13 Sep 2013 Buy Sell Agreements (memorandum)
This memo discusses the tax effect of the various options of funding a purchase of stock from a deceased shareholder. A Buy Out agreement contemplates that the Company would be the purchaser, and a Cross Purchaser Agreement contemplates that the surviving shareholder would be the purchaser.
- Corporate Buy Out Agreement. A Buy Out Agreement would obligate the Company to buy a deceased shareholder’s shares. That obligation could be funded by a life insurance policy owned by the Company.
- Limitations on Distributions. California law restricts a corporation from repurchasing shares unless it meets certain solvency tests. Life insurance premiums reduce retained earnings and insurance proceeds increase retained earnings. Since the Company would be the insurance beneficiary, the policy proceeds would be subject to the claims of the Company’s creditors. Thus, the insurance proceeds may not available for payment to a deceased shareholder’s estate.
- Income Tax Consequences. the Company could not deduct the payment of premiums on insurance used to fund a buy out agreement, and those premiums are not included in the shareholder’s income. The insurance proceeds would not be included in the Company’s income, and would not be taxed to the shareholders.
- Income Tax Issues. C Corporations (but not S corporations) are subject to an excise tax on unreasonable accumulations of earnings. An accumulation is not unreasonable to the extent it is necessary to meet the reasonable needs of the company’s business. The IRS may contend that the purchase of insurance does not meet the reasonable needs of the business. Life insurance can be justified as a reasonable need of the business if it is designed to avoid shareholder disputes, ensure continuing management, etc. and your minutes or the agreement specifically recite the business reasons for the insurance.The excess of premiums over cash surrender value reduces a corporation’s earnings and profits, and the excess of the proceeds over the premiums paid would increase earnings and profits. The determination of earnings and profits is significant since the amount of a distributions on that would be taxable as a dividend is limited to earnings and profits.In the case of a C corporation (but not an S corporation), insurance proceeds increase “accumulated current earnings” for alternative minimum taxable income tax purposes. Consequently, insurance proceeds may be subject to the alternative minimum tax even though the proceeds are not subject to the regular income tax.The repurchase of the decedent’s shares by the Company would be taxed to the surviving shareholders as a constructive dividend if the shareholders, and not the Company, are obligated to purchase the decedent’s shares.If the Company’s repurchase of the decedent’s shares is not “substantially disproportionate” (in this case, meaning that the decedent’s share holdings are reduced by more than 20%), the decedent’s estate may be taxable on a portion of the payments as dividends. Thus, the Company should be obligated, if it buys, to repurchase all of the decedent’s shares.
- Estate Tax Issues. Under both a cross purchase and buy out arrangement, the value of the stock, but not the insurance, would be included in the shareholder’s gross estate. If the decedent retains incidents of ownership in the insurance policy, the proceeds (as well as the value of the stock) may be included in the decedent’s estate. Incidents of ownership include the right to borrow against the policy, to change beneficiaries, and to cancel the policy. The ability of a controlling shareholder to control a policy may give him incidents of ownership.In some situations, the IRS has increased the value of the decedent’s shares to reflect the receipt of the insurance proceeds. To avoid this double counting, you should ensure that your buy sell agreement meets IRS requirements to fix the value of the shares. An agreement will not be respected as reflecting the value of shares unless the shareholders are subject to first refusal rights, the estate of a decedent is obligated to sell at a certain price, the price is fixed by the agreement, and that price is not a device to transfer the shares at less than adequate and full consideration. Since you intend to specify that the buy out price is fair market value, your agreement may not be useful as a means of setting the estate tax value.If the policy proceeds exceed the amount required to repurchase the decedent’s stock, those excess proceeds would be included in the decedent’s estate if the estate is entitled to the proceeds.
- Individual Beneficiaries. Naming the estate or individual as beneficiary would ensure the fastest receipt of the policy proceeds by the shareholder’s heirs and avoid claims of corporate creditors against the proceeds. If you use this alternative, the policy should contain a provision that the proceeds would not be paid until the decedent’s share certificates have been assigned and transferred back to the corporation. You should be aware that the IRS has taken the position that when proceeds are payable to the shareholder’s estate, they must be included in the gross taxable estate along with the value of the shares. The courts, however, have rejected this position if the buy out agreement is properly drafted to provide that the proceeds are intended to be applied as consideration for the shares.If the policy proceeds are payable directly to a beneficiary, the excess of the proceeds over the amount required to repurchase the decedent’s stock would be includible in the decedent’s gross estate.
- Cross Purchase Agreement. Cross purchase agreements provide that the surviving shareholders must purchase the decedent’s shares directly from the decedent’s estate. If life insurance is used to fund this obligation, each shareholder must obtain a policy on the life of each other shareholder in amounts sufficient to fund his purchase obligation.The primary disadvantages of cross purchase agreements are that two policies must be written, with each shareholder owning a policy on the life of the other. A problem is that the shareholders may be required to pay different premiums on the life of the other shareholder. One way of dealing with those problems is to use an insurance partnership between the shareholders which would own the policies and make the premium payments.An advantage of cross purchase arrangements is the avoidance of corporate tax issues such as accumulated earnings taxes, alternative minimum tax, and constructive dividends discussed above. The purchasing shareholder also obtains an increased basis in the purchased shares, unlike a corporate buy out arrangement.
- Income Tax Consequences. The payment of premiums under a cross purchase arrangement would not be deductible. The shareholders must raise the cash to make the payments from increased taxable salary or dividends. If the cash is paid out as compensation, the Company could deduct the payments, but not if the payments are dividends. Also, there is the risk that the IRS would recharacterize the payments as dividends if the amounts are deemed to constitute unreasonable compensation.The receipt of the insurance proceeds is not taxable income, except when the insurance policy is transferred to the shareholder for valuable consideration. The estate would also not have taxable income.The shareholder would obtain a basis in the purchased shares equal to the amount paid. The policy proceeds should be paid directly to the shareholder to ensure this result.As above, the value of the stock, but not the insurance, would be included in the shareholder’s gross estate.
- Mandatory Purchase Agreement. Whether to provide for a mandatory or optional purchase on a shareholder’s death is one of the most important decisions to make while the agreement is being drafted. The agreement could provide that the Company has the right to buy the decedent’s shares on death, that the Company is obligated to do so, or both. If the shareholders are obligated to purchase the decedent’s shares, the corporation should not have the option to purchase those shares (see discussion of constructive dividend issue above). For the same reason, if the Company is obligated to repurchase shares, it should be obligated to purchase all of the shares.
- Conclusion. The cross purchase agreement has the advantage of allowing the surviving shareholders to obtain a higher cost basis in purchased shares and avoids the alternative minimum tax issue, but the cross purchase is more complex since it requires multiple policies (or a partnership or trust arrangement) and requires the shareholders to pay the premiums with after tax dollars.