BY Thomas J. Perrone, CLU, CIC
S Corporations enjoy the advantages of limited liability, transferability of ownership and professional business operation and management. The S Corporation is taxed similarly to a partnership, as it is a pass through to the shareholders.
The C Corporation is taxed at the Corporation level first. When the C Corporation is profitable and generates taxable profits. When profits are distributed to the individual shareholder it is taxed again when dividends are received by the shareholder.
You will find S Corporations normally when the individual rates are lower than the Corporation rates. Also, losses in the S Corporation shareholders may benefit, by deduction, the losses on their individual tax returns.
S Corporation requirement
- No more than 100 shareholders- members of family are considered one shareholder
- Must be a domestic corporation
- Only individuals, a decedent’s estate, estate of individuals in bankruptcy, and certain trusts are eligible shareholders of s Corporation
- No shareholder can be a nonresident alien
- One class of stock (different voting rights are allowed)
Basis and S Corporation
There is only one level of taxation in the S Corporation. That is at the shareholder’s level.
If the shareholders basis exceeds the distribution, the shareholder usually will not be taxed when they receive the distribution.
If the S Corporation has never filed as a C Corporation and has no retained earnings or profits, distributions received by an s Corporation shareholder are not subject to income tax if the distribution does not exceed the shareholder’s basis. Consequently, the larger the basis the greater amount of distribution can be taken tax-free.
Quick overview of Basis
- nontaxable distributions of previously taxed income
- income distributed in the same year in which it was earned
- nondeductible expenditures such as life insurance expenses
Keep in mind that the adjustments to shareholder basis is an ongoing procedure and will vary from their initial contribution to, or investment in, the Corporation. Usually, a service corporation will have a low basis because of the low initial investment made in these types of businesses.
Life insurance to fund the Buy and Sell Agreement
Life Insurance can have several advantages for S Corporations in a buy-sell agreement.
A nondeductible expenditure such as life insurance premiums decreases a shareholders’ basis in an S Corporation. The cash value policy can help offset, eliminate, this adverse situation.
Life insurance cash value helps offset the premium charged to the capital account. The cash value offsets the premium paid so that the decrease to the capital account is offset by the cash value of the policy.
As an example, if the premiums are $15,000 and the cash value increases by $12,000, then only $3,000 is charged to the capital account reducing the basis of the stockholder by $3,000. As opposed to having a term insurance policy with a premium of $4,000. The permanent coverage will have less effect on the basis reduction of the stockholder than the lower term insurance premium.
Over a longer period, there will be in increase over the premium, consequently eliminating the basis reduction. In the term insurance scenario, the reduction of cost basis will continue. In some cases where the term must be renewed, or the term has an increasing premium, the lowering of the basis can be substantial.
Death benefit and basis
If the life insurance is set up as a redemption basis, it is possible to plan for an increase in basis for the remaining stockholders, by using a promissory note for the deceased stockholder before settling the life insurance claim. Since the death benefit is tax free income, it will increase the basis. Example: there are three stockholders, A dies. Instead of making the claim on the life insurance, A is bought out using a short-term promissory note. Once completed, the death claim is filed, and proceeds will come in tax free for the remaining stockholders which will increase their basis. If the death benefit were used for the decedent, there would have been a wasting of the basis since the decedent’s estate would normally receive a stepped-up cost basis.
Stock Redemption in S Corporation
The buy and sell agreement are between the stockholders and the Corporation. The S Corporation owns the policy on the stockholders and is the beneficiary of the policy. Death proceeds to the Corporation are tax free and increase the basis of the stockholders. A big advantage to arranging the buy and sell agreement under an S Corporation is avoiding the alternative minimum taxes and the loss of basis found in a C Corporation.
Cross Purchase buy and sell in s Corporation
The arrangement all owners of a business agree upon in advance to purchase proportionate shares of the decedent shareholder’s interest. Each stockholder would own life insurance on the other stockholder(s) and be the beneficiary.
- Life insurance premium is a nondeductible personal expense
- Shareholders receive the death benefit federal income tax-free
- The surviving stockholder uses the funds to purchase the stock, which will increase the basis of their holdings, by the amount purchased.
Some key issues:
Section 318 Attribution Rules
In a C Corporation, attributions can be avoided for tax purposes by arranging the buy and sell agreement under a Cross Purchase. Since the Corporation is not redeeming the stock, and it is the stockholder, attribution and the treatment of the redemption being treated like a dividend distribution is avoided.
In an S Corporation, if the S Corporation does not have retained earnings or profits , it will have the same tax result as if the shares were sold or exchanged, allowing the shareholder to recover their basis tax-free, with any amounts exceeding. Basis being treated as capital gains.
A poorly structured buy-sell agreement could result in the loss of S Corporation status, as well as the possibility of increasing the surviving shareholder’s tax burden on future distributions from, or on, the sale of the S Corporation. However, there are some great advantages of setting up a proper buy-sell agreement which can be even greater advantages than those available to C Corporations.
FREE REPORT “Jones Business Planning and Succession Report” ASK FOR REPORT R3
The S corporation can be a great tool for many business owners as a corporate structure. A Buy and Sell Agreement must be carefully considered and drafted with consideration of avoiding the loss of an S Corporation Election.