In planning for corporate or partnership buy-sell agreements funded with life insurance, as in any of the other “high risk areas discussed below, it is essential to examine (and suspect) any transfer of a life insurance policy funding the buy-sell arrangement.
Here is a checklist of potential transfer for value traps in the buy-sell planning area.
The Uninsurable Shareholder Trap
An uninsurable shareholder sells her individually owned insurance to a co-shareholder to help fund a cross-purchase agreement. The transaction clearly falls within the transfer for value rule—as do the following two transfers.
The Switch from Stock Redemption to Cross-Purchase Trap
A corporation sells a policy to a co-shareholder of the insured because the company wants to switch from a stock redemption plan to a cross-purchase agreement and sells its corporate-owned policies on the lives of its shareholders to their co-shareholders.
The Gift of Policies by Corporation Double Trouble Trap
Two shareholders want to change an insured stock redemption agreement to a cross-purchase plan. But instead of selling the policies, they intend merely to have the corporation give each shareholder the policy on the life of the insured.
Although the shareholders may call this transaction a gift to each other, the IRS is not likely to accept this transaction as a gift (and will probably challenge the distribution from the corporation as a dividend or as compensation).
The Purchase by Insured Followed by Gift Trap
Two shareholders want to change an insured stock redemption agreement to a cross-purchase plan. They intend to avoid the transfer for value rule by a purchase of the policy from the corporation by the insured followed by a gift of the policy from the insured to the other shareholder.
They will probably not succeed. The IRS will doubtlessly argue that the double transfer is really one directly from the corporation. Failing that argument, the IRS will claim the reciprocity—I’ll give you the policy on my life if you give me the policy on yours—constitutes consideration for the transfers.
The Sale by Estate Trap
Assume there are three shareholders, X, Y, and Z. The buy-sell agreement is set up on a cross-purchase basis so that each owns policies on the other shareholders’ lives. If X dies, the policy X owned on Y is sold by X’s estate to Z. The policy X owned on Z is sold by X’s estate to Y.
The proposed transactions will trigger the trap because Y and Z, as mere co-shareholders, are not protected parties. There are several possible indirect solutions to this problem:
- Both policies can be sold to the corporation. A sale of a policy to a corporation in which the insured is an officer or shareholder is a safe transfer. The corporation can then establish a stock redemption or Code section 303 partial stock redemption plan that meshes with the existing cross-purchase agreement. The result would be a hybrid plan, because the survivors, Y and Z in the example above, would still own policies on each other’s lives. Of course, they can also transfer those policies to the corporation and use a stock redemption agreement.
- The decedent’s estate can surrender each policy for cash or can keep the policies in force, or place the policies on extended term or make the policies paid up for a lower face amount.
- The survivors can purchase the policies on their own lives and continue them as personal insurance.
The Sale by a Trust Trap
A trust’s sale of an interest in a life insurance policy to trust beneficiaries other than the insured can trigger the trap. For example, suppose a couple creates an irrevocable life insurance trust and places cash inside the trust for the trust to purchase and pay premiums for a second-to-die life insurance policy on their lives. At some later date, the couple decides to discontinue contributions. Since the trust does not have sufficient funds to keep the insurance in force, the couple’s children decide to purchase the policy and pay premiums. There would be a transfer of a policy and it would be for valuable consideration.
In many of these situations, the solution is to make the buyers partners with the insured prior to the transaction. It is essential in these situations that the partnership be created and actively managed for reasons other than to merely to shield the transaction from the transfer for value rule. Be sure the entity is recognized as a partnership under state law. Also be sure that the partnership files federal income tax returns. It is also important to show that the parties intend to continue operating as a partnership at least through and including the year in which the purchase of the life insurance policy is consummated. Overall, create evidence that the firm is a legitimate operating entity.
The Trusteed Cross-Purchase Trap
Assume a cross-purchase buy-sell agreement is established and a trust is created to facilitate the transaction and assure an orderly transfer of the corporate stock (i.e., a trusteed cross-purchase arrangement). A corporate-owned life insurance policy on each shareholder’s life is then transferred to the trustee who is to collect the proceeds and pay them to shareholder’s estate.
The buy-sell agreement requires the insured’s co-shareholders to pay premiums on the policy. At the insured’s death, the trustee will collect the proceeds (on behalf of the surviving shareholders) and, in exchange for the stock held by the insured stockholder, pay the estate the appropriate amount of cash.
There is a transfer of a life insurance policy. But is there valuable consideration? If so, what is it and when is it paid? At least one court has held under these facts that the agreement of the co-shareholders to relieve the business of the burden of making premium payments and to buy the insured’s stock at his death with the policy proceeds was sufficient consideration to give rise to a transfer for value—even though no cash was paid for the policies.
