Corporate Buy-Sell Agreements
Securing a Future for Closely Held Corporations
David Joy, Jo Koehn, and Janice Klimek
a closely held corporation, shareholders are often concerned
about what might occur if one of the owners dies. Will the
deceased shareholder’s family retain the economic
value of the corporate interest? Can the surviving owners
avoid interference from the deceased shareholder’s
family? Will the survivors have the economic resources to
redeem the deceased owner’s interest? Given these
concerns, corporate owners are best served by entering into
a buy-sell agreement while they are all alive.
of Buy-Sell Agreements and Tax Implications
usually choose from two basic types of buy-sell agreements.
With a cross-purchase agreement, each owner of the corporation
purchases an insurance policy on the other shareholders.
The purchaser is both owner and beneficiary of the policies.
Upon the death of a shareholder, the other shareholders
are then able to use the life insurance proceeds to purchase
the deceased owner’s shares. Another commonly used
type of agreement is a stock redemption agreement, in which
the corporation owns policies on the lives of the shareholders.
When a shareholder dies, the corporation buys the deceased
shareholder’s interest in the company with the insurance
agreements. The cross-purchase form of the
buy-sell agreement offers several advantages. The family
of the deceased owner will have a tax basis equal to the
fair market value of the decedent’s stock at the date
of death, thus avoiding any income tax consequences as a
result of the sale. The fair market value of the shares
should be defined by the buy-sell agreement (see the Exhibit).
life insurance proceeds received by the surviving owners
are not subject to income taxation. For newly purchased
shares, the corporate shareholders will be entitled to a
tax basis equal to the purchase price. The stepped-up basis
should reduce future income taxes if the surviving shareholders
later sell their interests. The insurance proceeds are not
subject to the corporate alternative minimum tax (AMT) and
are also not subject to the claims of corporate creditors.
The AMT avoidance and creditor protection exist because
the proceeds are paid directly to the individual shareholders.
cross-purchase form of the buy-sell agreement carries several
disadvantages. The plan is difficult to administer if there
are numerous shareholders that must buy a plan for each
other. For example, for seven owners to cross-purchase life
insurance would require 42 (7 ¥ 6) policies. The number
of policies can multiply even further if disability coverage
is also part of the buy-sell agreement.
disadvantage of the cross-purchase agreement is that age
or insurability can create a disparity in premiums. Younger
or healthier owners may incur higher premiums to cover older
and less healthy owners. A possible solution to this drawback
is to have the corporation raise salaries to cover the premiums
incurred by the owners. Inequities may persist, however,
if owners’ marginal tax rates applied to the salary
reimbursements are different. Additionally, cross-purchase
agreement adopters should recognize that the cost of funding
the buy-sell agreement will be greater if the shareholders
have a higher tax rate than the corporation.
redemption agreements. Under a stock redemption
agreement, the corporation owns policies on the lives of
the shareholders. When a shareholder dies, the corporation
buys the deceased shareholder’s interest in the company
with the insurance proceeds. A prime advantage of the stock
redemption agreement is that it is easier to administer
for multiple shareholders. An additional advantage to the
stock redemption structuring of the buy-sell agreement is
that the corporation will bear the premium differences associated
with age disparities among shareholders.
corporation will not recognize income for tax purposes when
it receives the insurance proceeds. The corporation must,
however, heed the effect of the entire transaction (proceeds
received and redemption accomplished) on the earnings and
profits of the corporation. The earnings and profits will
increase with the life insurance proceeds received and decrease
as a result of the stock redemption, so the corporation
must attend to the overall net effect on earnings and profits
and consider how that might affect the dividend policy to
shareholders. For example, in the Exhibit’s Scenario
3, the corporation may have to issue dividends to avoid
the accumulated earnings tax on earnings and profits, assuming
that the reasonable needs of the business do not justify
maintaining earnings and profits above the $250,000 credit
(IRC section 535). These dividends would be taxed to the
remaining shareholders at ordinary income rates.
disadvantage of the stock redemption form of the buy-sell
agreement is that the remaining shareholders do not get
the benefit of a step-up in basis when the corporation purchases
the deceased shareholder’s interest. The continuing
shareholders retain their original bases in the company.
