Buy-sell agreements and possible tax consequences
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When should my business use stock purchase agreement?

MY BUSINESS IS ORGANIZED AS A CORPORATION. I UNDERSTAND MY NEED FOR A BUY-SELL AGREEMENT. BUT UNDER WHAT CIRCUMSTANCES ARE “STOCK REDEMPTION AGREEMENTS” PREFERABLE TO THEIR “CROSS PURCHASE AGREEMENT” COUNTERPARTS? WHAT FACTORS SHOULD I CONSIDER?

For corporations, buy-sell agreements come in two forms: stock redemption agreements (i.e. “entity” agreements), where corporation purchases a deceased owner’s stock, and cross-purchase agreements, where the surviving shareholders make the purchase. A stock redemption agreement is often preferable to a cross purchase agreement under several circumstances, including the following: (1) when there are several shareholders; (2) when it makes more economic sense, due to certain tax considerations, for the corporation to purchase the decedent owner’s interest, rather than the shareholders; (3) when it is desirable to prevent the application of the transfer for value rule, resulting in taxation of insurance proceeds after the death of a shareholder; and (4) when the parties desire that appreciated assets owned by the corporation fund the purchase price for a deceased owner’s stock. Each of these is more fully explained below.

1. IT IS OFTEN PREFERABLE TO USE A STOCK REDEMPTION AGREEMENT OVER A CROSS PURCHASE AGREEMENT WHEN THERE ARE MANY SHAREHOLDERS AND THE PURCHASE PRICE IS FUNDED WITH LIFE INSURANCE.

It is often preferable to use a stock redemption agreement when there are more than a few shareholders (and the purchase price for a departing shareholder’s interest is funded with life insurance) because it is transactionally simpler. Consider a corporation with 11 shareholders. Under a stock redemption agreement, the corporation must own 11 life insurance policies. However, under a cross purchase agreement, each shareholder would have to own 10 policies, one on each of the other shareholders, for a total of 110 policies. By contrast, when there are fewer shareholders this complication is minimized. If the corporation has two shareholders, then only two policies are needed, regardless whether a cross purchase or a stock redemption agreement is used.

2. OFTEN IT IS MORE ECONOMICALLY EFFICIENT FOR THE CORPORATION ITSELF TO PURCHASE THE DECEDENT OWNER’S INTEREST (UNDER A STOCK REDEMPTION AGREEMENT), RATHER THAN THE SURVIVING SHAREHOLDERS (UNDER A CROSS PURCHASE AGREEMENT), WHEN CERTAIN TAX-SENSITIVE CONDITIONS ARE PRESENT.

It is often more economical for the corporation, rather than the shareholders, to make the purchase when certain particular tax circumstances, relating to the corporation and the shareholders, are present. This entry describes three such circumstances below.

The first circumstance is when the corporation cannot make additional distributions to the shareholders without them being taxed as a dividend. Therefore, if the shareholders require the corporation to make a distribution so that they can buyout a departing shareholder’s stock, then those distributions will be taxed twice (“double taxation”). By contrast, double taxation could be avoided on those payments if the corporation itself were to purchase the decedent shareholder’s interest (or if the corporation pays the insurance premiums funding the buy-sell agreement).

Of course, the parties cannot take a “wait-and-see” approach, according to which the corporation might (or might not) pay the purchase price under the buy-sell agreement. Rather, for the entity/stock redemption to be valid for tax purposes, the buy-sell agreement must require all along that the corporation make the purchase. Thus, the parties must decide early on how to structure things. For this reason, it is advisable for the owners, the attorney, and the financial planners to be in discussions to help analyze what is best.

Second, it is also often better for the corporation (rather than the shareholders) to pay the purchase price of the deceased shareholder when the corporation is in a lower tax bracket than the individual shareholders.

To see why this is the case, consider the following. Suppose the buy-sell agreement is funded by life insurance. Then the question becomes who pays its premiums—the shareholder or the corporation itself. From a tax perspective, it is often better when the corporation pays for them when it is in a lower tax bracket. Suppose an aggregate of $60,000 is required for the premium. If each of the shareholders were to pay this amount under a cross-purchase agreement, then they would actually need approximately 28% to 39.6% more than this (depending upon their income tax bracket). By contrast, if the corporation were in the lowest income tax bracket, then it would need to earn only 15% more than $60,000 to fund the premiums under a stock purchase agreement (assuming the lowest corporate income tax bracket is 15%). In this scenario, all things being equal, the corporation should pay the premiums because it is more tax efficient.

Note that the converse also holds true. That is, if the shareholders were in a lower income tax bracket than the corporation, then it would be more tax economical (at least tax wise) for them to pay the purchase price for a deceased shareholder’s interest. To accomplish this, their salary would simply be increased so they may appropriately fund the insurance premium payments under the cross-purchase agreement. This assumes, of course, that the shareholders’ salaries may be increased without the increased amount being taxed as a dividend (salaries must be “reasonable”).

Third, it is also often better for the corporation (rather than the shareholders) to pay the purchase price of the deceased shareholder’s interest when part of the purchase price is to be paid in installments, plus interest.

To see this, consider the alternatives. On the one hand, if there were a cross-purchase agreement (i.e. where the surviving shareholders are the purchasers), then the shareholders may be limited (or unable) in their ability to deduct the interest portion on the installment payments, especially if they continue to make payments when they (the surviving shareholders) retire from the business.

