Question: I am unwinding the cross-purchase buy/sell agreement I have in place with the other 50% owner of my corporation. What are the tax consequences when we receive back from each other the policies of insurance on our lives?
Answer: Corporate buy/sell agreements are a relatively common means of addressing the purchase and sale of shares of closely-held businesses. These agreements typically provide for the purchase and sale of company shares upon a shareholder’s death and often upon other events such as a shareholder’s disability, retirement and employment termination. Corporate buy/sell agreements are usually either stock redemption agreements where shares of the departing shareholder are purchased by the corporation or cross-purchase agreements where the departing shareholder’s shares are purchased by the other shareholder(s). As in many cross-purchase arrangements such as yours, each shareholder holds one or more policies of insurance on the lives of one or more other shareholders.
One question which often arises is whether a transfer for value occurs when policies are transferred, thereby causing the policy proceeds to be taxable when the insured dies. While proceeds of life insurance are generally not subject to income tax when received, policy proceeds are taxable if the policy was acquired for a valuable consideration. Consider, for example, an insured owning a policy of insurance on his life with a face value of $100,000 which he sells to a third party for $40,000. Upon the insured’s death, the policy purchaser would report $60,000 of income, the difference between the $100,000 of insurance proceeds and the $40,000 the purchaser paid for the policy. This income is taxable because the purchaser acquired the policy from the insured for a valuable consideration.
Excepted from the transfer for value rule is a transfer of a policy by gift where the transferee does not pay the transferor for the policy, directly or indirectly. The transfer for value rule is also inapplicable when an insured reacquires a policy on the insured’s life. Accordingly, when your business partner transfers the policy on your life to you, the transaction will not constitute a transfer for value, thereby preserving the exclusion from income of the policy proceeds upon your death. The same holds true when you transfer the policy on the life of your business partner back to him or her.
Avoiding the transfer for value rules should not be your only objective as other tax consequences may result. When you and the other shareholder of the corporation exchange policies with one another, this will be viewed as a sale and exchange for income tax purposes. Tax will need to be paid computed based on the difference, if any, between the fair market value of the policy on your life which you receive from your business partner and your tax basis in the policy you transfer back to your partner.
Steps can nevertheless be taken to minimize the tax consequences. If the policies are term insurance policies, you can consummate the exchange shortly before the policy premiums are payable which is when the policies are likely to have a relatively small value. Whole life and other policies having a cash surrender value may present a greater challenge although consummating the exchange in close proximity to the premium payment date may also reduce the taxable income. With careful planning, the income from the policy exchange can often be minimized.
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