec. 1377(a)(2) option and creates the new tax year. 4. The death claim is held until after the establishment of the new tax year. 5. Death claim is paid and then the promissory note is paid off with the proceeds. The surviving shareholders are now the proud parents of the additional basis. What the PLR has done is to take away the ability to hold the death claim until after the new tax year is established and then book the proceeds. Accrual based corporations will have to count the death benefit at the time of death, prior to the new formation. This distributes basis to the decedent shareholder, who of course doesn’t need it. If you have a client who owns an S-Corporation and you know they have a stock redemption plan in place, this makes for a great opportunity to get in front of them or their accountant/attorney with the news. If the corporation is accrual based you may have the prospect of writing new insurance. Why? If the life insurance policies are owned by the corporation unless the shareholders are also partners in a partnership or LLC taxed as a partnership then the transferring of the policies to fund a cross purchase would violate the transfer for value exceptions. Don’t want to do that. I hope this topic was clear enough to follow. If you have any further questions don’t hesitate to call us. IRC Sec. 1377
(a) Pro rata share For purposes of this subchapter-(1) In general Except as provided in paragraph (2), each shareholder's pro rata share of any item for any taxable year shall be the sum of the amounts determined with respect to the shareholder-(A) by assigning an equal portion of such item to each day of the taxable year, and (B) then by dividing that portion pro rata among the shares outstanding on such day. (2) Election to terminate year (A) In general
Under regulations prescribed by the Secretary, if any shareholder terminates the shareholder's interest in the corporation during the taxable year and all affected shareholders and the corporation agree to the application of this paragraph, paragraph (1) shall be applied to the affected shareholders as if the taxable year consisted of 2 taxable years the first of which ends on the date of the termination. (B) Affected shareholders For purposes of subparagraph (A), the term "affected shareholders" means the shareholder whose interest is terminated and all shareholders to whom such shareholder has transferred shares during the taxable year. If such shareholder has transferred shares to the corporation, the term "affected shareholders" shall include all persons who are shareholders during the taxable year. (b) Post-termination transition period (1) In general For purposes of this subchapter, the term "post-termination transition period" means-(A) the period beginning on the day after the last day of the corporation's last taxable year as an S corporation and ending on the later of-(i) the day which is 1 year after such last day, or (ii) the due date for filing the return for such last year as an S corporation (including extensions), (B) the 120-day period beginning on the date of any determination pursuant to an audit of the taxpayer which follows the termination of the corporation's election and which adjusts a subchapter S item of income, loss, or deduction of the corporation arising during the S period (as defined in section 1368(e)(2), and (C) the 120-day period beginning on the date of a determination that the corporation's election under section 1362(a) had terminated for a previous taxable year. (2) Determination defined For purposes of paragraph (1), the term "determination" means-(A) a determination as defined in section 1313(a), or (B) an agreement between the corporation and the Secretary that the corporation failed to qualify as an S corporation. (c) Manner of making elections, etc. Any election under this subchapter, and any revocation under section 1362(d)(1), shall be made in such manner as the Secretary shall by regulations prescribe.