This result arises from the rules relating to the limitations on the deductibility of interest expenses under IRC §163. Generally, investment interest may be deducted only to the extent of one’s annual net investment income. IRC §163(d). This rule also applies to the interest one pays on debt he incurred on property held for investment. IRC §163(d)(3). Furthermore, if one does not “materially participate” in a business, then his investment in the business is considered an investment interest that is subject to the interest expense deduction limitations of IRC §163. Putting this all together, this means that if the shareholder at the time he pays for a departing shareholder’s interest is not continually and substantially involved in the business (did he retire?) then his interest deduction may be reduced or lost.

On the other hand, if the corporation were to buy (in installments, with interest) the deceased shareholder’s interest (i.e. under a stock redemption agreement), then all the interest payments would be deductible. This is because the limitations of IRC §163 on interest deductions do not apply to corporations. IRC §163(d)(1).

Sometimes a combination of insurance and an installment sale is used for the purchase of departing shareholder’s interest. This could arise if, for example, the value of the business increased more than anticipated and only a lesser amount of insurance was purchased, or the shareholder is not fully insurable. Under these circumstances, the purchase price should often be allocated so that the corporation is responsible for the interest portion and the surviving shareholders are responsible for the rest. For the same reasons explained above, from a tax perspective, this is often the more efficient way to structure things so that all the interest expenses get deducted.

3. IT IS OFTEN PREFERABLE TO USE A STOCK REDEMPTION AGREEMENT TO AVOID APPLICATION OF THE “TRANSFER FOR VALUE” RULE.

When the buy-sell agreement is funded with life insurance, it is typically advisable to avoid the so-called “transfer for value rule.” Usually, life insurance proceeds are not taxed. IRC §101(a). However, as an exception, if the life insurance policy is sold or transferred to another for value, the entire proceeds become subject to taxation. IRC §101(a)(2). This is the so-called “transfer for value rule,” and it can apply in the context of a cross-purchase agreement after the death of one of the shareholders. With a cross-purchase agreement, each shareholder owns a life insurance policy on each one of the other shareholders. After the death of one of the shareholders, the remaining shareholders may desire to purchase from his estate the other life insurance contracts on the surviving owners’ lives. When the estate sells those policies, the transfer for value rule applies. Consequently, when the policy eventually pays out after the death of another shareholder, the life insurance will be taxed (for income tax purposes).

There are many exceptions to the transfer for value rule but, unfortunately, none applies to shareholder-to-shareholder sales (or for estate of shareholder-to-surviving shareholder sales). As exceptions, the transfer for value rule does not apply (and thus life insurance proceeds are not taxed) if the transfer is to (i) a partner of the insured (i.e. the business is organized as a partnership), (ii) the transfer is to the partnership (of which the insured was a partner), or (iii) the policy is transferred to a corporation itself (provided the insured was a shareholder or an officer of it). See IRC §101(a)(2)(B)(explaining these “other property” exceptions). There are a couple of other exceptions to the transfer for value rule (e.g. (iv) the “transferor’s basis exception,” IRC §101(a)(2)(A), which often applies when a policy is gifted; and (v) when the policy is transferred to the insured), but they are not usually applicable in the buy-sell agreement context.

4. THE PARTIES DECIDE TO PURCHASE THE DECEASED SHAREHOLDER’S STOCK WITH APPRECIATED ASSETS OWNED BY THE CORPORATION.

It is sometimes preferable to use a sock purchase agreement rather than a cross purchase agreement when the parties desire that the deceased owner’s stock be purchased with appreciated corporate assets.

In general, one may distribute appreciate corporate assets (e.g. marketable securities, real estate) only if the corporation thereby realizes a gain on the distribution. IRC §311(b). However, prior to 1986, before the enactment of IRC §311(e), there was an exception to this rule that allowed tax-free distributions to a shareholder’s estate in complete redemption of the estate’s stock.

Thus, under current law, much of the incentive to purchase an owner’s stock with appreciated corporate assets has been reduced. Even so, sometimes it is still overall worthwhile for the parties to structure things in that way. When this is the case, using a stock redemption agreement form of a buy-sell agreement over a cross-purchase agreement form is necessary. The reason is plain: corporate assets, rather than a shareholder’s personal assets, are used to fund the transaction. It is sometimes overall worthwhile for the corporation to purchase the deceased owner’s stock with appreciated corporate assets when the shareholder is in a higher income tax bracket than the corporation.

To illustrate the above concepts, consider the following. Suppose a corporation has an appreciated asset worth $200,000, with a basis of $130,000. If the corporation distributes these to the shareholder (or the estate of the shareholder) it will realize a $70,000 gain on the distribution. Under IRC §301(d)(1), the estate will then have a fair market value basis of $200,000, and would not have any capital gain to realize from a subsequent sale of the asset. If the shareholder (or his estate) were to pay a higher tax than the corporation, then structuring things in this manner with the purchase price funded by a corporate appreciated asset would be more tax efficient. Furthermore, if the corporation had an existing capital loss of, say, $100,000 to offset the $70,000 gain, then no tax would result from either the distribution to the corporation (because of the gain/loss offset) or the subsequent sale of the asset by the deceased shareholder’s estate (because the estate receives a fair market value basis).