Proper planning of ownership and other policy rights is always an important concern with any life insurance policy to insure the most advantageous treatment for income, gift, and estate tax purposes. Ownership issues are generally not problematic in family situations as long as the spouses are the insureds and beneficiaries of the other’s death benefit. Major ownership concerns arise when three distinct parties are involved as insured, owner, and beneficiary. For example, assume a wife owns a JL policy with herself and her husband as insureds. Their son is named as beneficiary. If the husband dies first, the wife will have made a taxable gift of the death benefit to her son.4 They could have eliminated this adverse result by having the son own the policy.
The planning is also relatively easy in a typical key person business situation. The key person policy is usually owned by and payable to the company. If the company owns the policy and names itself as beneficiary of all death benefits, no special problems exist when using JL to insure key persons.
Ownership issues become more complicated when JL is used to fund business buy-sell agreements. Stock redemption buy-sell agreements present no special ownership planning problems when a company uses JL as the funding instrument. In fact, JL is uniquely suited to fund stock redemption agreements in small, closely-held businesses because one policy owned by the corporation on many lives is less expensive than many polices on each owner. Plus, the policy matures when the first owner dies, exactly when it is needed. For other reasons, however, entity buyout plans are often considered less favorable than cross-purchase agreements because of family attribution and tax basis issues.
Although cross-purchase buy-sell plans provide survivors with an increased basis, they also require, in the absence of some other funding mechanism, that each owner have life insurance on the other. The number of separate single life policies required can add up quickly as the number of owners increase. For example, with five owners, each one would need to acquire four policies covering each of the other owners, a total of twenty policies. If they use JL, they reduce the required number of policies to just five—one owned by each—covering the lives of the remaining four owners. If the buy-sell plan uses a trust, it is feasible that a single JL policy on all owners could fund the buy-sell agreement.
Cross-purchase Buy-sell Agreements
Although joint ownership by both insureds of a JL policy in a case with two business owners might seem to be the natural choice, it would be extremely unwise. As a joint owner of the policy, the death proceeds as well as the deceased’s share of the business value would be included in the estate, effectively causing double taxation. Even if the policy is owned by just one of the business owners, there is still a chance the policyowner will die first, with exactly the same double taxation as with joint policy ownership. They can avoid double taxation only if the business owner who does not own the policy dies first. However, if the business owners knew who would die first, a JL policy would not be necessary.
The key is to keep death proceeds out of the deceased’s estate through third party ownership of the JL policy. In the case of two business owners, this is traditionally accomplished through a trusteed plan. In the case of three or more owners, the alternatives include:
- a trusteed plan using a single JL policy on all owners;
- ownership by each business owner of a separate JL policy on all the other business owners’ lives; or
- a partnership organized to facilitate business continuity.
Trusteed Plans
In a trusteed plan, the company sets up a trust for the benefit of the shareholders. The trust would then apply for and own the JL policy insuring all the owners. Each business owner would have a specific and limited interest in the trust equal to his or her ownership interest less the interest of the decedent. The shareholders would have no other rights to the insurance policy, cash values, or the trust. For example, in a business with five equal owners, each survivor would be entitled to ¼ of any insurance proceeds on the decedent.
If corporate contributions to the trust pay the premiums, they would be taxable either as income or dividends to the shareholders.6 Alternatively, shareholders could make nondeductible contributions to the trust in proportion to their ownership interests. The trust would actually pay the premiums.
When the first shareholder dies, the death proceeds will pass to the surviving shareholders who can then use the proceeds to purchase their respective portions of the deceased’s interest in the corporation.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM