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.

Understanding how to properly structure a buy-sell A buy-sell agreement is important agreement for an S corporation has become extremely important, given its increasing popularity. In 2013, for most businesses because it over 67% of all corporations filed tax returns as an provides a “road map” for the S corporation.1 transfer of the business in the event of the owner’s death, disability, retirement, or other separation from the business.

1 IRS Data Book, Table 2, 2013.

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Buy-Sell Planning Consequences of Not Creating

A buy-sell agreement provides a “road map” for a Buy-Sell Plan the transfer of the business in the event of the There are a number of serious consequences that owner’s death, disability, retirement or other can occur from failing to create an S corporation separation from the business. Having a buy-sell buy-sell plan. They include: agreement in place can help mitigate conflict and n Fire sale of the business for an amount far below accelerate the transition of the business. 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.

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Importance of Buy-Sell Buy-Sell Basics

Planning for S Corporations While agreements may differ in their wording, A buy-sell agreement is extremely important most buy-sell agreements generally state that each for an S corporation due to the entity’s special owner agrees: requirements and tax attributes. Among other n Not to dispose of his or her ownership interest issues at stake, transfer of S corporation stock to during his or her lifetime without first offering it an ineligible entity or person could result in the for sale to the business entity or other owners involuntary termination of S corporation status. n That the surviving owners or the business entity For example, S corporation stock cannot be owned will purchase, and the deceased owner’s estate by a nonresident alien. So a transfer to such a will sell, the decedent’s ownership interest person would result in the loss of S corporation n Upon a pre-established valuation formula to be status. Additionally, transfers to entities such as used at the time of death in order to determine a partnerships, corporations and most trusts are definitive price for his or her ownership interests prohibited. A buy-sell agreement can ensure that S corporation stock does not inadvertently pass to an ineligible party, thus protecting the business’s Funding the Buy-Sell S corporation status. Agreement with Life Insurance An inadvertent termination of S corporation Acquiring the funds to complete a buyout can status will cause the corporation to be taxed as a be difficult, especially when the business owner C corporation as of the day of termination, which has died and the business may already be can produce adverse income tax consequences adversely affected by the loss of his or her services. to the shareholders. If S corporation status is The surviving owner(s) could raise the needed terminated, the corporation generally must wait funds by borrowing, selling business assets or five years before making a new S corporation using cash reserves, but all of these approaches election, resulting in the corporation being taxed are inherently uncertain and may put a severe on its net profits for five years.2 burden on the operations of the business. Life insurance offers a more secure basis for funding Furthermore, if the buy-sell agreement does not a buy-sell agreement. take advantage of the special tax attributes of S corporations, the surviving shareholders could A life insurance policy can provide the proper face additional tax burdens on future ongoing amount of liquidity when it is needed most—at the corporate distributions and/or those made upon death of a business owner. Funds received from the the sale of the corporation. death benefit of the policy can be used to purchase the decedent’s interest. If a permanent life insurance We will discuss the requirements for qualification policy is used, the cash values may also serve as a and maintenance of S corporation status in more source of funds for a buyout at dissolution, or when detail later in this Guide. a business owner becomes disabled, incapacitated or decides to retire.

2 IRC § 1362(g).

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Taking a Closer Look at the S Corporation The concept of basis There are two types of corporations: Subchapter C is extremely important and Subchapter S. Both enjoy the advantages of limited liability, transferability of ownership and when understanding professional business management. An S corporation is taxed similarly to a partnership, since its income S corporation taxation. is passed through to its shareholders.

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 Taxation Overview S Corporation Requirements Understanding buy-sell planning for S corporations In order to qualify for S corporation status, all of is difficult without having an idea of how they 3 the following requirements must be met: are taxed. The concept of basis is an extremely n The corporation must be a domestic corporation; important component of S corporation taxation. Following is an overview of the complex tax rules n It must not have more than 100 shareholders, that govern S corporations and their shareholders. but members of a family are treated as one shareholder;4

n Only individuals, a decedent’s estate, estates of As mentioned previously, an S corporation is subject individuals in bankruptcy, and certain trusts are to only one level of taxation, at the shareholder level. eligible shareholders of an S corporation; This does not mean, however, that all distributions to the shareholders will be subject to income tax. n No shareholder can be a nonresident alien; and If a shareholder’s tax basis in the S corporation n The corporation can only have one class of stock, exceeds the amount of the distribution, the 5 although different voting rights are allowed. shareholder usually will not be taxed when he or she receives the distribution. The concept of 3 IRC § 1361(b). basis, therefore, is extremely important when 4 IRC § 1361(c)(1)(A)(ii). For this purpose, an adopted child is treated understanding S corporation taxation. as a natural child and is included in the family. IRC § 1361(c)(1)(C). 5 IRC § 1361(c)(4).

