Trusteed buy-sell agreements are often the most elegant solution to the problem of how to fund the buyout of a deceased shareholder. But transfer-for-value problems with insurance-funded agreements can convert otherwise income-tax-free death benefits to ordinary income, costing surviving owners and their businesses big. As a result, avoiding the transfer-for-value rule is paramount in any buy-sell agreement.
Trusteed Buy-Sell Agreements
Under a trusteed buy-sell agreement, the trustee will purchase a life insurance policy on the lives of each of the owners and be named as beneficiary of each of the policies. The business owners will make contributions to the trust in proportion to their ownership interest in the company. Contributions will be used by the trustee to make premium payments. When one of the owners dies, the trustee collects the death benefit of the policy and distributes it to the surviving shareholders who will purchase the company’s shares from the deceased owner’s estate.
A trusteed buy-sell agreement solves a number of problems inherent in other types of buy-sell agreements. First, a trusteed agreement obviates the need for each owner to purchase policies on the lives of every other owner. Consider a business with three owners. Under a standard buy-sell agreement, each owner will need to purchase policies on the lives of every other owner, for a total of six policies. Increase the number of owners to four and 12 policies must be purchased.
In addition to reducing the number of policies necessary to keep the buy-sell agreement in place, a trusteed agreement also will ensure that owners do not borrow from policies or otherwise hamstring their ability to affect the purposes of the agreement. A trusteed agreement is particularly desirable where owners have an adversarial relationship and need a neutral party to facilitate their buy-sell agreement.
A trusteed buy-sell agreement has the additional advantage of keeping policies out of owners’ estates when they die holding policies on their co-owners lives. Because the trustee owns the policies, the business owners will not hold incidents of ownership in the policies and their value will not be included in their estates.
Although trusteed buy-sell agreements are an improvement on a standard buy-sell agreement, they raise a very significant income tax issue for shareholders.
The Transfer-for-Value Problem
In general, the proceeds of an insurance policy paid by reason of the insured’s death are received income tax free by the beneficiaries. A significant exception to the rule exists for policies that are transferred at some time after they are issued “for valuable consideration.” In its simplest terms, the transfer-for-value rule says that, if a policy is sold by its owner after the policy is issued, the income tax exclusion for life insurance proceeds will be lost and the beneficiaries will pay income tax on the amount of the death benefit.
But the transfer-for-value problem is not just an issue when a policy is transferred in a straight sale transaction. It can pop up in trusteed buy-sell agreements as well. When one of the owners dies, the deceased owner’s share of the policies owned by the trust on the other business owners will suddenly shift to the surviving owners. That shift can be considered by the IRS to be a “transfer.” Further, the transfer is “for value” because no business owner would agree to such an implicit transfer unless the other business owners entered into reciprocal promises to do the same. Those reciprocal promises are the value each owner gives in exchange for an interest in the policies. As a result, the IRS is keen to apply the transfer-for-value rules to trusteed buy-sell agreements and convert tax-free death benefits to ordinary gains.
For example, consider a corporation owned equally by three shareholders, John, Elizabeth, and Mark. The owners enter into a trusteed buy-sell agreement with each other. Under the agreement, the trustee purchases three $10,000 policies, one on the life of each shareholder. If John dies, the policy on his life will pay a death benefit of $10,000 to the trust. The trust will then distribute $5,000 each to Elizabeth and Mark who will purchase John’s stock from his estate. Now, the trust holds two $10,000 policies, one on each of the remaining shareholders’ lives. But prior to John’s death, Elizabeth and Mark each beneficially owned only one-half of the policies on each other’s lives; after John’s death, they each beneficially own 100% of the policy on the other surviving shareholder’s life.