When a corporation purchases the stock of a departing shareholder, it’s called a “redemption.” When the other stockholders purchase the stock, it’s called a cross-purchase. Typically, the redemption versus cross-purchase decision doesn’t impact the ultimate control results. The remaining shareholders end up with the same percentage interest in the company under either approach. Plus, with either approach, the departing shareholder or his or her estate ends up getting cash or a promissory note that will be paid off over time by the buyer of the stock. But beyond these common end results, there are important factors that may favor one approach over the other in any given situation.
And important tax factor is the impact on the outside tax basis of the stock owned by the other shareholders of a C Corporation. A stock redemption by a C Corporation will not increase the basis of the stock held by the remaining owners. By contrast, stock acquired in a cross-purchase transaction will result in a basis equal to the purchase price. This will result in a higher basis in the stock owned by the other shareholders. They will realize a lower capital gain on any subsequent sale of the stock.
Let’s assume for example that in the case of ABC Inc., Roger, one of the 20% percent shareholders leaves the company. His 20% stock interest has a fair market value of $400,000 at the time of the departure. If ABC Inc. redeems his stock on his departure for $400,000, Dave and Sue, the original 60% owners would end up owning 75% of the outstanding stock of the company and Joyce, the other owner, would now own 25% of the outstanding stock in the company. If Joyce’s basis in her 20% interest was $100,000, her basis and her new 25% interest is still $100,000. As for Dave and Sue, if their original 60% had a low basis, say, $50,000, the basis in their 75% interest would remain at that $50,000.
The stock redemption approach generates no basis step-up for the other owners. If the remaining shareholders acquired Roger’s shares through a cross-purchase on a proportionate basis, Dave and Sue would acquire ¾ of Roger’s 20% interest and Joyce would acquire the other ¼. Roger and Sue would still end up owning 75% and Joyce would still end up owning 25%. But the basis in their stocks would be very different. Under a cross-purchase, Dave and Sue would have paid $300,000 for Roger’s 15% interest resulting in a total basis in their shares to $300,000 plus the original $50,000 for a total of $350,000. Joyce will now have a basis in her shares equal to her original investment of $100,000 plus the $100,000 that she paid to Roger for ¼ of his stock. So her total basis would have been increased to $200,000.
On a subsequent sale of the stock or a liquidation of the company, Dave and Sue have an additional $300,000 that can be recovered tax-free and Joyce has an additional $100,000 that can be recovered tax-free. This basis issue usually is not a factor for S Corporations, partnerships, or limited liability companies. In these type of pass-through entities, the owners will receive a basis step-up whether a redemption or a cross-purchase strategy is used.
Does this basis difference always make the cross-purchase approach the best choice for C Corporations like ABC Inc.? Not always. In cases where there are many shareholders, the cross-purchase approach may be too cumbersome, particularly if there are multiple life insurance policies that need to be reshuffled every time an owner dies or is bought out. Beyond the complexity of the reshuffling, the policy reshuffling itself may trigger serious income tax problems that may destroy the tax-free character of the life insurance death benefit – a complete disaster.
Also, often the individual shareholders don’t have sufficient capital or income to fund a cross-purchase buyout. Their capital is tied up in the company and there’s no effective tax rate to get cash out of the company and in the hands of the shareholders to fund the buyout of the departing owner. Another factor that may favor a redemption strategy in a C Corporation is the deductibility of interest payments on any installment obligation given to the departing owner or his or her heirs. If ABC Inc. issues Joyce a long-term note in redemption of her stock, the interest paid by the corporation is tax deductible as a trade or business expense.
In contrast, if the other shareholders issue such a note to Joyce, the interest paid by the shareholders in a cross-purchase arrangement likely will be subject to the investment interest limitations which may delay or preclude any deduction. So in many cases, as a practical matter, the redemption approach is preferred simply from a funding standpoint.
In some situations, there are other factors that make the redemption approach unattractive. If ABC Inc. is large enough to be subject to the alternative minimum tax, it’s receipt of life insurance proceeds on the death of a shareholder may trigger an expensive alternative minimum tax for the corporation. Any C Corporation with gross receipts over $5 million in its first 3 years and over $7.5 million dollars in following years may be subject to the corporate alternative minimum tax. Plus, earnings accumulated inside a C Corporation to fund the buyout of a major shareholder at a future date may not qualify as reasonable business needs for purposes of the corporate accumulated earnings tax, and as a result, these accumulations may end up triggering expensive additional taxes.
State corporate laws often restrict or limit a corporation’s ability to redeem its own stock if it lacks sufficient capital surplus or retained earnings to fund the redemption. At a minimum, such state corporate statutes may mandate additional costs and hassles such as an independent appraisal just to get the deal done and in some states, they may require that any corporate obligation be subordinated to the rights of other corporate creditors.
Finally, restrictive covenants and loan agreements that a company has often limit the company’s capacity to redeem stock by making substantial payments to the owners of the business. All of these potential problems should be carefully evaluated when considering the potential of a redemption approach. Note that many of these factors do not come into play with a pass-through entity such as an S Corporation, a partnership, or a limited liability company.
As previously mentioned, the outside basis differential usually is not an issue plus getting money out of the entity and into the hands of the owners usually presents no difficult tax issues as it usually does in a C Corporation. And there are no alternative minimum tax risks or accumulated earnings tax concerns with one of these entities. State law and loan agreement restrictions may still be just as applicable when considering a redemption approach in one of these different types of entities.
In some situations, the solution is to draft the buy-sell agreement to provide flexibility. The agreement allows for a redemption by the corporation or a cross-purchase by the other shareholders and gives the company and the other shareholders the right to select the preferred approach when the trigger is pulled. This flexible approach sounds better than it really is because advanced planning for the funding whether through the use of life insurance, disability insurance, or internal funding usually requires a decision on which approach will be used at the time the funding vehicle is put in place, usually that’s upfront.