The accounting and tax aspects of a C corporation and a partnership are considerably different. The C corporation structure has two taxes. First, there’s an income tax at the corporate level on the net corporate income or profits. Then, if the corporate profits are subsequently distributed to the stockholders, there’s a second tax because the distribution will be taxed to the stockholder as a dividend.
Also, unlike in a partnership, C corporation stockholders who work for the corporation will be classified as employees and receive employment compensation. That compensation will be taxable to the stockholder/employee and deductible to the corporation. Because the compensation isn’t subject to income tax at the corporate level, it has the effect of reducing corporate profits. The employee compensation must be considered reasonable for the services performed.
Let’s begin our analysis of the C corporation by reviewing a set of simplified financial statements.
Kevin and his brother Karl formed a corporation 25 years ago. Our beginning-of-year balance sheet shows an original capital contribution of $200,000, or $100,000 by each brother. The corporation currently has $2.7 million of accumulated earnings and profits (E&P), also referred to as “retained earnings.” These earnings are allocated $1.35 million to each brother. So, the total net worth or book value is $2.9 million. (See “C Corporation Balance Sheet,” this page.)
Because the corporation is a taxpaying entity, it’s already paid the income tax on any corporate profits that have been retained in the corporation. The after-tax profits that remain in the corporation created the $2.7 million of accumulated E&P.
Here’s a substantial difference between a partnership and a C corporation: In a partnership, there’s only one tax to pay. The partners pay the income tax on the profits that the partnership retained. It’s as though the partners received the after-tax income and contributed it back to the partnership. The retained after-tax income increases each partner’s capital account. The partners’ capital accounts make up their cost basis. Any cash withdrawal from the partnership capital accounts isn’t subject to income tax.
In a C corporation, the corporation itself pays the tax on the net profits. The after-tax corporate income that’s retained by the corporation will be classified as accumulated E&P. But, a C corporation doesn’t receive the favorable income tax treatment accorded to a partnership for accumulated E&P, because the E&P will subsequently produce a taxable dividend if distributed to a stockholder. Any distribution of accumulated E&P to a stockholder will be presumed to be a taxable dividend with a maximum tax rate of 15 percent or
20 percent, depending on the recipient’s taxable income. (There’s also a potential 3.8 percent surtax depending on income.) The accumulated E&P in a C corporation doesn’t add to a stockholder’s cost basis.
To summarize, the after-tax income retained in a partnership increases the partners’ capital accounts, which, in turn, increase the partners’ cost bases. In addition, the after-tax income may be withdrawn tax-free. But, in a C corporation, while the accumulated E&P has already been taxed to the corporation, the after-tax income has never been taxed to the stockholders; therefore, it doesn’t add to the stockholders’ cost bases. Any subsequent distribution to a stockholder is presumed to be a dividend; thus, it’s taxable.
Corporate Income Statement
Let’s move on to our corporate income statement. Assume the corporation has $6 million of income and $5.85 million of tax-deductible expenses. Included in the expenses are the employee compensation paid to Kevin and Karl. Assume their employee compensation is $250,000 each.
At this point, the corporation will have a net income of $150,000. Assume the corporate income tax is $50,000. The after-tax income would be $100,000. Assume further that the corporation doesn’t declare a dividend.
Let’s look at the end-of-year-balance sheet. The $100,000 after-tax profit will increase the assets to $10 million. We still have liabilities of $7 million. Our net worth or book value also increases by $100,000 to $3 million. (See “End-of-Year Balance Sheet,” this page.)
The total cost basis will be Kevin and Karl’s original $200,000 capital contribution ($100,000 each), and that’s it. It won’t change, unless one brother sells his stock interest, makes an additional capital contribution or dies, in which case his stock interest receives a step-up in cost basis.
Think back to our partnership tax structure. (See “Insured Buy/Sell Agreements for a Partnership Entity,” Trusts & Estates (June 2014) at p. 25.) At this point, the cost basis to the partners would be the $200,000 capital contribution and the $2.8 million of previously taxed income that was left to accumulate in the partnership. In the partnership situation, Kevin and Karl had a combined cost basis of $3 million. But in a C corporation, their cost basis is just their original $200,000 capital contribution. The extremely low cost basis for the
C corporation will produce a substantial capital gain on any lifetime sale.
In a pass-through tax entity, life insurance payable to the partnership is treated favorably because income creates cost basis. That rule includes tax-free income provided by a life insurance death benefit. For income tax purposes, the tax-free income passes through the partnership and increases the partners’ capital accounts. The capital accounts provide cost basis to the partners. In addition, a subsequent distribution of cash from the capital accounts to the partners isn’t subject to income tax.
In a C corporation, the life insurance proceeds increase accumulated E&P. The proceeds aren’t subject to regular tax. However, they may be subject to the corporate alternate minimum tax, but that’s beyond the scope of this article.
The proceeds don’t provide tax-free income to the stockholders. Therefore, they don’t increase the stockholders’ cost bases. In addition, the proceeds are presumed to be a taxable dividend if they’re subsequently distributed to a stockholder, because they lose their tax-free status.
