FUNDING IRC SECTION 303 TO PAY ESTATE TAXES AND EXPENSES

By Joseph E. Godfrey III, CLU, AEP, Managing Director, Market Development, Hirschfeld, Stern, Moyer & Ross, Inc.

A section of the IRC allows businesses to pay the estate tax bills of the estate of the owner of the business. Restated, the business pays the tax--without the tax payment being
taxable!

IRC section 115(g)(3), which deals with redemptions for death taxes, was adopted by the 1950 Tax Act, effective for distributions after September 23, 1950. When the 1954 code was enacted, Sec. 115 was placed in the 300 section for redemptions, and resurfaced as section 303.

What is "new" about this old code section is that--

* it applies to S corporations as well as C corporations and

* it can be utilized in paying the 55% Generation Skipping Transfer Tax.

What exactly is IRC section 303, and how does it work? It was enacted to help estates that consist largely of closely-held corporation stock, to solve their liquidity problems and therefore protect them from forced liquidation or merger due to the heavy impact of death taxes.

If certain requirements are met, a closely held business can pay--free of income or capital gains taxes--the estate settlement costs of its owner(s). The company can, in effect, help the estate of its deceased businessowner(s) to pay--

* the entire Federal estate tax,

* all generation skipping transfer taxes,

* all local inheritance taxes,

* all interest on overdue taxes for (1), (2), and (3) above, plus

* all deductible funeral and administration expenses.

It is not considered to be a taxable dividend distribution under IRC section 301(a). This is true even though it is a partial redemption and not a complete termination of the estate owner's interest. Since the redemption occurs after death, there is also a step-up in basis, so there is no capital gains tax.

Even if an estate need not take advantage of section 303 because it has an abundance of liquid assets on hand, it may still choose to utilize section 303. Why? Because it is a way to take large amounts of money (earnings and profits/"E&P") out of a C corporation without dividend treatment. The funds need not be directly used to pay estate taxes. Sec. 303 is only a way to "measure" how much stock can be redeemed on a tax-free basis.

Furthermore, the company can have more than one class of stock (often issued in order for the principal owner to maintain control and not cause dilution). Non-voting common can be redeemed, for example, after a recapitalization. Or, a preferred stock dividend (which is generally tax-free) could be declared on the common, and then redeemed under IRC section 303. Another technique that combines the above two, is to obtain shareholder approval to issue a stock dividend of nonvoting shares, and then redeem the newly issued stock from the estate.

What are the criteria for a business owner's estate to qualify for IRC section 303 treatment? The businessowner's estate must meet the following conditions:

1. The stock to be redeemed must be in the taxable estate.

2. The value of all stock of the redeeming corporation, which is includable in the deceased businessowner's gross estate, must exceed 35% of the adjusted gross estate (gross estate less allowable deductions). Stock of two or more corporations will be treated as that of one corporation provided 20% or more of all the value of all the outstanding stock of each corporation is includable in the decedent's gross estate.

3. The dollar amount of the redemption is limited to the sum of the previously enumerated expenses: (a) Federal Estate tax, (b) generation skipping transfer tax, (c) local estate and/or inheritance tax, (d) interest on overdue taxes for 1., 2., and 3. above, plus (e) deductible funeral and administration expenses.

4. Stock must be redeemed within certain windows of time.

5. Stock must be redeemed from the deceased shareholder's estate.

When IRC section 303 is utilized, all estate settlement costs are paid at once, through the redemption of stock in exchange for cash. From whence does the cash come? Let's explore the options (and the related problems):

* Accumulate assets inside the business. The problem is that the IRS might say they are accumulated beyond the "reasonable needs of the business," and are therefore subject to the accumulated earnings tax. Let's assume it is possible to convince the IRS that there is a valid business reason for accumulating money.

* Maximize earnings. Growth in capital, dividends, and interest may be set aside but currently will be taxable to the corporation or to other individuals or trusts.

* Purchase municipal bonds. The result may be overall lower returns.

* The owner(s) may die before the amount accumulated will be sufficient to pay taxes.

A very plausible answer would be to purchase life insurance, the proceeds of which can be utilized to provide the required liquidity. It solves the three problems enumerated above:

* Generally the accumulated earnings tax is not imposed on income retained for the purchase of life insurance, if the insurance covers a valid business need and generally is related to that need.

* Putting the premiums inside the tax shelter of the policy avoids income and capital gains taxes during life (regardless of who owns the insurance contract, i.e., the company, an individual, or a trust), with proceeds paid out income tax-free at death. If the proceeds are payable to the company, they may balloon the value of the company for Federal estate tax purposes, although they can be reduced by the value of the loss of the key person(s). Such proceeds would be subject to an alternative minimum tax (AMT) calculation; however, the amount of this tax would generally be modest vis-a-vis income and capital gains taxes, and generally is not relevant in the majority of closely-held businesses.

* The problem of dying too soon is eliminated by the very nature of the life insurance contract. The event that creates the need for cash--DEATH--creates the cash to pay the taxes and other costs of settling the estate.

Coverage can be either on a single life, or on multiple lives. The second-to-die/survivorship form of coverage would be helpful, for example, where a large infusion of cash is needed after the second death of a husband and wife, or even two shareholders.

Proper estate and insurance planning can match the need for liquidity with the appropriate type of coverage (based on reasonably conservative assumptions) so that the policy(ies) will be in force at the date of death--even if that is beyond age 100. This is important, because some futurists predict more than a million people over the age of 100 in the U.S. by the middle of next century. Therefore, policy forms and illustrations should last as long as the taxpayer may last.

Prudent planning also requires exploration of other issues--including income, gift, and alternative minimum taxes to name a few--to determine the most advantageous ownership and beneficiary arrangements. For example, if the business were the owner and beneficiary, there might be an AMT payable. Is this the correct structure? Should insurance coverage be set up on split-dollar basis (whereby the corporation and executive/owner split the premiums and proceeds, so that the company is always repaid for the premiums it has advanced)? What is the correct split-dollar structure for both majority and minority owners? With split-dollar plans, historically the tax cost was based on the economic benefit provided (as determined by various tables); what are the safer methods (in light of TAM 9604001) that seek to charge the executive/owner with imputed income and gift taxes on the annual cash value increases?
Should an irrevocable life insurance
trust be the owner and beneficiary, or would specific individuals be more appropriate? *

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA/PFS
A. Kozak & Company

Contributing Editors:
Alan Fogelman, CPA
Clarfield & Company P.C.

David Kahn, CPA/PFS
Goldstein, Golub Kessler & Company, CPAs P.C.