Understanding the Tax Implications of Buy-Sell Agreements
In the previous article we discussed which type of buy-sell agreement would be most suitable for your business based on your business arrangement (i.e. single owner, partnership, C-Corp w/ multiple owners, etc). In this article we consider the tax implications of the different types of buy-sell agreements, which, in some cases, may further dictate which plan is most suitable. Leaving taxation aside, understanding the inner-workings of the different buy-sell arrangements is fairly straightforward; however, as you might expect, when you add the tax consequences to the equation, it becomes somewhat convoluted.
Deciphering the entire part of the tax code that governs buy-sell agreements simply can’t be done in the space allowed here; however, we can at least cover the highlights which can begin to point you in the right direction as you explore your options.
The Two Tax Certainties of Buy Sell Agreements
As you delve into the tax implications of buy-sell agreements you will no doubt find them to be confusing at best. We’ll try to simplify them as best we can here; however, before we get there, it may help to know that there are two certainties that you can count on regardless of your situation: 1) life insurance premium payments are not tax deductible, and 2) life insurance proceeds are excludable from the beneficiary’s taxable income. However, there are circumstances when life insurance proceeds can trigger a tax:
Transfer for value – in a cross purchase agreement, when the owner of a policy transfers it to another owner who then receives proceeds that exceeds his or her cost basis in the policy. Policies can be transferred to the insured or a partner of the insured or to the corporation (in an entity plan) without triggering transfer for value. Further, the transfer for value trigger can be avoided if the owners purchase the policies through a separate tax entity such as an LLC. In doing so, any transfers would occur as partner to partner which is an exception to the rule.
Alternative minimum tax – Life insurance proceeds paid to a corporation can trigger an alternative minimum tax which must be paid on income that is otherwise not includable as income. However, the AMT trigger is not likely to occur in smaller corporations.
It’s all about the Cost Basis
The biggest tax implication for buy-sell arrangements is in the calculation of the cost basis when proceeds are used to buy the interests of a deceased shareholder in a stock redemption or entity plan.
Under a cross-purchase agreement, the surviving partners or shareholders assume the original cost basis plus consideration for the amount paid for the deceased owner’s shares, so, in essence, they receive a step-up in basis. Hence, there is no tax consequence.
In a stock redemption plan, where the corporation, as a separate tax entity, uses the proceeds to buy back the deceased shareholder’s shares, the surviving shareholders assume the original cost basis without consideration for the amount paid, because the corporation paid for the shares.
In addition, when the surviving shareholders sell their interest they are subject to capital gains taxes on their portion of the gain as well as the portion of the gain of the deceased shareholder.
Cross-Purchase is more tax advantageous; but we have six owners!
Suffice it to say, stock redemption plans carry potential tax implications that can significantly impact shareholders. However, although the cross purchase arrangement is much more advantageous from a taxation standpoint, they can be extremely cumbersome in situations where there are multiple owners. For instance, if a business has six owners, it would require the purchase of 30 life insurance policies (a separate policy owned on each of the six lives by six owners).
A workaround for multiple owner situations would be to appoint a trustee to own a policy on each of the shareholders and would credit each with a pro-rata interest in policies of each of the other shareholders. The trustee would receive the insurance proceeds and pay the estate of the deceased shareholder in exchange for its shares. The trustee would then credit the each surviving shareholder with a pro-rata portion of the acquired shares.
It sounds fairly simple on the surface; however, to reduce the possibility of triggering transfer for value, the shareholders would need to establish a partnership or LLC to hold the policies, so that any transfers would occur partner to partner.
That’s our attempt at simplifying the tax implications of buy-sell arrangements. Needless to say, it can get complicated. But, with the right planning, it doesn’t have to be. The key is to partner with a professional, experienced in business continuation planning, who can narrow down your options to the one most suitable and tax efficient for your particular situation.