The $500,000 tax-free life insurance is being added to the $100,000 after-tax profit. In this situation, $600,000 would pass to accumulated E&P.
In our previous article in the June 2014 issue of Trusts & Estates, “Insured Buy/Sell Agreements for a Partnership Entity,” we spoke about a cross-purchase buy/sell. For a C corporation, the cross-purchase buy/sell is exactly the same as it is for the partnership entity. Kevin would purchase a $2 million life insurance policy on Karl, and Karl would purchase a $2 million policy on Kevin. When Karl dies, his estate will sell his 50 percent corporate interest to Kevin for $2 million. (See “Cross-Purchase Buy/Sell,” this page.)
Now let’s review the tax considerations. There’s no impact on the corporation financial statements because the corporation isn’t involved in the purchase of the life insurance and/or the buy/sell.
Karl will have an automatic step-up in his $100,000 cost basis because he owned a capital asset valued at $2 million when he died. At his death, the $2 million sale is implemented, and because of the step-up in basis, there will be no gain to acknowledge and no capital gains tax to pay. Because Kevin is the surviving stockholder, he’ll obtain a $2 million step-up in cost basis when he uses the $2 million of life insurance proceeds to purchase the stock from Karl’s estate.
Because the life insurance has created the funds for the stock redemption, Kevin will own 100 percent of the corporation with a fair market value (FMV) of $4 million and book value of $3 million. The value of the company hasn’t changed; the ownership has.
Note that Karl’s $1.4 million of accumulated E&P will now be attributable to Kevin because he purchased Karl’s 50 percent stock interest. This attribution will increase the potential taxable dividend up to the $2.8 million of accumulated E&P.
Stock Redemption Buy/Sell
In our previous article, we also discussed a stock redemption buy/sell for a partnership. This type of buy/sell is considerably more complex for a C corporation. We need to spend some time on how the life insurance impacts the financial statements and the cost bases of both Kevin and Karl.
In this case, the corporation itself will purchase $2 million of life coverage on each brother. The corporation will be the owner and beneficiary of the policies. Assume Karl dies first. The corporation will use the $2 million of life insurance to redeem his stock. Because Kevin isn’t purchasing the stock, he doesn’t receive any increase in cost basis.
Let’s analyze the impact of the life insurance on the balance sheet and cost bases to Kevin and Karl. Both Karl’s estate and Kevin have a current capital stock account of $100,000, and at this point, they each have $1.4 million (50 percent share) of accumulated E&P.
The life insurance provides $2 million of tax-free income. The tax-free income will increase accumulated E&P to $4.8 million.1 As a result, the accumulated E&P for each brother’s share will increase from $1.4 million to $2.4 million.
Impact of life insurance on Karl’s estate. This change will have virtually no impact on Karl’s estate because the $2 million of life insurance is designed to fund his $2 million stock redemption. The $2 million stock redemption price generally establishes the stepped-up value for his cost basis.
Fifty percent of the life insurance will cause Karl’s share of accumulated E&P to increase from $1.4 million to $2.4 million. His capital stock account of $100,000 and $2.4 million accumulated E&P will be terminated and deleted from the balance sheet when his 50 percent stock redemption is finalized.
Impact of life insurance on Kevin’s estate. Kevin’s 50 percent stock interest will increase to 100 percent when the stock redemption is implemented. His capital account was $100,000, and his accumulated E&P was $1.4 million. When Karl died, 50 percent of the $2 million of corporate life insurance was attributable to Kevin’s 50 percent stock interest. The life insurance income increases his accumulated E&P from $1.4 million to $2.4 million.
Any distribution of E&P is a taxable dividend, so this result won’t improve Kevin’s tax situation. He would prefer an arrangement in which the life insurance doesn’t increase his accumulated E&P.
Impact on corporate balance sheet. Because the $2 million of life insurance provided the funds for the $2 million stock redemption, none of the corporate assets had to be liquidated. Therefore, the book value was $3 million before the stock redemption, and it must be $3 million after the stock redemption.
You may wonder why we’re covering the life insurance income in such great detail. It’s important to understand these interactions because corporate owned life insurance increases accumulated E&P, which in turn increases any potential dividend tax to the surviving stockholder.
It would greatly minimize the taxable dividend problem to Kevin if we could somehow structure the life insurance so it wouldn’t increase E&P. If we could also use the life insurance to increase Kevin’s cost basis, we would hit a home run. And, there may be a way we can do so, via the so-called “wait and see” buy/sell.
“Wait and See” Buy/Sell
Let’s look at another example. The brothers are considering a buy/sell agreement that will be funded with $2 million of life insurance on each brother. They would like a buy/sell arrangement that will avoid an increase in the accumulated E&P attributable to the surviving owner to minimize the future dividend situation.
They also want the surviving brother to have a $2 million step-up in cost basis when the stock of his deceased brother is purchased. We always associate the step-up in basis for the surviving owner with the cross-purchase buy/sell.
