Using Life Insurance In A Qualified Plan To Fund A Client's Buy-Sell Plan

The first of these amendments allows for the purchase of life insurance on each plan participant and family member(s). Once in place, a business owner can purchase a policy on the life of a co-owner within his/her own defined contribution account. A portion of the annual tax-deductible contributions to the profit-sharing plan can be used to purchase the life insurance policy.

If there is a death, the death proceeds will be paid into the survivor’s profit-sharing account. Those funds can then be distributed and used to buy out the deceased’s business interest. Result: The survivors honor their commitment under the buy-sell plan and buy the deceased’s business stake from their estate or family.

To illustrate, consider John and Joan, each of whom owns a 50% share of Acme Inc. They are, respectively, 45 and 55 years old and are rated “non-smoker preferreds.” They have an unfunded cross-purchase agreement that obligates each to buy a $1,000,000 business interest from the other’s estate in the event one of them should die. The plan has been unfunded because they want a tax-deductible way in which to fund the plan.

Using their profit-sharing plan, John buys a $1,000,000 policy on Joan, and vice-versa. They can use some portion of their current tax-deductible plan contributions, or some portion of existing funds already inside their profit-sharing plan, to purchase a life contract. But each year, the 2 owners must recognize the economic benefit of the life insurance owned within their profit-sharing account, the benefit being an out-of-pocket cost. Typically, the recognition is handled under Table 2001, but some life insurance carriers offer lower, proprietary alternative term rates.

Were Joan to die, John would receive the risk portion of the death benefit (the portion over the cash surrender value of the policy) free of income tax. In turn, he can use those funds to buy out Joan’s stake in the business. The cash value portion of the death benefit is subject to income tax, though John is credited with basis in the policy for the economic benefits on which he has paid income tax. Alternatively, if a secondary guarantee lapse protection rider were used, there would be little or no cash value, but a guaranteed death benefit would be paid out to John.

Keep in mind that there is a price to be paid for the tax deductibility.

? Each year the owners will recognize taxable income based on the economic benefit of the life insurance within their plan.

? In addition to the annual economic benefit charge, not all of the death benefits are available to cover the purchase price. Any policy cash values must remain in the profit-sharing plan as an asset for retirement.

? Using a life insurance policy in a qualified plan may draw from assets that might otherwise be used to build funds for retirement.

? Because the plan design must accommodate the life insurance purchase and potential distribution of death benefits, this approach is limited to defined contribution profit-sharing plans.

? On many occasions there will not be a death, in which case the life insurance policy needs to be addressed. Many options will need to be weighed, including distributing the policy from the plan to the account owner or insured; plus ERISA, income and gift tax considerations. In these cases, it is important to work with a company that can help you value the policy under the parameters of Rev. Proc. 2005-25.

? Note also this concept is based on a pair of private letter rulings that do not extend to taxpayers other than those who requested the rulings.

While this approach will not work in every situation, where the right client exists, it may be ideal. It allows business owners to purchase life insurance on a tax-deductible basis or with funds that might otherwise lay dormant for years. By doing so, they are able to fund a business continuation plan and achieve significant long-term planning goals.