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S Corporation Basis Basics Permanent Life Assuming that the S corporation has never filed as Insurance Advantages a C corporation and/or has no retained earnings or Life insurance can have many advantages for profit, distributions received by an S corporation S corporations in a buy-sell agreement. shareholder are not subject to income tax as long as the distribution does not exceed the shareholder’s As previously mentioned, nondeductible expendi- basis. Therefore, the larger the shareholder’s basis, tures such as life insurance premiums decrease a the greater the amount of S corporation distributions shareholder’s basis in an S corporation. However, he or she can receive income tax-free. the purchase of a permanent cash value policy can help offset, if not eliminate, this adverse situation. Generally, as is the case with C corporations, a shareholder’s initial basis in the S corporation is For S corporations, any nondeductible expense equal to his or her initial investment or amount that is “properly chargeable to a capital account” paid to buy the corporation’s stock. However, will not reduce a shareholder’s basis.8 A policy’s unlike a C corporation, basis in the S corporation cash value is considered a capital account, so if is increased or decreased to reflect various events. permanent life insurance is purchased and owned by the S corporation, then any reduction in basis A shareholder’s basis is generally increased by for premiums paid would reasonably be limited to both taxable and nontaxable income items, such the amount of premiums exceeding the increase as death benefit from a corporate-owned life in policy cash value for the year. insurance policy and contributions of additional amounts to the corporation.6 For example, if a policy has an annual premium payment of $10,000 and the cash surrender Basis is decreased by: value for that year increases by $8,000, then the n nontaxable distributions of previously shareholder’s basis would be reduced by $2,000. taxed income; n income distributed in the same year in which If the annual premium for a term policy with the it was earned; same face amount is $3,000, the shareholder n losses; and saves $1,000 of basis reduction by purchasing a cash value policy. In subsequent years, the n nondeductible expenditures such as life amount of basis savings will likely increase with a insurance expenses.7 cash value policy because the cash value increase will likely be greater the longer the corporation Due to ongoing adjustments, a shareholder’s basis owns the policy. 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.

6 IRC § 1367(a)(1). 7 IRC § 1367(a)(2)(D). 8 IRC § 1367(a)(2)(D).

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If an S corporation buy-sell agreement is structured Cross-Purchase Arrangements as a stock redemption—which will be discussed in more detail later—the use of permanent cash for S Corporations value life insurance can help maintain a higher A cross-purchase buy-sell arrangement is an basis for the S corporation shareholder. A higher agreement in which all owners of a business agree basis will allow the shareholder to receive larger in advance to purchase proportionate shares of tax-free distributions from the S corporation. 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 Structuring the have each owner purchase a life insurance policy Buy-Sell Agreement on the life of each of the other business principals. The options for structuring a buy-sell agreement Using a cross-purchase agreement with an S are similar to those available for a C corporation. corporation results in tax treatment similar to Generally, a buy-sell agreement will be structured that of C corporations, including: either as a cross-purchase or a stock-redemption n Life insurance premium cost is a nondeductible arrangement. Due to the special tax attributes of personal expense. S corporations, a stock-redemption arrangement can be employed and constructed to avoid many n Shareholders receive the death benefit of the negative effects that such an arrangement federal income tax-free. would produce when used by a C corporation. 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 Policy & Death the other business owners. Each owner is the Benefit on Owner B beneficiary of his or her respective policy(ies).

The business is not part of the agreement. Premium

Upon the disability, death, or withdrawal of Owner A one owner, the remaining business owner(s) can use the policy cash value or proceeds to Buy-Sell Agreement purchase their pro rata shares of the withdrawing Life Insurance owner’s interest in the business. Policy

Premium

Policy & Death Benefit on Owner A

Owner B

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Stock-Redemption Arrangements for S Corporations

With a stock-redemption arrangement, the buy-sell Structuring a buy-sell agreement as a stock agreement between the S corporation and its share- redemption is particularly attractive for an holders requires that the S corporation will buy S corporation because it avoids major and the decedent’s estate will sell the decedent’s disadvantages such as alternative minimum stock upon death. To fund the arrangement, the taxes and loss of basis increase that occur when S corporation owns and is the beneficiary of such an arrangement is used for a C corporation. a life insurance policy on each shareholder.9

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 Buy-Sell Agreement purchases, owns, pays premiums on, and is the Business beneficiary of life insurance policies on each owner’s life. When an owner dies, the business Buy-Sell Agreement Benefits on Owners

receives the death benefit and uses the proceeds Policy & Death Premium 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. Owner A Owner B 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 Life Insurance Policy cash value accumulation and death benefit.

