A stock redemption or entity buy-sell agreement is a binding agreement that is implemented by the owner’s of a business to facilitate the orderly transition of a business interest in the event of the death, disability or retirement of a business owner. With a stock redemption plan, the company agrees to purchase the interest of a business owner in the event his or her business interest becomes available due to death, disability or retirement.
The entity agreement outlines the terms of the sale and establishes a formula for determining the actual sales price of the stock based on the company’s valuation. It also obligates the company to purchase the departing owner’s shares while at the same time mandating that the departing owner or her heirs sell their business interest back to the company.
Key Takeaways of What is a Stock Redemption Plan (Entity Plan)?
Company-Funded Buyout: A stock redemption plan requires the business entity, not the individual owners, to purchase the departing owner’s shares, often using life insurance for funding.
Efficient Business Continuity: These agreements provide a structured, efficient way to transfer ownership shares following death, disability, or retirement, preventing potential disputes or cash flow issues.
Tax Implications: While death benefit proceeds are typically income tax-free, there is no step-up in basis for surviving owners, and premiums are not tax deductible.
Simplified Administration: Only one life insurance policy per owner is needed, and the business pays all premiums, reducing individual financial obligations.
Valuation and Estate Planning Benefits: A properly structured agreement can help establish fair market value for estate tax purposes and provide immediate liquidity to the deceased owner’s heirs.
How Exactly Does a Stock Redemption Plan Work?
Life insurance is the most convenient, effective and economical tool for funding a buy-sell plan. In a stock redemption plan funded by life insurance, each business owner is party to an agreement where the business purchases a life policy on the life of each business owner in an amount equaling their respective business interests.
The company is the premium payer, policy owner and beneficiary of each of the policies. In the event an owner dies, the company receives the proceeds of the life insurance policy and uses the proceeds to purchase the deceased owner’s business interest at a previously agreed upon price. The deceased owner’s estate receives instant liquidity at a fair market value for their business interest.
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Advantages of Entity Plans
A properly drafted entity buy-sell agreement that is funded with life insurance will have the following advantages:
- Creates a binding plan for the efficient transition of a business interest in the event of an unforeseen death.
- Easy to implement and cost effective.
- Creates an instant market for the business at a pre-arranged fair market value.
- Policy cash values can be listed as an asset on the company’s balance sheet. Cash values may be accessed by the company for other business uses.
- May establish a useable fair market value for the business for estate tax purposes.
- Only one life insurance policy is required for each business owner.
- Business owners are not responsible for premium payments.
- Provides liquidity for the deceased owner’s estate.
Disadvantages of Entity Plans
The disadvantages of entity buy-sell agreements include:
- There is no step-up in basis. If a business owner dies, each owner’s business interest increases but their basis remains the same.
- Life insurance may be the alternative minimum tax.
- Policy premiums are not deductible.
- Policy cash values are subject to the creditors of the business.
Stock Redemption Buy-Sell Agreements and Taxes¹
Tax issues with stock redemption plans include:
- Life insurance policy premiums are not tax deductible to the business.
- Any death benefit proceeds received by the business are generally received income tax free.
- If the business is properly valued, the value defined in the buy-sell may likely be binding when calculating the estate tax value for income and estate tax purposes.
- Once a deceased owner’s shares are purchased, the remaining owner’s do not receive an increase in their cost basis for tax purposes.
Effective use of a properly funded entity buy-sell agreement will assure an efficient transition for your business. Without an established funded plan, your business will experience significant costs if a fellow business owner dies unexpectedly. Why wait till it is too late to plan? Call MEG Financial today at (877) 583-3955 to discuss your business continuation concerns. A licensed insurance agent can personally review your circumstances and help you uncover potential options for your business.
¹ Neither MEG Financial nor any of its licensed agents provide legal or tax advice. Please consult your CPA or tax advisor for tax questions relating to your specific circumstances.
Who Benefits Most from a Stock Redemption Plan?
A stock redemption plan is most beneficial for private corporations, including S corporations, closely held businesses, and companies with multiple shareholders aiming to maintain internal control and provide a clear succession strategy. These agreements help ensure that when an owner passes, retires, or voluntarily exits, their ownership interest is redeemed by the company, not sold to outside parties, preserving the company’s founding principles and leadership structure.
Buy-sell agreements like stock redemption plans are often structured as legally binding agreements that clearly outline the purchase obligation and current market price for shares. This protects the company interests and ensures other shareholders are not caught off guard during a transition. In a redemption, the company typically uses its own funds or life insurance proceeds to buy back the stock owned by the departing or deceased owner.
Frequently Asked Questions About What is a Stock Redemption Plan (Entity Plan)?
1. How Does a Stock Redemption Plan Work?
In a insured stock redemption agreement, the business itself agrees to purchase a departing owner’s shares, typically using life insurance as funding, upon death, disability, or retirement. The company is both the owner and beneficiary of the policy, ensuring funds are available for the buyout.
2. Who Pays for the Life Insurance in a Stock Redemption Plan?
The company pays all life insurance premiums, owns the policies, and is the beneficiary. Individual owners are not financially responsible for these premiums.
3. What Happens to the Shares After the Owner Leaves or Passes Away?
The departing owner’s shares are sold back to the company. These shares are usually retired or held as treasury stock, reducing the total outstanding shares and increasing the percentage ownership of remaining shareholders.
4. What Are the Tax Consequences of a Stock Redemption Plan?
Death benefit proceeds are generally income tax-free to the company, but there is no step-up in basis for the remaining owners. Premiums are not tax-deductible, and policy cash values may be subject to creditor claims.
5. Who Should Consider a Stock Redemption Agreement?
Stock redemption plans are ideal for privately held corporations, especially those with multiple owners or family members involved in the business, looking to maintain internal control and ensure a smooth ownership transition.
Conclusion and Summary of What is a Stock Redemption Plan (Entity Plan)?
A stock redemption plan, also known as an entity buy-sell agreement, is a legally binding arrangement designed to ensure business continuity when a business owner retires, becomes disabled, or passes away. It is most commonly used in closely held corporations or privately owned businesses and is often funded through life insurance policies owned by the company.
This structure allows the business to purchase the departing owner’s shares at a pre-agreed value, providing liquidity to the estate and maintaining control within the business. While there are tax considerations and limitations, stock redemption plans are a practical option for business owners looking to secure an orderly transition of ownership and protect their company’s financial health.
