PHOENIX — Life insurance professionals had better make sure clients get tax advice before using life insurance in buy-sell arrangements.
Terri Getman, a vice president at Prudential Financial Inc., Newark, N.J., (NYSE:PRU) described the potential pitfalls here during a session at the FSP Forum, an event organized by the Society of Financial Service Professionals, Newtown Square, Pa.
“Many life insurance professionals are not familiar with the various tax treatments of business buy-sell agreements,” Getman said. “This aspect of business planning is not easy. If nothing else, advisors need to recognize that there are differences, depending on the type of agreement. And if, they don’t possess the requisite expertise, then they need to partner with other professionals who have it.”
A buy-sell agreement can help users keep unwanted parties from acquiring an interest in a business.
An agreement also can create a market for an owner’s interest, help avoid transfers that could negatively impact an entity’s formation or tax status, and prevent disputes between heirs and survivors.
When funded with life insurance, a buy-sell agreement can provide estate liquidity and survivors’ income.
These and other benefits could be compromised if advisors and their clients fail to consider the tax rules, Getman warned.
One pitfall is the “triple tax trap” family buy-sell arrangement.
The problem arises when a buy-sell agreement is established at below fair market value and the estate is taxed at more than the agreed price if the arrangement fails to meet requirements to fix the estate value.
In that event, the client could lose use of the marital deduction. There also could be a taxable gift if the client fails to exercise a “bargain option;” and if the option is exercised, there may be a taxable gift, Getman said.
“One solution to the problem is to not do a buy-sell agreement,” Getman said. “The business owner could simply pass the business interest to family members active in the business. And he or she could own insurance to provide income to the spouse and help equalize the estate for non-business family members.”
Tax consequences also have to be weighed in situations involving transfers for value, Getman said.
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.”