Business Succession Planning with S Corporations Producer Guide For producer use only. Not for distribution to the public.
A buy-sell agreement is extremely important for an S corporation due to the entity s special requirements and tax attributes. Business owners usually don t think about what will happen to their businesses in the event of their death or life changing event. Nevertheless, since the business is likely to make up a substantial portion of the owner s net worth, creating a business succession plan one that includes a buy-sell agreement is critical to ensure the owner s family s well-being, as well as the continuity of the business. The objective of this guide is to provide a general overview of the differences between S and C corporation requirements and taxation to help you better understand the issues that arise when structuring a buy-sell agreement. Note that in structuring a buy-sell agreement, all documents must be drafted by legal counsel. Additionally, it s important to bring in qualified advisors to provide any necessary professional services such as accounting or tax advice. A buy-sell agreement is important for most businesses because it provides a road map for the transfer of the business in the event of the owner s death, disability, retirement, or other separation from the business. Understanding how to properly structure a buy-sell agreement for an S corporation has become extremely important, given its increasing popularity. In 2013, over 67% of all corporations filed tax returns as an S corporation. 1 1 IRS Data Book, Table 2, 2013. t r a n s a m e r i c a 1
Buy-Sell Planning A buy-sell agreement provides a road map for the transfer of the business in the event of the owner s death, disability, retirement or other separation from the business. Having a buy-sell agreement in place can help mitigate conflict and accelerate the transition of the business. Consequences of Not Creating a Buy-Sell Plan There are a number of serious consequences that can occur from failing to create an S corporation buy-sell plan. They include: n Fire sale of the business for an amount far below fair market value n Uncertainty and instability among employees and creditors n Unqualified and inexperienced heirs running the business n Sale to an entity ineligible to own S corporation shares, resulting in inadvertent termination of subchapter S status n Increased chance of disagreements and conflict among heirs, resulting in lengthy and costly litigation n Lack of liquidity to pay estate taxes and other administration costs n Lack of a market for the business a highly valued asset that may represent a significant portion of the estate n Possible termination of the business n Loss of stream of income to remaining family members n Business valuation disagreements, especially IRS litigation n Tremendous stress on the business cash flow or credit line as a result of an effort to purchase the decedent owner s interest from his or her estate. These negative consequences arising from the business owner s loss can be avoided by planning ahead. 2 Business Succession Planning with S Corporations
Importance of Buy-Sell Planning for S Corporations A buy-sell agreement is extremely important for an S corporation due to the entity s special requirements and tax attributes. Among other issues at stake, transfer of S corporation stock to an ineligible entity or person could result in the involuntary termination of S corporation status. For example, S corporation stock cannot be owned by a nonresident alien. So a transfer to such a person would result in the loss of S corporation status. Additionally, transfers to entities such as partnerships, corporations and most trusts are prohibited. A buy-sell agreement can ensure that S corporation stock does not inadvertently pass to an ineligible party, thus protecting the business s S corporation status. An inadvertent termination of S corporation status will cause the corporation to be taxed as a C corporation as of the day of termination, which can produce adverse income tax consequences to the shareholders. If S corporation status is terminated, the corporation generally must wait five years before making a new S corporation election, resulting in the corporation being taxed on its net profits for five years. 2 Furthermore, if the buy-sell agreement does not take advantage of the special tax attributes of S corporations, the surviving shareholders could face additional tax burdens on future ongoing corporate distributions and/or those made upon the sale of the corporation. We will discuss the requirements for qualification and maintenance of S corporation status in more detail later in this Guide. Buy-Sell Basics While agreements may differ in their wording, most buy-sell agreements generally state that each owner agrees: n Not to dispose of his or her ownership interest during his or her lifetime without first offering it for sale to the business entity or other owners n That the surviving owners or the business entity will purchase, and the deceased owner s estate will sell, the decedent s ownership interest n Upon a pre-established valuation formula to be used at the time of death in order to determine a definitive price for his or her ownership interests Funding the Buy-Sell Agreement with Life Insurance Acquiring the funds to complete a buyout can be difficult, especially when the business owner has died and the business may already be adversely affected by the loss of his or her services. The surviving owner(s) could raise the needed funds by borrowing, selling business assets or using cash reserves, but all of these approaches are inherently uncertain and may put a severe burden on the operations of the business. Life insurance offers a more secure basis for funding a buy-sell agreement. A life insurance policy can provide the proper amount of liquidity when it is needed most at the death of a business owner. Funds received from the death benefit of the policy can be used to purchase the decedent s interest. If a permanent life insurance policy is used, the cash values may also serve as a source of funds for a buyout at dissolution, or when a business owner becomes disabled, incapacitated or decides to retire. 2 IRC 1362(g). t r a n s a m e r i c a 3
