BUSINESS STRATEGIES. Stock Redemption Arrangement for Closely Held Corporations. A successful business has a business succession strategy.

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1 THE PRUDENTIAL INSURANCE COMPANY OF AMERICA BUSINESS STRATEGIES Stock Redemption Arrangement for Closely Held Corporations BUSINESS CONTINUATION A successful business has a business succession strategy. You incorporated your small business for good reason; to protect its value and to guard against liability issues to name a few. Having a set plan for business continuation helps ensure that your business continues as you want it to. The following statements may refl ect you and your feelings about your business: You have spent many long hours working in and creating value in your business, and it is either one of the major assets or the major asset in your estate. You would like to create a ready market for the sale of your shares at your death. You want to see that the business remains in the hands of just the surviving shareholders. You see the need to establish an estate value for your business interest in order to reduce the potential for IRS disputes. You want to be certain funds will be available to help with the buyout of a deceased or departing shareholder s interest. If you relate to these statements, establishing a stock redemption buy-sell arrangement funded with life insurance may be right for you. A stock redemption buysell arrangement is: A contract agreed to by the corporation and shareholders that requires the corporation to purchase the interest of a shareholder under specified terms and conditions. An arrangement that, when funded with life insurance, helps ensure that cash will be available to help with the buyout Prudential Financial, Inc. and its related entities Ed. 09/2014 Exp. 03/22/2016

2 BENEFITS TO THE DEPARTING SHAREHOLDER OR HEIRS If properly drafted, implemented, and maintained, the arrangement helps to establish the business value for estate tax purposes. It provides a ready market for the sale of the business interest. It ensures that cash to help pay estate taxes and/or to meet family needs will be available. The shareholder s heirs are relieved of further corporate responsibilities. Where life insurance is used to fund the buyout, the heirs of the deceased shareholder immediately receive cash, avoiding delays and potential liquidation losses and are no longer dependent on the corporation for their financial security. BENEFITS TO THE CORPORATION AND REMAINING SHAREHOLDERS The corporation receives life insurance proceeds to finance the buyout of the deceased shareholder at the exact time when needed. The corporation continues uninterrupted with the surviving shareholders as owners. A stock redemption agreement funded with permanent life insurance can provide needed cash to help meet the contractual obligations established by the agreement, potentially minimizing the impact on working capital and cash flow. In contrast to a cross purchase agreement, a stock redemption agreement funded with life insurance allows the corporation to purchase just one policy on each owner. Employees, creditors, and suppliers feel more secure knowing the business has a succession arrangement in place. Where permanent policies are purchased, the cash values of the policies are assets of the business that are reflected on the balance sheet and are available for business needs. 1 1 Life insurance policy cash values are accessed through withdrawals and policy loans. Interest is charged on loans. Loans and withdrawals cause a reduction in cash values and death benefits, may affect any guarantees against lapse, and may have tax consequences.

3 HOW A STOCK REDEMPTION BUY-SELL ARRANGEMENT WORKS Corporation 2. Premiums 3. Policy Proceeds Insurance Company 1. Agreement 1. Agreement Shareholder A 4. Cash 5. Stock Shareholder B Estate of Deceased Owner 1 The corporation enters into a stock redemption agreement with each shareholder. This agreement obligates the business to purchase the deceased shareholder s stock in the corporation, and obligates the decedent s estate to sell the deceased shareholder s stock back to the corporation. 2 The corporation purchases life insurance protection on the life of each shareholder equal to at least the value of the shareholder s interest. The corporation is the owner, premium payer, and beneficiary of each policy. You should consult your legal counsel to determine whether notice and consent under IRC 101(j) is required before the policies are issued to receive tax-favored treatment. 2 3 At the death of a shareholder, the corporation collects the life insurance policy proceeds from the insurance company. 4 The corporation pays the agreed upon amount, determined by the terms of the stock redemption agreement, to the shareholder s estate. 5 The owner s estate releases its stock to the business. 2 Life insurance death proceeds are generally received income tax-free (IRC 101(a)). For employer-owned contracts issued after August 17, 2006, death proceeds will be subject to income tax. However, where specific employee notice and consent requirements are met, and certain exceptions apply, death proceeds can be received income tax free (IRC 101(j)).

