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.