Arrangement for Closely
“A successful business has a
business succession strategy.”
We offer you this concept piece to help you understand how life insurance can be used
to help provide funds for business continuation arrangements. This material contains
references to concepts that have legal, accounting and tax implications. It is not
intended as legal, accounting or tax advice. Consult your own attorney and/or tax
advisor for advice regarding your particular situation. Accordingly, any information in this
document cannot be used by any taxpayer for purposes of avoiding penalties under the
Internal Revenue Code.
Life insurance is issued by The Prudential Insurance Company of America, Newark, NJ,
and its affiliates. All are Prudential Financial companies and each is solely responsible
for its own financial condition and contractual obligations. Like most Insurance policies,
our policies contain exclusions, limitations, reductions of benefits and terms for keeping
them in force. Your licensed financial professional can provide you with costs and
Not insured by FDIC or any Federal Government Agency. May Lose Value.
Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate.
Prudential, Prudential Financial, the Rock logo, and the Rock Prudential logo are registered service marks of The Prudential
Insurance Company of America and its affiliates.
IFS-A012896 Ed. 10/08 Exp. 12/10
Stock Redemption Arrangement Page 2
Do you identify with the following?
You are a business owner who:
♦ Has spent many long hours working in and creating value in your business and it is
either one of the major assets or the major asset in your estate.
♦ Would like to create a ready market for the sale of your shares at your death.
♦ Wants to see that the business remains in the hands of just the surviving
♦ Sees the need to establish an estate value for your business interest in order to
reduce the potential for IRS disputes.
♦ Wants to be certain funds will be available to help with the buyout of a deceased or
departing shareholder’s interest.
If so, you may want to consider establishing a stock
redemption buy-sell arrangement funded with life
insurance. A stock redemption buy-sell arragement is:
♦ A contract agreed to by the corporation and shareholders requiring the corporation
to purchase the interest of a shareholder under specified terms and conditions.
♦ An arrangement that, when funded with life insurance, helps ensure that cash will be
available to help with the buyout.
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Stock Redemption Buy-Sell Arrangement
3. Policy Proceeds
1. Agreement 1. Agreement
4. Cash 5. Stock
1. The corporation enters into a stock redemption agreement with each shareholder,
obligating the business to purchase the deceased shareholder’s stock in the
corporation and obligating the decedent’s estate to sell.
2. The corporation purchases life insurance protection on the life of each shareholder
equal to at least the value of the shareholder’s interest. The corporation is the
owner, premium payer, and beneficiary of each policy. You should consult your legal
counsel to determine whether notice and consent under IRC § 101(j) is required
before the policies are issued to receive tax-favored treatment. 1
3. At the death of a shareholder, the corporation collects the life insurance policy
proceeds from the insurance company.
4. The corporation pays the agreed upon amount, determined by the terms of the stock
redemption agreement, to the shareholder’s estate.
5. The owner’s estate releases the partnership or LLC interest to the business.
Life insurance death proceeds are generally received income tax-free [IRC § 101(a)].
For employer-owned contracts issued after August 17, 2006, death proceeds will be
subject to income tax. However, where specific employee notice and consent
requirements are met, and certain exceptions apply, death proceeds can be received
income tax-free [IRC § 101(j)].
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Benefits to the Departing Shareholder or Heirs:
♦ If properly drafted, implemented, and maintained, the arrangement helps to establish
the business value for estate tax purposes.
♦ It provides a ready market for the sale of the business interest.
♦ It ensures that cash to help pay estate taxes and/or to meet family needs will be
♦ The shareholder’s heirs are relieved of further corporate responsibilities.
♦ Where life insurance is used to fund the buyout, the heirs of the deceased
shareholder immediately receive cash, avoiding delays and potential liquidation
losses and are no longer dependent on the corporation for their financial security.
Benefits to the Corporation and Remaining
♦ The corporation receives life insurance proceeds to finance the buyout of the
deceased shareholder at the exact time when needed.
♦ The corporation continues uninterrupted with the surviving shareholders as owners.
♦ A stock redemption agreement funded with permanent life insurance can provide
needed cash to help meet the contractual obligations established by the agreement,
potentially minimizing the impact on working capital and cash flow.
♦ In contrast to a cross purchase agreement, a stock redemption agreement funded
with life insurance allows the corporation to purchase just one policy on each owner.
♦ Employees, creditors, and suppliers feel more secure knowing the business has a
succession arrangement in place.
♦ Where permanent policies are purchased, the cash values of the policies are assets
of the business that are reflected on the balance sheet and are available for
business needs. 2
Life insurance policy cash values are accessed through withdrawals and policy loans.