Compared to the cross-purchase agreement, the stock redemption
structuring will create greater capital gains upon the ultimate
disposition of shares if made before death. After the stock
redemption is accomplished, however, the corporate assets
should be relatively unchanged (the insurance proceeds have
been used to purchase the deceased’s interest), but
each owner now enjoys a greater percentage of ownership.
tax implications. When a cross-purchase plan
exists, the proceeds from the life insurance are not included
in the deceased shareholder’s estate. The deceased
is not the owner of the policy and, therefore, the insurance
proceeds payable at death are not included in the estate.
Under a redemption approach, however, the estate tax consequences
can become more pronounced when the deceased shareholder
has a controlling interest. A shareholder who owns more
than a 50% interest either directly or indirectly is deemed
to control a corporation, under IRC section 267. In this
situation, the shareholder is deemed to have an ownership
interest in the life insurance policy due to the shareholder’s
ability to designate a beneficiary, as well as other ownership
interests. The fact that control exists over the policy
in majority ownership instances would result in the proceeds
being includable in the deceased’s estate. Thus, the
after-tax returns on life insurance policies can be substantially
reduced if estate taxes are incurred as a result of the
life insurance proceeds being included in the estate.
the case of family-owned corporations, purchase prices specified
by the buy-sell agreements are often disputed by the IRS
as not representing fair value. If a corporation owns life
insurance for the purposes of funding the redemption of
the stock, and the deceased shareholder owns a controlling
interest in the corporation, the probability that the life
insurance policy will be included in the decedent’s
estate is substantial. Note, however, that if the family
members own the insurance policy on the decedent, they will
receive the life insurance proceeds without including them
in the taxable estate. Thus, the cross-purchase option may
be preferable to the redemption option.
Issues of Buy-Sell Agreements
is a distinct difference between the values that should
be established for the two alternative approaches to a buy-sell
agreement. This difference is due to the ownership of the
life insurance policy. In a cross-purchase agreement, the
deceased shareholder has no economic interest in the life
insurance policy on his life. Accordingly, the surviving
shareholders should expect to pay the fair market value
of the underlying net assets, which represents the value
of the business operations.
the stock redemption approach, the corporation owns the
policies, and therefore the value of the corporation includes
both the business operations and the insurance policies.
The redemption price of a buy-sell agreement should typically
include a portion of the life insurance proceeds. If the
stock redemption agreement is so structured, the tax implications
may be negative, because the life insurance proceeds may
be subject to both estate tax and income tax if the decedent
is deemed to possess an ownership interest in the policy.
Given these tax implications, including the value of life
insurance proceeds in the buy-sell valuation price may result
in an unsatisfactory after-tax return.
valuation issue is that the premiums on older shareholders
can be considerably higher than the premiums on younger
shareholders. As each unit of stock incurs the same cost,
older shareholders will incur higher premiums than they
would under a cross-purchase plan. Accordingly, younger
shareholders expect to reap a greater benefit from the insurance
policies than their older counterparts. Thus, younger shareholders
would be entitled to a greater benefit at a lower cost under
a stock redemption approach than for a cross-purchase approach.
scenario suggests that the redemption price should include
a portion of the life insurance payments, unless older shareholders
are compensated for the disparity in the premiums. This
would convert potentially nontaxable deferred income into
accelerated taxable income. It would also precipitate similar
adjustments for the purchase price for younger shareholders.
The proper pricing for a buy-sell agreement becomes much
more complex in the case under the redemption alternative.
of the Buy-Sell Agreement
of insurance. Any buy-sell agreement requires
a decision regarding the type of insurance policy to purchase.
The initial choice is between term and whole life insurance.
Premiums for term life insurance increase throughout the
coverage period, whereas premiums for whole life are level
throughout the coverage period. If the shareholder dies
in the first few years of coverage, the cost of term insurance
will be less than the cost of whole life insurance. Conversely,
the cost of term life may be much greater than whole life
if an individual exceeds the life expectancy used for underwriting
the whole life insurance policies.
life insurance with cash value buildups can offer advantages.
