The Buy/Sell Cost Basis Conundrum

Stock redemption plans are problematic at any net worth.

The recent discussion surrounding Stock Redemption Buy/Sell Agreements has primarily focused on clients anticipating a future estate tax liability. The Connelly decision, which drove this conversation, makes this appropriate and understandable. However, it also created another reason why using a stock redemption agreement may be a mistake for any business owner, regardless of net worth.

The potential inclusion of life insurance proceeds received by a business under a stock redemption Buy/Sell Agreement (BSA) — ushered in by the Connelly decision — is a significant change to what was thought to be settled law. The initial analysis focused on the increased estate tax exposure created by a higher-than-expected business valuation. While this is a significant issue for these clients, the number of impacted clients is relatively small, with fewer than 3,000 taxable estate tax returns filed most years.

Impacts on Clients Without Potential Estate Tax Exposure

It turns out the Connelly decision also impacts them, just not as directly. Businesses these clients own will also be worth more than anticipated if they receive life insurance proceeds under a Stock Redemption BSA. A company worth $4MM with a stock redemption plan between two equal shareholders would suddenly be worth $6MM upon receipt of the $2MM life insurance proceeds.

If that new, higher value is then the basis for execution of the buy/sell agreement​, each owner’s share of the business is now worth $3MM, and there is a resulting $1MM liquidity shortfall that needs to be addressed. The theoretically straightforward solution of purchasing additional life insurance will further complicate the matter as each extra $1 of insurance also increases the company's value and may not be justified in the eyes of the insurance company under traditional financial underwriting protocols. The resulting lack of clarity around how to value the business and execute the buy/sell agreement​ will likely create chaos rather than the clarity sought by all involved.

That alone could be enough to consider updating an existing Stock Redemption BSA to an alternative structure. However, some will argue that this can be addressed in other ways, or might not even come to light based on the lack of an IRS audit or other “trigger“ that brings it to the attention of surviving owners or beneficiaries. Rather than debate this issue, however, taking a broader perspective uncovers this as simply an additional problem inherent in these types of agreements that can be easily avoided.

The Primary Issue? Taxation to the Point of Forcing Business Sell-Offs

Table 1: Projected Tax – Both Owners Live

In the example above, if the $4MM business was capitalized with a total of $500,000 split evenly between two owners, their individual cost basis is $250,000. With each owner’s share now worth $2MM, if the business were sold, each owner would be taxed on the gain of $1.75MM. Today’s long-term capital gains rate likely translates to a tax bill of $262,500 for each owner.

Table 2: Projected Tax – Surviving Owner – Stock Redemption

Of course, if one of the owners dies, the deceased owner no longer has a problem under current law, nor does their family, as the cost basis is stepped up at death. However, the potential tax is now much higher for the surviving owner. They are the sole owner of a business worth $4MM, but their cost basis remains $250,000. Because the business redeemed the shares, rather than the surviving owner purchasing them

Table 3: Projected Tax – Surviving Owner – Alternative BSA

Under a different buy/sell agreement​ structure based on the surviving owner receiving the insurance proceeds and purchasing the shares directly, they avoid the issues created by the Connelly decision and increase their cost basis by an amount equal to the purchase price. Between this new purchase and the original capitalization of the business, their total cost basis is now $2.25MM, and the taxable gain, should they sell, is only $1.75MM. Today’s long-term capital gains rates translate into $400,000 of tax savings. All they may need to do to unlock this tax savings is update a buy/sell agreement to a different structure that allows for the direct purchase of the deceased owner’s share of the business.

Even With the Connelly Decision as a Catalyst, Stock Redemption Plans Have Been Suboptimal

Regardless of estate tax exposure, business owners of any net worth would be well-served by avoiding stock redemption plans today. The remaining question at this point is which of the various structures that allow the surviving owner to realize the increased cost basis would be most appropriate. The answer depends on the nature of the business and the industry's broader planning landscape.

Your clients rely on you to guide them through complex financial decisions, and with the Connelly decision introduced, there’s no time to wait for new issues to surface. Schedule a consultation with LIFE Brokerage to explore strategies that ensure your clients' agreements work in their favor.