Under an entity-purchase plan, the business entity agrees to buy and the principals agree to sell their business interests at some triggering event such as death, disability or retirement. In an insurance-funded plan, the policies are owned and paid for by the business. The business is the beneficiary and will use the death proceeds to purchase a deceased principal's interest.

Corporate entity-purchase plans are usually referred to as "stock redemption" plans.

Example: D, E, F and G, equal shareholders in DEFG, Inc., a corporation worth $1,200,000, adopt a stock redemption agreement. The four principals own 100 percent of the stock. To fund the buy-sell agreement, the corporation will purchase $300,000 insurance on the lives of each of the four shareholders. Four policies will be needed.

As shown here, if D dies, the corporation will use the $300,000 death proceeds to redeem D's one-quarter interest in the business. Each surviving owner's share of the business will be increased by redemption of D's interest; their bases in the business will remain the same.

Note: Partnership entity-purchase plans would work in much the same way as the stock redemption plan illustrated. In sole proprietorships, remember, only cross-purchase plans can be used, since there is no separate business entity apart from the owner.

Tax treatment (under the current tax law)

• Premium payments are not considered business expenses and are not tax deductible.
• Death proceeds are received by the business, income-tax free (except for the alternative minimum tax).
• Proceeds of policies owned by the business on the deceased's life will not be included in the deceased's estate.
• The surviving principals' interests in the business increase when the death proceeds are used to purchase the business interest from the deceased's estate; their bases remain the same.
• The deceased's estate receives a step-up in basis for the business interest sold (usually, the new basis is the fair market value at the deceased's death). No capital gain will result if the amount the estate receives for the business equals the fair market value.

Stock redemption buy-sell agreement

Example: D, E, F and G are equal shareholders in DEFG Inc., a corporation worth $1,200,000. The corporation buys $300,000 insurance on the life of each principal. Here's how this plan would work if D dies. Note: The broken lines represent dollars and interests transferred at death.

At D's death, DEFG Inc. has 400 outstanding shares valued at $1,200,000. Shareholders E, F and G still each own 100 shares, but they now own thirty-three and one-third percent of the corporation instead of 25 percent; their bases remain the same.

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