If policies are held for a significant number of years,
the cash values of whole life policies can supplement pension
benefits or help fund shareholder buyouts. Additionally,
the policy’s cash value is a liquid asset of the corporation
that may help secure advantageous loan terms for the company.
may choose to forgo whole life insurance and purchase term
insurance. The early premiums saved may be invested in the
company to either reduce debt or promote growth. In favorable
economic conditions, the return on investment will typically
be greater than the earnings attributed to the cash value
of the whole life policy. The possibility of premium savings
in the event of premature death and the excess expected
returns on premium differences invested are advantages for
addition to cost, insurability is a key consideration. The
ability to maintain life insurance throughout a shareholder’s
life is important. Whole life insurance policies grant coverage
until death that may not be cancelled by the insurance company.
This feature has persuaded many that whole life insurance
is the proper means to finance corporate buy-sell agreements.
The term life insurance industry has, however, modified
its products so that policyholders can purchase term life
with the same benefit. This can be accomplished with either
a guaranteed insurability option or lengthy (20- to 30-year)
policy terms. The addition of a guaranteed insurability
option to a term policy will increase the cost of the term
insurance. The increased premium, however, will still be
lower than whole life premiums in the beginning years. Owners,
therefore, must weigh the escalating premium structure of
term insurance against the early returns that might be realized
by purchasing less-expensive term insurance and investing
the premiums saved.
time, the value of a successful corporation will grow. Assuming
the buy-sell agreement ties the purchase price to fair market
value, owners should ensure that additional life insurance
can be acquired over time to keep pace with the increasing
value of corporate shares. Typically, guaranteed insurability
options (available on either term or whole polices) allow
the policyholder to acquire additional life insurance at
a shareholder dies, several issues arise with respect to
policy ownership by the deceased and the remaining shareholders
in the cross-purchase arrangement. The policies insuring
remaining shareholders but owned by the deceased will carry
beneficiary designations, generally family members. With
whole life, the family inherits the cash surrender value
of the policies. With no continued business purpose, and
out of courtesy to the surviving shareholders, the surviving
family beneficiaries may choose to cash out the value of
a cross-purchase approach, the death of a corporate shareholder
will not diminish the value of the enduring corporation.
Because individuals and not the corporation hold the life
insurance policies, the receipt of death benefits or cash
values by the policy beneficiaries will not decrease the
assets of the corporation. This fact does, however, create
a funding issue for the remaining shareholders. The remaining
cross-purchased policies will likely not cover the continuing
value of the business. The surviving shareholders may need
to address the shortfall by purchasing additional insurance
if other funds are not readily available.
alternative to purchasing additional insurance would be
to use term life insurance to fund the buy-sell agreement.
The value of a term life policy is normally equal to the
unearned premium for the year of death, usually very small
in comparison to whole life insurance. Given this low value
of term life insurance, shareholders should consider purchasing
term insurance as joint tenants with rights of survival.
The insurance policies could then transfer from the deceased
shareholder to the surviving shareholders without triggering
the recognition of income upon the death of the insured.
shareholders. The preceding discussion has
assumed that the shareholders can obtain new insurance policies
on each other. Some individuals, however, may not be insurable
at the time that the buy-sell agreement is adopted. In this
case, the only alternative is to use an existing policy
of the uninsurable shareholder. Such shareholders hopefully
own whole life insurance policies on their lives that have
appreciated in value. A shareholder will typically expect
to be compensated for the cash surrender value of the policy
upon transferring it to either the corporation or fellow
shareholders. The most important factor in determining which
party to sell the policy to is the tax treatment afforded
when the insurance proceeds are ultimately received. If
the corporation purchases the policy, the insurance proceeds
will not be taxable; if the shareholders purchase the policy,
the insurance proceeds will be taxable. The shareholders
must weigh the tax advantages of the corporate stock redemption
against the tax advantage of using a cross-purchase buy-sell
approach. If a policy must be purchased because there is
an uninsurable shareholder, the issues are the same as previously
discussed except that now the shareholders that have purchased
the uninsurable’s policy must pay taxes when the proceeds
are received. Recall that although the insurance proceeds
will be nontaxable to the corporation when the life insurance
proceeds are received, the remaining shareholders must weigh
this benefit against the fact that they will not receive
a step-up in basis upon the death of the noninsurable shareholder.
