ESTATE PLANNING CHALLENGES FACING S CORPORATIONS
Many small business owners choose Subchapter S as a business entity primarily due to liability and income tax considerations. However, such an election may often result in business continuation challenges in later years, when estate planning becomes a more crucial issue. Estate planning for S corporation shareholders is essential because the improper transfer of shares could potentially terminate the corporation’s S status. Therefore, a carefully drafted buy-sell agreement is of utmost importance to all shareholders.
Buy-Sell Agreement Considerations
A buy-sell agreement must address several key issues to help ensure the proper transfer of shares and to maintain the integrity of the S corporation status. The agreement should detail who can and cannot be the recipient of shares. This may include prohibiting the transfer of shares to partnerships, corporations, nonqualifying trusts, and individuals who are nonresident aliens. A sound agreement should also contain a provision ensuring the number of shareholders will not increase beyond 100, or the S corporation status could be terminated. The American Jobs Creation Act of 2004 increased the permissible number of shareholders to 100 from 75; further, eligible members of the same family may now be treated as a single shareholder.
Another important issue that has resulted in closer scrutiny from the Internal Revenue Service (IRS) is the possibility that a buy-sell agreement could create a second class of stock. However, regulations have been enacted stating that as long as there is a bona fide agreement to redeem or purchase stock upon a specified triggering event (i.e., death, disability, divorce, or separation from service), such redemption or purchase would not constitute the creation of a second class of stock.
Additional planning considerations arise with respect to the valuation of shares. In order for the valuation of shares under a buy-sell agreement to be recognized for estate valuation purposes, the buy-sell agreement must: 1) not serve as a mechanism for transferring shares to family members for less than full and adequate consideration; 2) be a bona fide business agreement; and 3) have terms and provisions similar to an “arm’s-length transaction.” Also, the share price that is set must apply both during life and at death.
Finally, a determination must be made as to the type of buy-sell agreement to be used, and how the agreement will be funded. Although various hybrid arrangements exist, there are generally two types of buy-sell agreements: a cross purchase and an entity purchase. In brief, with a cross purchase, the individual owners buy out the deceased or disabled owner’s shares. With an entity purchase, the business entity buys out the deceased or disabled owner’s shares.
Both arrangements have various advantages depending on the type of entity and the goals of the shareholders. For instance, under a cross purchase arrangement, a key advantage to the surviving S corporation shareholders is that their basis will increase by the amount of interest each shareholder purchases, respectively. An entity purchase may not afford shareholders this benefit. However, because a cross purchase requires arrangements between shareholders, the demographics of the shareholders (e.g., significant age disparity or disproportionate ownership interests) may be detrimental to the overall success of such a plan. In this respect, an entity purchase may be more appropriate in some situations.
Funding a Buy-Sell Agreement
One of the best methods for funding a buy-sell agreement is life insurance. Life insurance offers some distinct advantages: 1) the only costs to the shareholders (or corporation) are for the premium payments, which are not tax deductible; and 2) the policy’s death benefit proceeds are usually not income taxable to S corporation shareholders. With a cross purchase arrangement, each individual owner typically purchases a policy on every other individual owner. With an entity purchase arrangement, the corporation purchases a life insurance policy on each individual owner.
Estate and business continuation planning for S corporation shareholders can be exceedingly complex. Often, such planning becomes a delicate balance between meeting the organizational goals of the S corporation and the personal goals of the shareholders. Therefore, it is important that all the involved parties consult with qualified legal, tax, financial, and insurance professionals.