Loans are at interest. Loans and withdrawals cause a reduction in cash values and
death benefits, may affect any guarantees against lapse, and may have tax
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Tax Considerations for the Departing Shareholders or
♦ Qualifying for sale or exchange treatment. Generally, under IRC § 301, stock
redemptions are treated as corporate distributions (dividends) to shareholders and
will be taxed as ordinary income to the extent of earnings and profits (E&P).
However, where shareholder’s qualify the stock redeemed as a “sale or exchange”
under one of the “safe harbors” found in IRC § 302, the person whose stock is being
redeemed will receive capital gains treatment. Where a lifetime redemption occurs
and qualifies for sale or exchange treatment, the difference between the basis of the
stock and amount realized in the redemption will be taxed as capital gains.
♦ Stock redemptions at death are tax advantageous since the basis of the stock
receives a “step-up” to fair market value. 3 A sale made quickly after death will
generally result in no gain, assuming that the sale price is not significantly different
from the estate value.
♦ Caution for family owned corporations. One of the most common safe harbor
routes used to achieve capital gains treatment for a stock redemption is a “complete
termination.” A complete termination occurs whenever the corporation repurchases a
shareholder’s entire ownership interest if between unrelated shareholders. However,
where family members are shareholders, additional rules under IRC § 318
complicate the ability to achieve sales or exchange treatment by attributing to a
redeeming shareholder stock that is owned by another family member or by various
entities involving family members. An individual is deemed to own stock directly
owned by his/her spouse, children, grandchildren, and parents. In addition, “entity
attribution” can result where stock owned by a partnership, estate, trust, or another
corporation is attributed to family members as beneficial owners. The constructive
ownership rules are complicated and their application requires expert legal advice.
It is important to note that the danger of ordinary income tax treatment exists in
every buy-sell arrangement structured as a stock redemption in the C corporation
context where the business involves family members. In contrast, where the
redemption involves an S corporation that has never been taxed as a C corporation,
redemption will not result in ordinary income tax, even where there are related family
Under the Economic Growth and Tax Relief Reconciliation Act of 2001, for the year
2010, the estate tax is repealed. For deaths occurring in that year only, a modified step-
up in basis will be available. This is limited to a step-up of $1.3 million in total for all
beneficiaries and an additional $3 million step-up available for property passing to a
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♦ A properly drafted buy-sell agreement can help establish the value of the business
interest for estate tax purposes.
Tax Considerations for the Corporation and
♦ For employer-owned life insurance policies issued after August 17, 2006, IRC §
101(j) provides that death proceeds will be subject to income tax; however, where
specific employee notice and consent requirements are met and certain safe harbor
exceptions apply, death proceeds can be received income tax-free. Life insurance
proceeds are otherwise generally received income tax-free under IRC § 101(a).
However, if the corporation is a C corporation and subject to corporate alternative
minimum tax (AMT), policy cash values and death proceeds will affect adjusted
current earnings. 4 A corporation taxed as an S corporation is not subject to AMT.
♦ Premiums paid for life insurance are not income tax-deductible by the corporation.
♦ Stock redemptions increase the surviving shareholder’s interest in the C corporation
but do not increase their stock basis.
♦ Although the surviving shareholders have the same proportion of ownership in
relationship to each other after the redemption as prior to the redemption, care must
be taken that control of the business is not shifted unintentionally. For example: Dad
and son own, respectively, 40% and 20% of the corporation, with a key employee
(unrelated) owning the remaining 40%. Combining their voting power, dad and son
control the corporation. If dad’s stock were redeemed, the key employee would own
the majority of the outstanding stock and have control of the business.
♦ Where life insurance is used as a funding vehicle in a C corporation redemption,
death benefit proceeds received by the C corporation have no effect on a
shareholder’s basis in the stock. In contrast, in an S corporation, where life
insurance is used to help fund the stock redemption arrangement, death benefit
proceeds do increase shareholder basis. Since high basis in an S corporation
shelters future distributions from income taxation, the use of life insurance can be an
important tax strategy. The amount of basis increase the surviving shareholders
receive depends on a number of factors. Consult your legal and tax advisors for a
Corporations in their first year or having average annual gross receipts less than $7.5
million for the preceding three-year period (average annual gross receipts of $5 million
for initial qualification) are no longer subject to AMT.
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♦ If needs and circumstances change, policies can be transferred from the corporation
to the insured shareholder without creating “transfer-for-value” taxation issues.
Recommended Action Plan
1. Seek the professional advice of your attorney regarding your personal needs and
objectives for the disposition of your business interest in the corporation.
2. Meet with your accountant, attorney, and/or professional appraiser to determine
the value of your business interest.
3. Determine the appropriate insurance solution.
4. Have your attorney draft the stock redemption agreement, corporate resolution,
and other appropriate documents.
5. Apply for the life insurance to be owned by the corporation and complete all
medical and underwriting requirements.
6. Review the buy-sell arrangement with your licensed financial professional,
attorney, and accountant on a regular basis.