Since the deceased shareholder automatically gets a step up in basis, the key is to redeem the deceased shareholder’s interest before applying for the life insurance proceeds. That way, the income from the life insurance proceeds can be allocated 100% to the remaining shareholders, increasing their inside basis in the company.
Step 1. Upon the death of the shareholder, his or her interest should be fully redeemed by the issuance of a note (or notes) equal to the buy-out price. If the buy-out price exceeds the proceeds of the insurance policy, a second note should be issued.
Step 2. After the shareholder’s interest has been completely redeemed, the corporation should file an election under Section 1377(a)(2) of the Internal Revenue Code to terminate their tax year.
Step 3. Only after redeeming the shareholder and terminating the S-Corp’s tax year, should the corporation apply for the proceeds from the life insurance policy.
Step 4. The proceeds from the policy will be used to repay the note to the deceased shareholder in full.
If structured in this manner, the income from the proceeds will be allocated 100% to the remaining shareholders, avoiding a wasted allocation of basis to the deceased shareholder (who already has a step up in basis).
If the proceeds from the life insurance policy are insufficient, the company may either issue a second note, as discussed earlier, or may pay the balance of the buy-out in cash.