Understanding Stock Redemption Buy-Sell Agreements

A buy-sell agreement with stock redemptions is a common strategy for business succession, particularly when ownership changes due to a shareholder’s death, retirement, or departure. This strategy is suitable for businesses that do not face estate tax concerns and seek a straightforward method for transitioning ownership. However, recent court rulings, such as the Connelly case, have impacted the tax treatment of these arrangements, particularly how the basis of the remaining shareholders is treated.

Understanding Stock Redemption Buy-Sell Agreements

In a stock redemption buy-sell agreement, the business entity itself is the buyer of the departing or deceased owner’s shares. Upon a triggering event like the death of a shareholder, the company uses its funds—often funded by life insurance policies on the shareholders—to repurchase the shares from the departing owner or their estate.

Here’s a simplified breakdown of how this arrangement works:

1. Life Insurance Policies: The business purchases life insurance policies on each shareholder. The company owns the policies, pays the premiums, and is the beneficiary of the death benefits.
2. Triggering Event: When a shareholder dies, the business receives the life insurance proceeds.
3. Stock Redemption: The company uses the life insurance proceeds to redeem (buy back) the deceased shareholder’s shares from their estate.
4. Share Redistribution: After the redemption, the remaining shareholders’ ownership percentages increase proportionally because there are fewer outstanding shares.

Why Use a Stock Redemption Buy-Sell Agreement?

A stock redemption buy-sell agreement is often used in businesses where:

• There are multiple owners, and a simpler structure is desired for the buyout.
• The business wants to maintain control over the process and the life insurance policies.
• The remaining shareholders want to avoid the administrative complexity of cross-purchase agreements, especially when there are many owners.

Impact of the Connelly Ruling on Stock Redemption Agreements

The Connelly court ruling has significant implications for businesses using stock redemption agreements, particularly regarding the tax treatment of basis adjustments. Here’s what the ruling highlighted:

• In a stock redemption scenario, when a business entity receives life insurance proceeds and uses them to buy back shares from a deceased shareholder’s estate, the remaining shareholders do not receive a step-up in basis for their remaining shares. This can lead to higher capital gains taxes when the remaining shareholders eventually sell their shares, as their basis remains the same.
• The court ruled that the life insurance proceeds received by the business in a redemption do not count toward a basis adjustment for the remaining shareholders. Essentially, the business entity benefits from the proceeds but does not pass any tax basis advantages to the individual shareholders.

How to Structure a Stock Redemption Strategy to Address Connelly Issues

To address the issues raised by the Connelly ruling, businesses using a stock redemption strategy can implement specific tactics:

1. Use Life Insurance Proceeds for Redemption Without Expecting a Basis Step-Up: In scenarios where a step-up in basis is not crucial (such as when there are no anticipated capital gains or sale of stock), a stock redemption strategy can still be effective. The company uses the life insurance proceeds to redeem shares, and while the remaining shareholders do not get a basis adjustment, the structure remains simple and administratively efficient.
2. Tax Planning for Minimal Impact: Businesses can mitigate the lack of a basis step-up by planning for future tax consequences. For instance, shareholders can explore ways to reduce their taxable capital gains in other areas or work with tax advisors to minimize the impact of not having a stepped-up basis when shares are eventually sold.
3. Hybrid Buy-Sell Agreements: One alternative is to set up a hybrid buy-sell agreement, where a business can opt for either a stock redemption or a cross-purchase based on specific circumstances. This approach gives flexibility and allows the business to choose the most tax-efficient path. For example, if one owner dies, the business can initially use a redemption but switch to a cross-purchase for subsequent owners to secure a basis adjustment.

Example: Stock Redemption Buy-Sell in Action

Scenario: A business has three owners—Alice, Bob, and Carol. The business owns life insurance policies on each of them, each with a death benefit equal to their ownership stake in the company. The company pays the premiums and is the beneficiary of the policies.

• Alice Passes Away: Alice dies, and the company receives $1 million in life insurance proceeds. It uses this money to buy back Alice’s shares from her estate.
• Share Redistribution: After Alice’s shares are redeemed, Bob and Carol’s ownership percentages increase because Alice’s shares are retired.
• Tax Consideration: Bob and Carol’s basis in their shares does not change because the company—not the individual shareholders—received the life insurance proceeds and used them for the redemption. As a result, if Bob or Carol later sell their shares, they will have a higher capital gains tax liability due to their unchanged basis.

In this scenario, the business benefits from a straightforward transition of ownership using the life insurance proceeds, but the remaining shareholders must be prepared for the potential tax implications of the unchanged basis.

Advantages of Stock Redemption Buy-Sell Agreements

• Simplicity: Easier to administer than cross-purchase agreements, especially with many shareholders.
• Centralized Management of Insurance: The business owns the policies, reducing the need for multiple policies for each owner.
• Control: The business controls the buyout process, making it easier to manage and fund the purchase of shares.

Disadvantages in Light of Connelly

• No Basis Adjustment: The most significant drawback highlighted by the Connelly ruling is that the remaining shareholders do not receive a basis increase when the company redeems shares. This can result in higher capital gains taxes when the surviving shareholders eventually sell their stock.
• Potential AMT Exposure: If the business is structured as a C-corporation, it may be subject to the corporate alternative minimum tax (AMT) on life insurance proceeds, reducing the financial benefits of the insurance payout.

When Is a Stock Redemption Strategy Suitable?

A stock redemption buy-sell agreement might be the right choice when:

• Estate Tax Concerns Are Minimal: If the business owners are not worried about federal estate tax or their estates are well below the exemption threshold, they might prioritize the simplicity of stock redemption.
• No Immediate Need for Basis Step-Up: The remaining shareholders do not expect to sell their shares in the near future, or they have other tax strategies in place.
• Desire for a Centralized Approach: The business owners prefer a centralized approach to managing life insurance policies and handling the buyout process.

A stock redemption buy-sell agreement can still be an effective tool for business succession, even in light of the Connelly ruling, as long as the business owners understand the tax implications. By not expecting a basis adjustment from the life insurance proceeds, businesses can avoid potential pitfalls and maintain a smooth ownership transition process. For those seeking a more flexible approach, combining elements of stock redemption with cross-purchase options (hybrid agreements) may provide a tailored solution that balances simplicity with tax efficiency. Consulting with tax and legal professionals is critical to ensure that the chosen structure aligns with the business’s goals and circumstances.

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Michiel Laubscher & Laubscher Wealth Management LLC is not an investment advisor and is not licensed to sell securities. None of the information provided is intended as investment, tax, accounting, or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other offerings. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information contained herein is at your own risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Michiel Laubscher & Laubscher Wealth Management LLC does not promise or guarantee any income or specific result from using the information contained herein and is not liable for any loss or damage caused by your reliance on the information contained herein. Always seek the advice of professionals, as appropriate, regarding the evaluation of any specific information, opinion, or other content.