Redemptions versus cross-purchase agreements.

The death of one of the owners of a closely held corporation can cause special problems for the owner's estate, especially those dealing with the value of the corporation's stock. One way to avoid many of these problems is through the use of a buy-sell agreement.

BUY-SELL AGREEMENTS

A buy-sell agreement is one that provides that remaining stockholders or the corporation itself will buy a stockholder's interest when he or she dies.

A principal advantage to using a buy-sell agreement is it fLxes the estate tax value of the decedent's stock interest. Without such an agreement, determining an acceptable value for stock not readily traded can be difficult (if not impossible).

In order to fLx the stock's value for estate tax purposes, the agreement's purchase price must have been reasonable when the agreement was made, the estate must be obligated to sell the decedent's interest and the interest must not have been sold during the decedent's lifetime without first being offered to the purchasers (the corporation or the other shareholders). In addition, the agreement must be a bona fide business arrangement; it must not be a device to transfer property to members of the decedent's family at a reduced value; and it must be comparable to similar arm's-length transactions.

REDEMPTION

If the decedent's stock is to be purchased by the issuing corporation, the agreement is a redemption. The major advantage of a redemption is its simplicity; only the corporation and the deceased stockholder are involved. This is especially true if there are numerous shareholders and if the agreement is funded by life insurance (as is often the case).

In addition, a corporation may be in a better financial position to pay the purchase price (or if funded with life insurance, the premium payments). Economically, a redemption agreement may be a better strategy if the purchase price (or premium payments) will not be taxable to the other shareholders as dividends.

Redemption agreements also may be disadvantageous. Some states have requirements that redemptions may be made only from specifically designated types of surplus or only if certain balance sheet ratios are maintained. (Funding the agreement through insurance usually alleviates this problem.) Some lenders have restrictions on the use of redemptions in loan agreements, to ensure the corporation's funds will go to paying its debt service. The funding of a redemption purchase price may give rise to an accumulated earnings issue, since the Internal Revenue Service may question the accumulation of funds to provide for the redemption. If funded by insurance, the proceeds may be subject to the alternative minimum tax. Since the proceeds are payable to the corporation, they may be subject to the corporation's creditors.

CROSS-PURCHASE

If the surviving shareholders in a closely held corporation (rather than the corporation itself) purchase the decedent's interest, it is considered a cross-purchase agreement. In this type of agreement the corporation is not a party to the agreement.

A major advantage of a cross-purchase agreement is the stepped-up basis the other shareholders receive; the basis of their interests in the corporation includes the purchase price of the decedent's stock. Also, this stock is generally bought with aftertax dollars; thus, since the individual shareholders usually are in lower tax brackets than the corporation, the purchase is "less expensive" from a tax viewpoint.

The major disadvantage of cross-purchase agreements is liquidity; each shareholder must have the funds necessary to pay for his or her portion of the decedent's interest in the corporation. While these agreements are usually funded through insurance, such policies complicate the situation tremendously. For example, a corporation with only five shareholders needs 20 separate insurance policies to be properly covered-that is, each shareholder needs to have a policy on each of the other four shareholders. Since every shareholder holds a policy on each of the other shareholders, they must be very careful to make sure the ownership and beneficiary designations involved are properly coordinated.

For a discussion of buy-sell agreements and other current developments, see the Tax Clinic department, edited by Gary Zwick, in the August 1992 issue of The Tax Adviser.

--Nicholas J. Fiere, editor

The Tax Adviser

Ed. note: The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.