Student Question of the Week: Buy-Sell Agreements

Student Question from Holly S
Course: Income Tax Planning

Student Question:

Hi Dan.

On this page, step 6 of the Stock Redemption steps seems incorrect. My understanding from a prior lesson was that the remaining owner % would be unchanged (stay at 33% in this example) since the corporation bought the deceased owner’s shares. What am I missing?

Thanks.

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Instructor Response:

Hi Holly!

Great question here! I think you may be confusing the value of their stock with the actual percentage ownership. If there are three owners and one dies, in both a Stock Redemption and Cross-Purchase, the surviving owners will each have 50% of the stock. In the Cross-Purchase, the surviving owners buy it from the deceased owner and in a Stock Redemption, the company buys it.

Let’s look at a very simple example.

EXAMPLE

Dave, Mary, and Tom each own 2 shares of ABC Inc. Each share is valued at $10, so each owner has a 33% stock interest valued at $20. Let’s ignore the life insurance part and go straight to what happens when Dave dies.

Cross Purchase: In a Cross-Purchase, Mary and Tom each buy 1 share (valued at $10 per share) of ABC Inc. stock from Dave’s estate. The result is that Mary now owns 3 shares (50% of the stock) valued at $30, and Tom owns 3 shares (50%), valued at $30. The percentage interest for Mary and Tom went from 33% to 50%, and the value of their stock went from $20 to $30.

Stock Redemption: In a Stock Redemption, ABC Inc. will purchase back the 2 shares from Dave’s estate for $20. That stock is now retired. So, the result is that Mary and Tom each still own 2 shares valued at $20, but the percentage ownership for each has increased to 50% because there are now only 4 total shares of ABC Inc. when previously there were 6.

Hopefully, this short example helps illustrate the difference in stock ownership by percentage and value. Let me know if you have any questions about this.

Dan