Section 318 Attribution Rules code’s attribution rules, an S corporation is treated It is important to understand the attribution rules of as a partnership.10 Similarly for family attribution, § 318 in both the C corporation and S corporation an individual is treated as owning stock owned by setting. Under this statute, an individual or entity is his/her spouse, children, grandchildren and parents, treated as owning stock owned by certain related but not siblings or in-laws. family members, corporations, partnerships, estates, and trusts. These rules assume such related If attribution rules apply in the C corporation individuals and entities have a unified economic setting, the stock redemption transaction between interest. Thus, stock owned by a partnership or the C corporation and the decedent’s estate may estate is considered as owned by the partners or be treated as a dividend distribution rather than as beneficiaries with present interests. Under the 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)

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With dividend treatment, the entire proceeds capital transaction. Family attribution rules may be received from this transaction would be treated and waived in some cases. taxed as a dividend subject to ordinary income tax rates up to the amount of earnings and profits (E&P) While entity and family attribution rules apply to in the C corporation. Treatment as a sale transaction S corporations as well, the redemption of the to which capital gains tax rates apply reduces the shareholder’s shares of an S corporation with no taxable gain by offsetting the estate’s basis in the retained earnings or profits will have the same tax shares against the redemption proceeds. The result as if the shares were sold or exchanged.11 dividend treatment may result in a substantially This allows the shareholder to recover his or her greater tax liability than if attribution rules did not basis in the shares tax-free, with any amounts apply and the stock redemption were treated as a 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).

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Alternative Minimum Taxes (AMT) Since the basis of property included in a decedent’s Annual increases in cash value and receipt of death estate is stepped up, or increased, to the fair benefits by a C corporation could result in AMT market value of the property at the date of death, being levied on the corporation. An S corporation Mike’s basis is increased by $500,000, but Dan’s is not subject to AMT. step-up is wasted because at his death his shares already received a basis step-up equal to their fair Avoiding Wasted Basis: market value. Using a Short Year Election When a C corporation purchases shares from a If an S corporation uses the cash basis accounting decedent, the surviving shareholders’ bases do not method, a “short year” election to terminate the increase. The unchanged basis results because the S corporation tax year under IRC § 1377(a)(2) corporation—not the shareholders—purchased the can be made after the death of a shareholder shares. Thus, a future sale of corporate stock by the and the redemption of his shares, but before the surviving shareholders could result in a larger death benefits are received. An S corporation’s taxable gain. accounting method can usually be ascertained by asking the corporation’s accountant. As mentioned previously, cost basis in an S corporation is increased when the corporation By quickly redeeming the shares and terminating receives either taxable or nontaxable income. the corporation’s tax year, life insurance proceeds Nontaxable income includes amounts received can be received in the following tax year. This from death benefits on life insurance policies allows the surviving shareholder(s) to receive a owned by the corporation. As a result, when basis increase for the entire amount of the life using a stock-redemption arrangement for an insurance death benefit and thus avoid “wasting” S corporation, unlike a C corporation, receipt of any basis. death benefits will likely result in a basis increase for the surviving shareholders based on each one’s To revisit the Walking Boots S corporation example, pro rata ownership. after Dan’s death and prior to the receipt of the life insurance death benefit, Dan’s shares are The amount of the increase will depend on whether redeemed and Mike elects to terminate the the S corporation can make a “short year” election, S corporation tax year. Mike’s basis will be discussed below. increased by the full amount of the life insurance death benefit, or $1 million. As a result, Mike’s For example, assume Mike and Dan are both 50% basis in the S corporation will be $1.1 million, owners of Walking Boots Corp., an S corporation. which will allow him to take distributions from the Currently, Mike and Dan each have a basis in the S S corporation up to that amount income tax-free. corporation of $100,000. Walking Boots Corp. owns a $1 million term policy on Dan. If Dan were to die, Stock Redemption both Mike’s and Dan’s estates’ basis should be increased by $500,000—which is equal to each Arrangement Valuation Issues one’s ownership share, 50%, of the $1 million death One of the concerns regarding the use of a benefit—producing a total basis of $600,000 for stock-redemption arrangement is that, since the each owner. 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

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equal to the death benefit received by the corpo- ration. This increase in value may then increase Strength and Stability from the decedent’s estate tax burden. an Industry Leader Transamerica Life Insurance Company and Many commentators believe that, although the Transamerica Financial Life Insurance Company death benefit is received by the S corporation, the (collectively “Transamerica”) have the strength value of the asset is offset by the corporation’s and experience to help policy owners as they look obligation under the buy-sell agreement to use ahead to the future. Transamerica was built on a those funds to purchase the decedent’s shares. simple, but powerful, promise: to provide quality Thus, the valuation of the S corporation may not be financial products at competitive prices. affected by the death benefit of the life insurance Transamerica has been helping families and policy. This position is supported by rulings in businesses to secure their financial futures for 13 several court cases. more than a century, and this tradition of excellence continues today. 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. 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.

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