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Succession Planning and Key Person Life Insurance: The Tax Implications

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If a corporation purchases life insurance on the life of a key person to indemnify it against loss on account of the key person’s death, are proceeds includable in the insured’s estate?

If, at an insured’s death, a policy was owned by and payable to a corporation and the insured possessed no “incidents of ownership” in the policy, the proceeds are not includable in the insured’s gross estate. If the insured possessed at death any incidents of ownership in the policy, the proceeds are includable in the gross estate even though the corporation has been named owner and beneficiary.

Death proceeds of life insurance owned by and payable to a corporation are considered, along with the other non-operating assets, as a relevant factor in valuing a corporation’s stock for estate tax purposes. Consequently, where an insured is a stockholder, the value of proceeds will be reflected in valuing stock includable in the insured’s gross estate. It is not correct to value the stock first, without considering the insurance proceeds, and then simply add the amount of proceeds to that value. Factoring life insurance proceeds into the valuation of stock may or may not result in an increase in value equal to the full value of the insurance proceeds, depending on the valuation method. 

For example, it may be possible to obtain some reduction in the value of stock to reflect loss to the business of the key person’s services. The executor must offer proof to establish that the insured’s death actually did cause a loss as a loss does not result per se from the death of the owner and manager of a corporation.

It has been held that no decrease in value for loss of an insured’s services will be allowed if the stock is personal holding company stock where the assets consist almost entirely of stocks and bonds; a corporation must be an operating business requiring management, with going value and good will.

If an insured is a controlling stockholder, that is, one who owns stock amounting to more than 50% of the total combined voting power of the corporation, then to the extent proceeds are payable other than to or for the benefit of the corporation, any incidents of ownership in the insurance held by the corporation as to the proceeds will be attributed to the insured and thereby will cause the proceeds to be includable in the insured’s gross estate.

In a revenue ruling, X corporation owned insurance on the life of its controlling stockholder, D. The corporation assigned all of its incidents of ownership in the policy to A. D died within three years of the assignment, and proceeds of the policy were paid to A. The IRS held that the proceeds were includable in D’s estate under IRC Section 2035 by reason of attribution to D of the incidents of ownership held by the corporation. The ruling failed to identify the policy’s beneficiary before the assignment.

The IRS also held that proceeds were includable in an insured’s estate under IRC Section 2035 where a corporation transferred a policy insuring the controlling shareholder to a third person within three years of the insured’s death even though the insured disposed of the insured’s stock after the transfer of the policy and prior to the insured’s death.

Proceeds also were includable in an insured’s estate where a corporation retained ownership of a policy and an insured transferred enough stock so as to cease being a controlling shareholder within three years of death.

How is a closely held business interest valued for federal estate tax purposes where there is a purchase agreement?

The value of a closely held business interest is to be determined without regard to any purchase agreement exercisable at less than fair market value, determined without regard to the purchase agreement, unless the purchase agreement:

(1) is a bona fide business arrangement;

(2 )is not a device to transfer property to members of the decedent’s family for less than full or adequate consideration in money or money’s worth; and

(3) has terms comparable to those entered into by persons in an arm’s length transaction.

Whether or not an agreement is subject to IRC Section 2703, case law has established the additional following rules:

(1)  An estate must be obligated to sell at death under either a mandatory purchase agreement or an option held by the business or survivors.

(2)  The price must be fixed by the terms of the agreement or the agreement must contain a formula or method for determining the price.

(3)  The agreement must prohibit an owner from disposing of his or her interest during life without first offering it to the other party or parties at no more than the contract price.

(4)  The price must be fair and adequate when the agreement is made.

If a business purchase agreement calls for shares to be purchased from an estate with installment purchase notes bearing a rate of interest lower than the market rate at the date of death, an executor may be allowed to discount the value of the shares by the difference between the interest rate called for in the buy-sell agreement and the prevailing rate at the date of death.

A first-offer agreement, under which survivors have no enforceable right to purchase the business interest and can purchase the interest only if the executor wishes to sell, does not fix the value of the interest for estate tax purposes.

If an agreement is between closely related persons and is merely a scheme for avoiding estate taxes, the price set in the agreement will not control.

A buy-sell agreement is not binding unless it represents a bona fide business agreement and is not testamentary in nature. An agreement may be found to be a scheme for avoiding estate taxes even where it serves a bona-fide business purpose. No effect will be given to an option or contract under which a decedent is free to dispose of the interest or shares at any price he or she chooses during life.

On the other hand, an agreement that restricts sale during life, but not at death, will also fail to fix the estate tax value.

— Read more from 23 Days of Tax Planning Advice: 2017 on ThinkAdvisor.