Taking a Closer Look at the S Corporation There are two types of corporations: Subchapter C and Subchapter S. Both enjoy the advantages of limited liability, transferability of ownership and professional business management. An S corporation is taxed similarly to a partnership, since its income is passed through to its shareholders. The concept of basis is extremely important when understanding S corporation taxation. With a C corporation, however, the possibility of double income taxation exists once at the corporate level when the company generates taxable profits, and again at the individual level when dividends are received. When the current tax environment features individual tax rates that are lower than corporate rates, profitable businesses may elect to become S corporations to take advantage of the lower individual rates and reduce their total income tax liability. In addition, if the business suffers a loss, S corporation shareholders may benefit by deducting the losses on their individual tax returns. S Corporation Requirements In order to qualify for S corporation status, all of the following requirements must be met: 3 n The corporation must be a domestic corporation; n It must not have more than 100 shareholders, but members of a family are treated as one shareholder; 4 n Only individuals, a decedent s estate, estates of individuals in bankruptcy, and certain trusts are eligible shareholders of an S corporation; n No shareholder can be a nonresident alien; and n The corporation can only have one class of stock, although different voting rights are allowed. 5 3 IRC 1361(b). 4 IRC 1361(c)(1)(A)(ii). For this purpose, an adopted child is treated as a natural child and is included in the family. IRC 1361(c)(1)(C). 5 IRC 1361(c)(4). S Corporation Taxation Overview Understanding buy-sell planning for S corporations is difficult without having an idea of how they are taxed. The concept of basis is an extremely important component of S corporation taxation. Following is an overview of the complex tax rules that govern S corporations and their shareholders. As mentioned previously, an S corporation is subject to only one level of taxation, at the shareholder level. This does not mean, however, that all distributions to the shareholders will be subject to income tax. If a shareholder s tax basis in the S corporation exceeds the amount of the distribution, the shareholder usually will not be taxed when he or she receives the distribution. The concept of basis, therefore, is extremely important when understanding S corporation taxation. 4 Business Succession Planning with S Corporations
S Corporation Basis Basics Assuming that the S corporation has never filed as a C corporation and/or has no retained earnings or profit, distributions received by an S corporation shareholder are not subject to income tax as long as the distribution does not exceed the shareholder s basis. Therefore, the larger the shareholder s basis, the greater the amount of S corporation distributions he or she can receive income tax-free. Generally, as is the case with C corporations, a shareholder s initial basis in the S corporation is equal to his or her initial investment or amount paid to buy the corporation s stock. However, unlike a C corporation, basis in the S corporation is increased or decreased to reflect various events. A shareholder s basis is generally increased by both taxable and nontaxable income items, such as death benefit from a corporate-owned life insurance policy and contributions of additional amounts to the corporation. 6 Basis is decreased by: n nontaxable distributions of previously taxed income; n income distributed in the same year in which it was earned; n losses; and n nondeductible expenditures such as life insurance expenses. 7 Due to ongoing adjustments, a shareholder s basis in an S corporation will vary from his or her initial contribution to or investment in the corporation. If the corporation is a service corporation, the shareholder s basis could be low because of the low initial investment typically made in these types of corporations. Permanent Life Insurance Advantages Life insurance can have many advantages for S corporations in a buy-sell agreement. As previously mentioned, nondeductible expenditures such as life insurance premiums decrease a shareholder s basis in an S corporation. However, the purchase of a permanent cash value policy can help offset, if not eliminate, this adverse situation. For S corporations, any nondeductible expense that is properly chargeable to a capital account will not reduce a shareholder s basis. 8 A policy s cash value is considered a capital account, so if permanent life insurance is purchased and owned by the S corporation, then any reduction in basis for premiums paid would reasonably be limited to the amount of premiums exceeding the increase in policy cash value for the year. For example, if a policy has an annual premium payment of $10,000 and the cash surrender value for that year increases by $8,000, then the shareholder s basis would be reduced by $2,000. If the annual premium for a term policy with the same face amount is $3,000, the shareholder saves $1,000 of basis reduction by purchasing a cash value policy. In subsequent years, the amount of basis savings will likely increase with a cash value policy because the cash value increase will likely be greater the longer the corporation owns the policy. 6 IRC 1367(a)(1). 7 IRC 1367(a)(2)(D). 8 IRC 1367(a)(2)(D). t r a n s a m e r i c a 5
