You’ve heard it many times: Change is good. Well, maybe that’s true when you’re talking about a new house or a promotion at work, but when it comes to small-business plans, change can have unexpected repercussions.

Consider this scenario: At the urging of one of his advisors, a business owner client calls to tell you that he wants to convert the plan you carefully developed for him–an entity buy-sell arrangement–to a cross-purchase buy-sell arrangement.

The entity arrangement you set up provides cash for the company to purchase business interests through life insurance. And, you’ve periodically reviewed your client’s situation to make sure the death benefit covers the increasing value of the business. But if you’re to fund a new cross purchase buy-sell arrangement using your client’s existing life insurance, you’ll need to change the policy ownership and the beneficiary.

But before responding to your client’s request, you need to determine if there are broader implications.

You check your records and note the business is an “S” corporation with 2 owners: Robert, 62, and Melissa, 58. When you worked with them to set up their buy-sell arrangement several years ago, you convinced them to fund the agreement with life insurance.

After all, you noted, they would need money to make sure the business could afford to purchase the deceased’s stock without impairing the financial stability of the business. (The business would have an obligation to buy the deceased owner’s portion of the business–in essence, a liability. And life insurance offset that liability.)

When you set it up, the entity arrangement made sense, and it probably still makes sense today. However, one of your clients’ other advisors convinced them that a cross-purchase arrangement would better suit their needs. That’s most likely because the step-up to current market value in basis treatment for the surviving owner is not fully available in the entity plan.

In an S corporation, basis is constantly adjusted, increased by income received and decreased by expenses paid and distributions made to shareholders. Life insurance proceeds paid to an S corporation increase a shareholder’s basis in stock. So, at death, the deceased shareholder’s stock receives a proportional increase upon receipt of the life insurance proceeds. Though this doesn’t have the same step-up effect as in a cross-purchase, it softens the impact of a stock redemption on basis for the surviving shareholder.

The switch to a cross-purchase agreement also would impact the tax treatment of the death proceeds: They may no longer be income-tax-free. Whereas the business entity as policyowner is exempt from the transfer-for-value rule when insuring an officer or shareholder, co-shareholders as policyowners are not.

Here’s how the cross-purchase agreement works: The policy insuring Robert transfers to Melissa who names herself as beneficiary, and the policy insuring Melissa transfers to Robert who names himself as beneficiary. If either of them dies with this life insurance arrangement, the only income-tax-free portion of the death proceeds are the consideration at the time of the transfer and any future premiums paid.

The “transfer-for-value” rule states that the exemption to this harsh tax treatment applies if the new owner is: (1) the insured; (2) a corporation in which the insured is a shareholder; (3) a partnership in which the insured is a partner; or (4) a partner of the insured. All other transfers are subject to the tax treatment noted. This situation doesn’t normally come up except in business insurance arrangements.

To avoid this adverse tax treatment, the life insurance could remain with the business and be treated as “key person” coverage. This assumes the business owners are still insurable, since they would have to apply for new policies to fund the cross- purchase arrangement. As “key person” coverage, the policy ultimately could be used to provide supplemental retirement benefits. This would involve a separate agreement drafted under the new rules established by the requirements of Section 409(A).

Or the policy could be transferred to the insured and he or she could name a beneficiary. The business could assist with the premiums by using a bonus arrangement. At some future time, the insured could tap the values in the policy for supplemental retirement benefits using a loan, a withdrawal or a combination of the two.

Depending on who wants the tax advantages of the income aspects of the life insurance later on, the business or the insured, would likely determine ownership. The current costs for this future income might be the determining factor. Insurability may be the other factor, especially now that the insureds are older.

The bottom line: When working with a closely held business, it’s best to think through a change in the ownership of any life insurance. Pay particular attention to the purpose of the insurance and the type of business.