4 TAX CONSIDERATIONS FOR THE DEPARTING SHAREHOLDERS OR HEIRS Qualifying for sale or exchange treatment. Generally, under IRC 301, stock redemptions are treated as corporate distributions (dividends) to shareholders and will be taxed as ordinary income to the extent of earnings and profits (E&P). However, where shareholder s qualify the stock redeemed as a sale or exchange under one of the safe harbors found in IRC 302, the person whose stock is being redeemed will receive capital gains treatment. Where a lifetime redemption occurs and qualifies for sale or exchange treatment, the difference between the basis of the stock and amount realized in the redemption will be taxed as capital gains. Stock redemptions at death are tax advantageous since the basis of the stock receives a step-up to fair market value. A sale made quickly after death will generally result in no gain, assuming that the sale price is not significantly different from the estate value. Caution for family-owned corporations. One of the most common safe harbor routes used to achieve capital gains treatment for a stock redemption is a complete termination. A complete termination occurs whenever the corporation repurchases a shareholder s entire ownership interest if between unrelated shareholders. However, where family members are shareholders, additional rules under IRC 318 complicate the ability to achieve sales or exchange treatment by attributing to a redeeming shareholder stock that is owned by another family member or by various entities involving family members. An individual is deemed to own stock directly owned by his/her spouse, children, grandchildren, and parents. In addition, entity attribution can result where stock owned by a partnership, estate, trust, or another corporation is attributed to family members as beneficial owners. The constructive ownership rules are complicated and their application requires expert legal advice. It is important to note that the danger of ordinary income-tax treatment exists in every buy-sell arrangement structured as a stock redemption in the C corporation context where the business involves family members. In contrast, where the redemption involves an S corporation that has never been taxed as a C corporation, redemption will not result in ordinary income tax, even where there are related family members. A properly drafted buy-sell agreement can help establish the value of the business interest for estate tax purposes.

5 TAX CONSIDERATIONS FOR THE CORPORATION AND REMAINING OWNERS For employer-owned life insurance policies issued after August 17, 2006, IRC 101(j) provides that death proceeds will be subject to income tax; however, where specific employee notice and consent requirements are met and certain safe harbor exceptions apply, death proceeds can be received income tax free. Life insurance proceeds are otherwise generally received income tax free under IRC 101(a). However, if the corporation is a C corporation and subject to corporate alternative minimum tax (AMT), policy cash values and death proceeds will affect adjusted current earnings. 3 A corporation taxed as an S corporation is not subject to AMT. Premiums paid for life insurance are not income tax deductible by the corporation. Stock redemptions increase surviving shareholders interest in the C corporation but do not increase their stock basis. Although the surviving shareholders have the same proportion of ownership in relationship to each other after the redemption as prior to the redemption, care must be taken that control of the business is not shifted unintentionally. For example: Dad and son own, respectively, 40% and 20% of the corporation, with a key employee (unrelated) owning the remaining 40%. Combining their voting power, dad and son control the corporation. If dad s stock were redeemed, the key employee would own the majority of the outstanding stock and have control of the business. Where life insurance is used as a funding vehicle in a C corporation redemption, death benefit proceeds received by the C corporation have no effect on a shareholder s basis in the stock. In contrast, in an S corporation, where life insurance is used to help fund the stock redemption arrangement, death benefit proceeds do increase shareholder basis. Since high basis in an S corporation shelters future distributions from income taxation, the use of life insurance can be an important tax strategy. The amount of basis increase the surviving shareholders receive depends on a number of factors. Consult your legal and tax advisors for a complete discussion. If needs and circumstances change, policies can be transferred from the corporation to the insured shareholder without creating transfer-for-value taxation issues. 3 Corporations in their first year or having average annual gross receipts of $7.5 million or less for the preceding three-year period (average annual gross receipts of $5 million or less for initial qualification) are no longer subject to AMT.

6 RECOMMENDED ACTION PLAN 1 Seek the professional advice of your attorney regarding your personal needs and objectives for the disposition of your business interest in the corporation. 2 Meet with your accountant, attorney, and/or professional appraiser to determine the value of your business interest. 3 Determine the appropriate insurance solution. 4 Have your attorney draft the stock redemption agreement, corporate resolution, and other appropriate documents. 5 Apply for the life insurance to be owned by the corporation and complete all medical and underwriting requirements. 6 Review the buy-sell arrangement with your financial professional, attorney, and accountant on a regular basis. All guarantees and benefits of the insurance policy are backed by the claims-paying ability of the issuing insurance company. Policy guarantees and benefits are not backed by the broker/dealer and/or insurance agency selling the policy, nor by any of their affiliates, and none of them makes any representations or guarantees regarding the claims-paying ability of the issuing insurance company. This information is intended to help you understand how life insurance can be used to help provide funds for business continuation arrangements. This material is designed to provide general information in regard to the subject matter covered. It should be used with the understanding that it does not constitute legal, accounting, or tax advice. Such services should be provided by the client s own legal, accounting, and tax advisors. Accordingly, information in this document cannot be used for purposes of avoiding penalties under the Internal Revenue Code. Securities and Insurance Products: Not Insured by FDIC or Any Federal Government Agency. May Lose Value. Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate. Life insurance is issued by The Prudential Insurance Company of America and its affiliates. All are Prudential Financial companies located in Newark, NJ, and each is solely responsible for its own financial condition and contractual obligations. Life insurance policies contain exclusions, limitations, reductions of benefits, and terms for keeping them in force. Your financial professional can provide you with costs and complete details. The availability of other products and services varies by carrier and state. The Prudential Insurance Company of America, Newark, NJ Prudential Financial, Inc. and its related entities.

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