If an S corporation buy-sell agreement is structured as a stock redemption which will be discussed in more detail later the use of permanent cash value life insurance can help maintain a higher basis for the S corporation shareholder. A higher basis will allow the shareholder to receive larger tax-free distributions from the S corporation. Structuring the Buy-Sell Agreement The options for structuring a buy-sell agreement are similar to those available for a C corporation. Generally, a buy-sell agreement will be structured either as a cross-purchase or a stock-redemption arrangement. Due to the special tax attributes of S corporations, a stock-redemption arrangement can be employed and constructed to avoid many of the negative effects that such an arrangement would produce when used by a C corporation. Cross-Purchase Arrangements for S Corporations A cross-purchase buy-sell arrangement is an agreement in which all owners of a business agree in advance to purchase proportionate shares of another owner s interest in the business if that principal dies or becomes disabled. A convenient way to fund a cross-purchase arrangement is to have each owner purchase a life insurance policy on the life of each of the other business principals. Using a cross-purchase agreement with an S corporation results in tax treatment similar to that of C corporations, including: n Life insurance premium cost is a nondeductible personal expense. n Shareholders receive the death benefit federal income tax-free. When a surviving shareholder uses a life insurance policy s death benefit to purchase a decedent s stock, the surviving shareholder s basis in his or her stock is increased by an amount equal to the purchase price. Cross-Purchase With this arrangement, each business owner purchases life and/or disability insurance on the other business owners. Each owner is the beneficiary of his or her respective policy(ies). The business is not part of the agreement. Upon the disability, death, or withdrawal of one owner, the remaining business owner(s) can use the policy cash value or proceeds to purchase their pro rata shares of the withdrawing owner s interest in the business. Owner A Buy-Sell Agreement Policy & Death Benefit on Owner B Premium Premium Policy & Death Benefit on Owner A Life Insurance Policy Owner B 6 Business Succession Planning with S Corporations
Stock-Redemption Arrangements for S Corporations With a stock-redemption arrangement, the buy-sell agreement between the S corporation and its shareholders requires that the S corporation will buy and the decedent s estate will sell the decedent s stock upon death. To fund the arrangement, the S corporation owns and is the beneficiary of a life insurance policy on each shareholder. 9 Structuring a buy-sell agreement as a stock redemption is particularly attractive for an S corporation because it avoids major disadvantages such as alternative minimum taxes and loss of basis increase that occur when such an arrangement is used for a C corporation. Stock Redemption The stock redemption buy-sell agreement is generally used with any business entity that has multiple owners who want to use the assets of the business to fund the agreement. The business purchases, owns, pays premiums on, and is the beneficiary of life insurance policies on each owner s life. When an owner dies, the business receives the death benefit and uses the proceeds to help purchase the deceased owner s business interest from his or her estate. The deceased business owner s estate is paid the agreed-upon price, and the surviving business owners own the entire business. Both the C corporation and the S corporation will show the life insurance policy cash values as a business asset. Premiums paid by both a C corporation and S corporation are nondeductible. However, only a C corporation may be subject to an alternative minimum tax liability for the policy cash value accumulation and death benefit. Owner A Buy-Sell Agreement Business Premium Policy & Death Benefits on Owners Life Insurance Policy Buy-Sell Agreement Owner B Section 318 Attribution Rules It is important to understand the attribution rules of 318 in both the C corporation and S corporation setting. Under this statute, an individual or entity is treated as owning stock owned by certain related family members, corporations, partnerships, estates, and trusts. These rules assume such related individuals and entities have a unified economic interest. Thus, stock owned by a partnership or estate is considered as owned by the partners or beneficiaries with present interests. Under the code s attribution rules, an S corporation is treated as a partnership. 10 Similarly for family attribution, an individual is treated as owning stock owned by his/her spouse, children, grandchildren and parents, but not siblings or in-laws. If attribution rules apply in the C corporation setting, the stock redemption transaction between the C corporation and the decedent s estate may be treated as a dividend distribution rather than as an actual sale of the asset ( capital transaction ). 9 In order to prevent the death benefits from being included in taxable income, there are certain exceptions for which the purchase of the policy must qualify and additional recordkeeping and reporting requirements the corporation must follow pursuant to IRC 101(j) and 6039I. 10 IRC 318(a)(5)(E) t r a n s a m e r i c a 7