Kevin could consider structuring a “wait and see” buy/sell agreement. This type of plan allows a choice of either a stock redemption or cross-purchase buy/sell arrangement. When the first stockholder dies, the first option to purchase the stock belongs to the corporation. If the corporation doesn’t redeem the stock, the option passes to the surviving stockholder. If the surviving stockholder doesn’t purchase the stock, the agreement will provide that it’s now mandatory for the corporation to redeem the stock. The decision as to whether the corporation or the surviving stockholder will purchase the stock isn’t made until after the first stockholder dies.
But in this case, we’re structuring an insured buy/sell agreement. We can’t wait until after someone dies to decide how the life insurance is going to be structured. We have to make a decision up front as to who will be the owner and beneficiary of the insurance. In almost every situation involving a “wait and see” buy/sell, the life insurance will be structured as though it’s intended to fund a cross-purchase agreement. Kevin will own a $2 million policy on Karl, and Karl will own a $2 million policy on Kevin.
Assume Karl dies first. We have a $4 million C corporation with accumulated E&P of $2.8 million. Kevin collects the $2 million of life insurance he owned on Karl. The first option to purchase the stock belongs to the corporation.
The corporation intends to redeem the stock from Karl’s estate, but it doesn’t have the cash to fund the redemption. Remember, the life insurance proceeds were payable to Kevin. So, assume the corporation issues a short-term interest-bearing note to Karl’s estate. The note will be personally co-signed by Kevin and backed up by his personal assets. The stock will be held in escrow. If the purchase price isn’t paid within, say, 60 days, the stock will revert back to Karl’s estate. This arrangement eases one of the concerns of both brothers: It will provide substantial security to Karl’s estate. The corporation will now proceed to implement what amounts to a non-insured stock redemption arrangement.
Karl’s estate takes the note from the corporation for $2 million. This action means the buy/sell has been implemented. The current book value is $3 million, but the buy/sell price is 50 percent of the $4 million FMV—$2 million. Because there’s a $2 million note payable by the corporation on the corporate books, it will cause the corporate assets to be reduced by $2 million and cause the book value to be reduced by $2 million.
The balance sheet will be revised as a result of the redemption. The book value must be reduced to reflect the non-insured stock redemption that’s been implemented. (See “Revised Balance Sheet,” this page.)
The current capital stock account is $200,000. The accumulated E&P is $2.8 million. The $3 million current book value must be reduced for the $2 million stock redemption to give us the correct book value of $1 million. The redemption causes Karl’s $100,000 portion of capital stock and $1.4 million accumulated E&P to be terminated.
Let’s take a look at the portion of the accumulated E&P that’s attributable to Kevin. The fact that the life insurance wasn’t payable to the corporation will benefit Kevin because it didn’t increase accumulated E&P. Thus, Kevin’s portion of E&P isn’t increased by 50 percent of the $2 million of life insurance proceeds. As a result, he continues to own his $100,000 of capital stock and
$1.4 million accumulated E&P, even though the book value is just $1 million.
Remember, we indicated earlier that in a C corporation, accumulated E&P is essentially tainted money because it hasn’t been taxed to the stockholders. Now we see why.
Under this arrangement, the accumulated E&P attributable to Kevin doesn’t increase because the life insurance isn’t payable to the corporation. His $100,000 of capital stock and $1.4 million of accumulated E&P don’t change. This situation fulfills one of the two buy/sell objectives.
Now let’s turn to our second objective. The brothers wanted the surviving brother to obtain a $2 million step-up in cost basis. At this point, Kevin has the $2 million of life insurance proceeds.
The corporation needs the $2 million to pay off the note for the stock redemption. Kevin would simply make a capital contribution of the $2 million proceeds to the corporation. The corporation will use the $2 million to pay off the note. The capital contribution will increase Kevin’s $100,000 cost basis by $2 million to $2.1 million.
After the transaction, the balance sheet would look something like this:
Capital stock: $2.1 million.
Accumulated E&P (attributable to Kevin): $1.4 million.
The negative figure for Treasury stock: $500,000.
The end result produces an updated corporate book value of: $3 million.
We’ve now accomplished both objectives. By first doing the stock redemption via a note payable, we should be able structure the life insurance so that it doesn’t increase accumulated E&P. And, by having Kevin use the $2 million of life insurance proceeds to purchase corporate stock or make a capital contribution to the corporation, he receives the same $2 million step-up in cost basis he would have received under a cross-purchase buy/sell. And, bear in mind that after the capital contribution is made, the corporation will again have a book value of $3 million and an FMV of $4 million.
The E&P won’t increase because the life insurance wasn’t payable to the corporation, minimizing Kevin’s dividend problem. Also, his $2 million capital contribution increases his cost basis by that amount.
Implementation of these strategies can be very complicated. It requires proper drafting of documents and the opinion of a tax attorney to assure the Internal Revenue Service doesn’t “collapse” the transaction.
1. Revenue Ruling 55-33 and Internal Revenue Code Section 1.312 (6)(b).