Accordingly, as the percentage of stock owned by the uninsurable
shareholder increases, the likelihood that a stock redemption
buy-sell agreement is preferable increases.
without life insurance policies. Although
risk-averse shareholders generally prefer to fund buy-sell
agreements through the purchase of life insurance, not all
shareholders are risk averse. Risk-seeking shareholders
have two alternatives: to invest capital in life insurance
to fund the buy-sell agreement, or to invest to grow (or
perhaps to sustain) the corporate business operations. If
capital funds are limited, shareholders may not have the
luxury of funding both alternatives.
typically base premiums on a relatively low rate of return
to the insured. If it were not for the favorable tax treatment
provided by life insurance proceeds, few would use life
insurance as an investment. In contrast, the return on corporate
business operations, especially in the early years, may
yield substantially greater returns than those offered through
life insurance. Thus, risk-seeking shareholders may reason
that if they live at least as long as their actuarially
determined life expectancy, the return on capital invested
should be greater for funds invested in the corporation.
Another reason not to fund the buy-sell agreement is that
buy-sell settlements often occur at the date of retirement—not
at death—leaving no need for life insurance to fund
that decide not to fund settlements with life insurance
typically expect that corporate earnings and profits will
increase as the corporation matures. In such situations,
C corporations often must pay dividends to avoid the corporate
accumulated earnings tax. Alternatively, corporations may
elect S status, whereby earnings flow through to shareholders
and are taxed then at the individual shareholder level.
Either way, shareholders will likely incur increased taxes.
Regardless of the corporate form, earnings may be strategically
accumulated so they can fund needed buy-sell settlements.
When the corporation executes the buy-sell agreements, the
estate of a deceased shareholder will receive the proceeds
for selling the stock without incurring income taxes (the
share basis will be the fair market value at the date of
death). If the buy-sell agreements are executed at the date
of retirement, not at the date of death, retired shareholders
will benefit from capital gains treatment. Buy-sell agreements
should specify an installment purchase option (rather than
the immediate purchase of shares) where time might be needed
to accumulate funds for the redemption of the stock (e.g.,
upon the sudden death of a shareholder).
funding of the buy-sell agreement. Shareholders
that are more risk averse may choose a combination approach
to funding the buy-sell agreement. A portion of the buy-sell
agreement can be funded with life insurance to guard against
premature deaths, with the remainder funded by accumulated
earnings and corporate profits. For example, shareholders
could initiate a buy-sell arrangement to purchase 80% of
the stock through a cross-purchase agreement (with funding
provided by life insurance), and 20% of the stock would
be redeemed by the corporation upon the death of a shareholder.
Alternatively, shareholders may opt to initially fund 100%
of the buy-sell agreement with a cross-purchase design funded
by insurance. The funding of the agreement can then change
annually, with the corporation assuming responsibility for
purchasing any incremental increases in shareholder value
as the corporation grows. This approach eliminates the need
for shareholders to increase the amount of life insurance
over time. It also provides assurance to the shareholder’s
family that it will receive a minimum amount whether or
not the corporation can generate the funds needed for the
combination approach may be especially appropriate for family
corporations. Tax law limits the amount of stock purchased
by the corporation that can be classified as redemption
instead of as a dividend to the sum of the estate, inheritance,
legacy, succession taxes, generation-skipping taxes, and
funeral and administrative expenses allowable as deductions
to the estate of the deceased. Share value in excess of
IRC section 303 limitations may be purchased with life insurance
proceeds. The basis of this purchase will be the fair market
value of the shares at the date of death. To remove the
value of the remaining shares from the deceased shareholder’s
estate free of taxes, the buy-sell agreement should provide
a member of the family an option to buy the stock from the
estate. The family member may then choose to exercise the
right to purchase remaining shares, as determined by the
IRC section 303 limitations. The combination approach (part
corporate redemption, part family member purchase) can result
in the total value of the deceased’s corporate shares
being extracted from the estate without income tax consequences.
The case law [see Estate of James J. Durkin, Sr.,
99 TC 561 (1992) and Zenz v. Quinlivan, 213 F2d
914 (6th Cir. 1954)] indicates, however, that the taxpayer
must not be obligated to purchase the stock.
Joy, PhD, CPA, and Jo Koehn, PhD, CPA, CFP,
are professors of accounting, and Janice Klimek, PhD, CPA,
is an assistant professor of accounting, all at Central Missouri