This article discusses a technique that allows S Corporations to obtain the advantages of an entity redemption and still provide surviving shareholders with an increased basis.

Redemption Advantages
Under cross purchase, each owner must own a policy on every other owner. When there are three or more owners, the number of policies needed rapidly becomes unwieldy. Under a stock redemption agreement, the corporation is the only buyer so only one policy per owner is needed. Cross purchase can be effected with one policy per owner using a trust or joint ownership arrangement, however tax issues accompany each of these devices.

When a disparity in premiums exists due to age or health, corporate ownership of the policies allows the costs to be borne equally by all owners. Finally, central corporate ownership of the policies allows for efficient and orderly administration.

Still, a cross purchase agreement is often favored because the surviving owners receive a step up in basis for shares purchased under the agreement. Also, where the Alternative Minimum Tax (AMT) is a concern, corporate ownership of the policies increases that risk.

S Corporations
S corporations unique pass-through status allows their owners to structure the buy-sell agreement as an entity redemption yet still obtain a basis step up. (The AMT is not a concern because it does not apply to S corporations).

When a shareholder dies, the death benefit received by the S corporation is tax exempt income and increases the basis of each shareholder. The basis increase is pro rata to each shareholder because the S Corporation passes through its items of income, loss, deduction and credit to the shareholders on a per-share, per-day basis.

When an S corporation receives life insurance proceeds in the same tax year as a redemption of a deceased shareholder, a portion of the basis increase is allocated to the estate of the deceased shareholder and away from the surviving shareholders. Basis allocated to the deceased's shares may be wasted because those shares received a step up in basis to fair market value at deceased's death.

Allocating the Basis
If an allocation of basis to the deceased's shares may be wasted, the shareholders may want to structure the buy-sell agreement so that the basis increase from the insurance proceeds accrues only to the surviving shareholders.

This can be done by sequencing events so that the S corporation redeems all of the stock of the deceased shareholder prior to filing the insurance claim and receiving the insurance proceeds. Upon termination of deceased shareholder's interest, the remaining shareholders can elect to close the corporation's books for purposes of allocating the corporation's items of income, loss, deduction and credit.

Then, the S corporation may file the insurance claim and collect the proceeds. By terminating the deceased's interest in the company before filing the insurance claim, the basis increase from the death benefit is allocated to the surviving shareholders.

Caveats
The IRS could argue that the S corporation constructively received the death benefit upon the shareholder's death. Also, shareholders must be cash basis taxpayers.

Finally, it should be noted that because premium payments are not deductible to the S corporation, they may reduce each shareholder's basis proportionately.
 
Summary
Determining the best arrangement for a buy-sell agreement requires consideration of a variety of tax and practical issues. This technique may make the decision easier for S corporations by achieving seemingly divergent objectives with a single tool.

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