Getman: Beware Of Buy-Sell Tax Traps

If, for example, a policy is transferred for “valuable consideration,” a portion of the death proceeds will be taxed, except where the transfer is to an exempt transferee. The transfer-for-value rule may be triggered, for example, when the value is broadly defined or when there is a change in the beneficiary designation.

The rule could apply to any form of buy-sell agreement, but it is more likely to occur in a corporate cross-purchase agreement, Getman said. Examples include a restructured stock redemption to cross-purchase agreement, the use of existing policy coverage to fund a cross-purchase, and acquiring a co-shareholder’s policy from the estate of a deceased shareholder.

“The solution here is to structure the transfer-for-value to an exempt transferee,” Getman said. “The transfer could be to an insured, to a partner of the insured, to a partnership in which the insured is a partner or to a corporation in which the insured is an officer or shareholder.”

Yet another transfer-for-value issue arises, Getman said, in cases involving multiple owner policies in a trusteed buy-sell agreement. A tax hit can result at the death of the shareholder if the surviving owners acquire a greater interest in the remaining trust-owned policies.

To circumvent this problem, Getman advised structuring the arrangement as a transfer to an exempt transferee under the transfer-for-value rule. The rule can thus be avoided if the insured or shareholders are partners in a partnership or limited liability company, or if an LLC or partnership is used in place of a trust.

A transfer-for-value problem surfaces yet again where a surviving owner/insured wants to acquire a policy on a second surviving owner/insured’s life from the estate of a third departing owner/beneficiary. In this instance, Getman recommends structuring the transfer as a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder.

In instances involving C Corp. stock redemption arrangements, Getman said, the redemption of stock can be taxed (per Internal Revenue Code Sections 301 and 302) as a distribution. The distribution would be treated as ordinary income to the extent of earnings and profits, then be tax-free to the extent of the shareholder’s basis. A capital gain or loss would apply to the balance.

But Getman noted that it is possible to have a stock redemption for a sale or tax exchange treatment. The benefits: tax-free recovery of the shareholder’s basis (in which the basis is allocated in proportion to the amount of stock sold); and a capital gain/loss tax treatment on the balance.

In respect to the tax treatment of life insurance proceeds, said Getman, a key question for many C corporations is whether the business’ ownership of a policy on the business owner’s life causes the proceeds to be included in the business owner’s estate.

The answer, Getman said, is “no” where proceeds are paid to the corporation, but “yes” in instances involving a controlling (more than 50%) shareholder, to the extent that proceeds are not payable to the corporation.

How should life insurance proceeds received by a business be considered in determining the value for a deceased owner’s estate?

“The valuation treatment of life insurance should be addressed specifically in the buy-sell agreement,” said Getman. “If the agreement is silent and proceeds are significant in relation to the value of the business, the result may be litigation.”