Life insurance is a tax-leveraged tool that facilitates countless business transfer, estate and executive benefit strategies. In many business situations, life insurance is the primary funding vehicle for transfer of business interests. This article focuses on four business exit planning pitfalls to avoid.
Recommending a redemption plan in a C Corporation
Business owners often make use of corporate-owned life insurance to fund a buy-sell agreement that generates the cash needed to buy out a deceased shareholder's interest in a company. While this technique (commonly referred to as an entity agreement) may be an effective tactic to fund such an obligation, it is not without pitfalls in the case of a C Corporation.
Unlike a cross-purchase agreement, where the policies are held personally on the other owners, surviving stockholders are not entitled to a step-up in cost basis. This can have adverse implications when the business is later sold or liquidated.
There may be other negative consequences. While the proceeds of personally held life insurance are given a level of creditor protection depending on the state, corporate-owned life insurance is given no such protection. Furthermore, the life insurance proceeds may be subject to the corporate alternative minimum tax if the business is not a qualifying small corporation. Finally, under the transfer-for-value rule (more on this later) subsequent policy transfers to individual shareholders may subject the otherwise income tax-free proceeds to taxation.
Not recommending a redemption plan in an S Corporation
While redemption plans may not be ideal for C Corporations, quite the opposite often applies in the case of S Corporations. Although potential creditor claims and transfer-for-value issues may still be present, the pivotal step-up in basis issue can be resolved by using a short-year election (IRC 1377(a)(2)). In essence, if the S Corporation is a cash-basis taxpayer, the surviving shareholders can receive a 100 percent basis step-up if the corporate tax year is terminated shortly after the death of a shareholder but before the tax-free proceeds of life insurance are paid to the corporation. This allows the full amount of proceeds to step-up the basis of the surviving shareholders. This technique effectively allows a business to minimize the number of policies while enjoying the tax advantages of a traditional cross-purchase agreement.
Failure to monitor buy-sell insurance funding formula
A well-drafted buy-sell agreement is an excellent vehicle to smooth the transition from exiting owners to remaining and new owners. Among other things, it spells out the rights, terms, identity of the parties, and a valuation method that is specifically tailored to the needs of a particular business. Although book value may be an accurate measure of value in some companies, most businesses require more sophisticated techniques, such as capitalized or discounted future earnings formulas. The IRS will focus on the technique most appropriate for a particular line of business when conducting a valuation for estate planning purposes. This underscores the importance of closely monitoring the buy-sell funding formula to ensure there is no major discrepancy between the IRS value and the price the surviving shareholders can pay.
Apart from the tax issues, keep in mind the surviving family members have a vested interest in obtaining full (and fair) value on the sale of the business.
Forgetting the transfer-for-value rule
Life insurance proceeds are generally not subject to taxation unless the policy itself (or an interest in the policy) is transferred for valuable consideration, in which case the transfer-for-value rule is triggered. Under this rule, the death benefit becomes taxable, minus whatever consideration was given in return for the policy. Lest one thinks such a situation is highly improbable, consider a typical stock redemption. With such an arrangement, it would not be uncommon to have the shareholders decide to use the same policies to convert to a cross-purchase agreement. This seemingly innocuous transaction may trigger the transfer for value rule, causing a portion of the proceeds to be subject to ordinary income tax at the next death.
Fortunately, advisors can take advantage of a number of exceptions to this rule. If the transfer falls under one of these exceptions, the death proceeds will not be subject to income tax. These include transfers to the insured, partners of the insured, partnership in which the insured is a partner, or a corporation in which the insured is an officer or shareholder. Also exempt are transfers where the individual receiving the basis is determined in whole or in part by reference to the basis of the transferor. This "carryover basis exception" applies when the transfer is by gift rather than for value.
This article outlines four business exit planning life insurance blunders. Each mistake is insidious in that mere improper ownership or an innocent transfer of a life insurance policy can have far-reaching tax consequences. Like any powerful tool, life insurance is most effective when handled with care and used properly.
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