With dividend treatment, the entire proceeds received from this transaction would be treated and taxed as a dividend subject to ordinary income tax rates up to the amount of earnings and profits (E&P) in the C corporation. Treatment as a sale transaction to which capital gains tax rates apply reduces the taxable gain by offsetting the estate s basis in the shares against the redemption proceeds. The dividend treatment may result in a substantially greater tax liability than if attribution rules did not apply and the stock redemption were treated as a capital transaction. Family attribution rules may be waived in some cases. While entity and family attribution rules apply to S corporations as well, the redemption of the shareholder s shares of an S corporation with no retained earnings or profits will have the same tax result as if the shares were sold or exchanged. 11 This allows the shareholder to recover his or her basis in the shares tax-free, with any amounts exceeding basis being treated as capital gains. 12 C Corporation Example Craig, who recently passed away, owned 75% of Family Corporation, a C corporation. Craig s son Todd owns the remaining 25%. Per a stock-redemption buy-sell arrangement, Craig s estate sells its shares to Family Corporation for $3 million, the fair market value of the shares at Craig s death. At Craig s death, per current estate tax law, the income tax basis of Craig s shares was increased, or stepped up, to the fair market value of the shares at the time of his death, which in this example is $3 million. Normally, a sale of C corporation shares would be treated as a capital transaction, resulting in only the amount of gain (the redemption proceeds in excess of the seller s basis in the shares) being subject to taxes at the capital gains rate. In this example, this would result in no taxable gain, since the estate s basis in the shares ($3 million) is equal to the $3 million sale price. Nevertheless, because Craig s son Todd owns shares in the corporation and is the sole beneficiary of Craig s estate, stock attribution rules may apply to deem Todd to own 100% of the shares and, if they do, the $3 million distributed in exchange for Craig s shares will likely be treated as a dividend to the extent of E&P. This could result in Craig s estate having some or all of the $3 million being subject to taxes at ordinary income tax rates. S Corporation Example The same facts as above exist, except that in this example Family Corporation is an S corporation with no retained earnings or profits. As occurred with the C corporation, because Todd owns shares in the corporation and is the beneficiary of Craig s estate, Todd will be deemed to own 100% of the shares. But as discussed previously, distributions from an S corporation with no retained earnings or profits are only taxable if they exceed the shareholder s basis in the S corporation. To the extent a distribution does not exceed a shareholder s basis, the excess is taxable at the capital gains rate. Therefore, although the $3 million received by Craig s estate may be a distribution due to stock attribution, it is of no consequence since the S corporation had no E&P, and the estate received a stepped-up basis in the corporation stock of $3 million. Thus, the redemption resulted in no taxable gain to Craig s estate. 11 Whether a distribution is characterized as a redemption under IRC section 302(a) or as a distribution under IRC section 1368(a) may make little difference to a redeeming S corporation shareholder because of the distribution rules governing S corporations that have no earnings and profits. 12 IRC 1368(b). 8 Business Succession Planning with S Corporations
Alternative Minimum Taxes (AMT) Annual increases in cash value and receipt of death benefits by a C corporation could result in AMT being levied on the corporation. An S corporation is not subject to AMT. Avoiding Wasted Basis: Using a Short Year Election When a C corporation purchases shares from a decedent, the surviving shareholders bases do not increase. The unchanged basis results because the corporation not the shareholders purchased the shares. Thus, a future sale of corporate stock by the surviving shareholders could result in a larger taxable gain. As mentioned previously, cost basis in an S corporation is increased when the corporation receives either taxable or nontaxable income. Nontaxable income includes amounts received from death benefits on life insurance policies owned by the corporation. As a result, when using a stock-redemption arrangement for an S corporation, unlike a C corporation, receipt of death benefits will likely result in a basis increase for the surviving shareholders based on each one s pro rata ownership. The amount of the increase will depend on whether the S corporation can make a short year election, discussed below. For example, assume Mike and Dan are both 50% owners of Walking Boots Corp., an S corporation. Currently, Mike and Dan each have a basis in the S corporation of $100,000. Walking Boots Corp. owns a $1 million term policy on Dan. If Dan were to die, both Mike s and Dan s estates basis should be increased by $500,000 which is equal to each one s ownership share, 50%, of the $1 million death benefit producing a total basis of $600,000 for each owner. Since the basis of property included in a decedent s estate is stepped up, or increased, to the fair market value of the property at the date of death, Mike s basis is increased by $500,000, but Dan s step-up is wasted because at his death his shares already received a basis step-up equal to their fair market value. If an S corporation uses the cash basis accounting method, a short year election to terminate the S corporation tax year under IRC 