Course: Insurance Planning
Lesson: 17 – Business Uses of Life and Disability Insurance

Student Question:

Under the Stock Redemption Method – how is basis treated specifically to stock remaining outstanding (not Treasury stock) and how does this compare to the Cross Purchase Method? Is basis treated the same – do both methods provide the same tax benefits to surviving shareholders?

Jim D.

Instructor Response:

Hi Jim,

Great question! The choice of the Redemption or Cross-Purchase will have a significant income tax impact for the surviving shareholders. One method will reduce future capital gains taxes and the other will not.
In the Stock Redemption Method, the surviving shareholders receive no increase in tax basis. The business owns and pays the premium for a policy on each shareholder in the Stock Redemption Method. The individual shareholders do not pay any premiums or own any of the policies.

  • At the death of a shareholder, the business has two choices in accounting for the purchase (redemption) of the decedent shareholder’s shares:
    • Retire the stock so that the only stock outstanding is in the hands of the surviving shareholders, or
    • Distribute the shares purchased from the decedent’s shareholder’s estate (Treasury stock) to the surviving shareholders in a pro rata manner that preserves their relative ownership in the business.
  • The surviving shareholders receive no increase in tax basis because they paid nothing for the Treasury shares received, if any.

The surviving shareholders receive an increase in their income tax basis in the Cross-Purchase Method.

  • In the Cross-Purchase Method, each shareholder owns and pays the premiums for a life insurance policy on every other shareholder. The business does not own or pay premiums for any of the life insurance policies.
  • At the death of a shareholder, income tax-free death benefits are paid directly to the surviving shareholders.
  • The surviving shareholders purchase the decedent shareholder’s shares from his or her estate using cash from the tax-free death benefit.
  • Because the surviving shareholders are paying for the decedent shareholder’s shares using their own cash, their tax basis is increased by the purchase price. The increased basis means their capital gains taxes will be reduced when the shares are sold in the future.

Although reducing future taxes by increasing basis is a powerful factor, other factors such as age/health/relative ownership of the shareholders and the number of shareholders should be considered as well.

Onward and Upward,