Question: I am one of two equal shareholders in a corporation and we are in the process of implementing a buy/sell agreement. Are there any reasons why the business should not own insurance on our lives to provide funds to purchase the shares of the deceased shareholder?
Answer: What you are referring to as a buy/sell agreement is presumably an agreement restricting the transfer of shares and providing for the purchase and sale of shares on the occurrence of various events, one of which is the death of a shareholder. Life insurance is often acquired pursuant to such arrangements to provide liquidity for the purchase of a deceased shareholder’s shares. To the extent life insurance is not purchased or is inadequate to satisfy the purchase obligation, the purchasing party will normally satisfy the difference.
The answer to your question depends on a number of factors. You did not specify whether or not your corporation is a C corporation or an S corporation. The structure of your buy/sell agreement may be impacted by your corporation’s tax status.
A corporation which has elected S corporation status and, therefore, is not subject to tax on its income, will receive the proceeds of insurance on a deceased shareholder’s life without incurring any tax. While the receipt of life insurance proceeds by a C corporation will similarly be income-tax free, the receipt of such proceeds may create an alternative minimum tax liability for the corporation. Many C corporations convert to S corporation status simply to avoid incurring alternative minimum tax when life insurance proceeds are received on the death of a shareholder.
You might consider an alternative structure for your buy/sell agreement, regardless of whether your corporation is a C corporation or an S corporation. Instead of the corporation owning and receiving life insurance proceeds and being the party required to purchase or redeem the deceased shareholder’s shares, the surviving shareholder can be the purchasing party. Each shareholder can maintain a policy of insurance on the other shareholder’s life in a so-called cross-purchase arrangement. When a shareholder dies, the surviving shareholder can collect the proceeds of insurance on the deceased shareholder’s life and purchase the shares of the deceased shareholder with such proceeds.
While economically there may seem to be few differences between the two arrangements, there are significant differences from a tax perspective. If shares are being purchased in a cross-purchase arrangement, the surviving shareholder’s basis of the shares acquired equals the amount paid for such shares. For example, if the surviving shareholder collects $500,000 of insurance proceeds on the deceased shareholder’s life and uses such proceeds to acquire the deceased shareholder’s shares, the surviving shareholder’s basis in the shares acquired is $500,000. Effectively, the surviving shareholder is receiving an income tax basis in the shares that are acquired, which basis could result in a lesser tax obligation on the sale or liquidation of the company. Contrast that result with that of a company purchase arrangement where there is no impact on the surviving shareholder’s tax basis in the corporation’s shares. In the case of a C corporation, the cross-purchase arrangement offers the additional advantage of avoiding the alternative minimum tax on the receipt of life insurance proceeds as the proceeds are received by the surviving shareholder, not the corporation.
There are of course other considerations that need to be addressed in structuring your buy/sell agreement. If the shareholders own the buy/sell policies, then they must pay the policy premiums. To the extent the corporation pays additional salaries to the shareholders to satisfy the premium payments the shareholders must make, the shareholders will be taxed on the incremental salary payments. In some cases, a shareholder may be concerned that the other shareholder will not properly maintain the insurance required for buy/sell purposes. A similar concern may arise with a non-creditworthy shareholder where the prospect of creditors making claims to the shareholder’s assets arises. Some of these concerns may be overcome by having the buy/sell policies held in escrow.
While a full analysis of the desired structure for your buy/sell agreement is beyond the scope of this discussion, you should be aware that insurance-funded cross-purchase arrangements often provide advantages to a conventional company-purchase buy/sell agreement.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to email@example.com.