1377(a)(2) can be made after the death of a shareholder and the redemption of his shares, but before the death benefits are received. An S corporation s accounting method can usually be ascertained by asking the corporation s accountant. By quickly redeeming the shares and terminating the corporation s tax year, life insurance proceeds can be received in the following tax year. This allows the surviving shareholder(s) to receive a basis increase for the entire amount of the life insurance death benefit and thus avoid wasting any basis. To revisit the Walking Boots S corporation example, after Dan s death and prior to the receipt of the life insurance death benefit, Dan s shares are redeemed and Mike elects to terminate the S corporation tax year. Mike s basis will be increased by the full amount of the life insurance death benefit, or $1 million. As a result, Mike s basis in the S corporation will be $1.1 million, which will allow him to take distributions from the S corporation up to that amount income tax-free. Stock Redemption Arrangement Valuation Issues One of the concerns regarding the use of a stock-redemption arrangement is that, since the S corporation is the owner and beneficiary of life insurance policies on the lives of the shareholders, the death of an insured shareholder will increase the overall value of the S corporation by an amount t r a n s a m e r i c a 9
equal to the death benefit received by the corporation. This increase in value may then increase the decedent s estate tax burden. Many commentators believe that, although the death benefit is received by the S corporation, the value of the asset is offset by the corporation s obligation under the buy-sell agreement to use those funds to purchase the decedent s shares. Thus, the valuation of the S corporation may not be affected by the death benefit of the life insurance policy. This position is supported by rulings in several court cases. 13 In addition, the use of a valuation formula to determine the value of the corporation could also minimize the impact of the death benefit. The client should seek the advice of a qualified accredited appraiser to determine the ultimate impact of an insurance policy on the valuation of the corporation. Strength and Stability from an Industry Leader Transamerica Life Insurance Company and Transamerica Financial Life Insurance Company (collectively Transamerica ) have the strength and experience to help policy owners as they look ahead to the future. Transamerica was built on a simple, but powerful, promise: to provide quality financial products at competitive prices. Transamerica has been helping families and businesses to secure their financial futures for more than a century, and this tradition of excellence continues today. Conclusion Due to its complexity and the special requirements that exist, structuring a buy-sell agreement for an S corporation can be extremely challenging. Nevertheless, because of the increasing popularity of these corporations, gaining a basic understanding of their requirements and taxation is essential to assist shareholders in structuring a buy-sell agreement advantageously. A poorly structured buy-sell agreement could result in the loss of S corporation status, as well as the possibility of increasing the surviving shareholders tax burden on future distributions from or sale of the S corporation. However, S corporations have special attributes that, in combination with a well-developed buy-sell arrangement, could provide greater advantages than those available to C corporations. 13 See, for example, Estate of Blount v. Commissioner, 96 AFTR 2d, 2005-6795 (428 F. 3d 1338) (11th Cir. 2005) (Death benefit proceeds from a corporate-owned life insurance policy should not be included in the value of a corporation, if there is a contractual obligation through a stock-purchase buy-sell agreement to use those funds in a stock buyout.) See also Cartwright v. Commissioner, 183 F. 3d 1034 (9th Cir.1999). 10 Business Succession Planning with S Corporations
Transamerica Life Insurance Company, Transamerica Financial Life Insurance Company (collectively Transamerica ) and its agents and representatives do not give tax or legal advice. This material and the concepts presented here are for information purposes only and should not be construed as tax or legal advice. Any tax and/ or legal advice you may require or rely on regarding this material should be based on your particular circumstances and should be obtained from an independent professional advisor. Discussions of the various planning strategies and issues are based on our understanding of the applicable federal income, gift, and estate tax laws in effect at the time of publication. However, tax laws are subject to interpretation and change, and there is no guarantee that the relevant tax authorities will accept Transamerica s interpretations. Additionally, this material does not consider the impact of applicable state laws upon clients and prospects. Although care is taken in preparing this material and presenting it accurately, Transamerica disclaims any express or implied warranty as to the accuracy of any material contained herein and any liability with respect to it. This information is current as of June 2015. Life insurance products are issued by Transamerica Life Insurance Company, Cedar Rapids, IA 52499, or Transamerica Financial Life Insurance Company, Harrison, NY, 10528. All products may not be available in all jurisdictions. Transamerica Financial Life Insurance Company is authorized to conduct business in New York. Transamerica Life Insurance Company is authorized to conduct business in all other states. For producer use only. Not for distribution to the public. OLA 1542 0615