In another example, assume six shareholders, all related, would like to establish a buy-sell agreement. But they are concerned about the bookkeeping and costs of the thirty policies needed to insure each shareholder individually. Their attorney suggests that they form a trust, contribute cash to the trust to pay the premiums, have the trust buy one policy on each shareholder’s life, and use the proceeds to buy the stock for the surviving shareholders. When a shareholder dies, his interest in the policies on the lives of the surviving shareholders disappears (according to the contract).
In the authors’ opinion, trouble awaits those who fund a cross-purchase buy-sell in a trust which provides that, at the death of one shareholder, the interest he had in the policies on the lives of the others terminates (vanishes into thin air) and magically the survivors end up with an interest (through the trust) in the remaining policies on the other survivors lives. This “one trust-one policy on each shareholder’s life” cross-purchase technique (unless the shareholders are also partners) is almost certain to attract litigation with the IRS.
Why? Upon the first death, there will be no physical transfer, and legal title to the policies on the lives of the survivors will not change. The trust will still be the legal owner of the policies. But the beneficial interest in the decedent’s share of the policies on his co-shareholders’ lives will shift to them. Each survivor will gain a beneficial interest he did not have before on the life or lives of his co-shareholders. Furthermore, on each subsequent death, there will be an additional transfer of equitable ownership to the surviving co-shareholders.
Where is the valuable consideration? No policyowner would allow the beneficial interest in a policy he or she owned on another shareholder’s life to pass to the other shareholders unless each of the other shareholders did the same. That reciprocity would be consideration enough for the IRS.
The Group Funded Cross-Purchase Buy-Sell Tax Trap
Abe and Sadie are unrelated shareholders. Each is insured for $100,000 under a corporate-owned group term life contract paid for by the corporation. They name each other as beneficiaries of their respective group term life coverage in order to fund the buy-sell with (from the corporation’s perspective) tax deductible dollars. Each agrees to accept the proceeds of the other’s group term life insurance as payment for his share of the business.
There is clearly a transfer of an interest in a policy and, although no cash is paid in return for the policies and even though the coverage is pure term insurance, there is the requisite valuable consideration, which is reciprocity. Abe would not have named Sadie as his beneficiary without her agreement to do the same.
The Endorsement Type Split-Dollar Tax Trap
Ted and Carol want to set up a cross-purchase buy-sell agreement. Neither has the after-tax cash to pay premiums. Their corporation sets up a split-dollar arrangement to assist them in funding the buy-sell. The corporation will purchase a policy on the life of each shareholder. At the death of either insured, the corporation will recover its outlay first. Any death benefit in excess of the corporation’s interest (i.e., its cumulative outlay) will be payable to the insured’s co-shareholder. The net proceeds of the policy on Ted’s life will be paid to Carol and the net proceeds of the policy on Carol’s life will be paid to Ted.
In the authors’ opinion, when the corporation as policyowner names each insured’s co-shareholder as beneficiary of part of the proceeds, there is a transfer of part of the corporation’s interest in the policy, a portion of the death proceeds. In reality the corporation shifts the beneficial right to the death proceeds from itself to each insured’s co-shareholder in consideration of the insured’s continuing services as an employee. Thus, there is a transfer of an interest in a policy from the corporation to the co-shareholder of the insured employee (i.e., the corporation allows the insured to name the policy beneficiary) in return for the valuable consideration of the employee’s services.
A further argument the IRS could make is that—to the extent each shareholder recognizes income (economic benefits)—it is as if the corporation purchases term insurance on his behalf. Normally, such a transaction would not be a problem because the term insurance purchased is usually on the insured’s life and, if it is transferred to someone other than the insured, it is typically done without consideration. In a cross-purchase endorsement split-dollar, however, the employer owns each policy at inception. The policy insures the life of a co-shareholder of the person to whom the company endorses (shifts an interest in) a portion of the policy proceeds. This is clearly a transfer of an interest in a policy and the reciprocity, the fact that each shareholder tacitly allows the other to do so, provides the requisite consideration.
Avoiding the transfer is the answer to the problem. Instead of using the endorsement method in which the corporation is the original owner of the policy, the collateral assignment method eliminates any need to transfer an interest in the policy. Under the collateral assignment method, each shareholder purchases a policy on the life of his or her co-shareholder and owns it from the beginning. He or she then collaterally assigns it to the corporation (a protected party) as security for the loan. Because there is no transfer of a policy or an interest in a policy (except to a protected party), the transfer for value rule will not apply.
The Perhaps not so Safe Gift Tax Trap
Assume a father gives a policy on his life to his son and the father pays the gift tax. After the gift of the policy, the father and son enter into a cross-purchase agreement for the purchase of the father’s stock in a corporation at the father’s death. The father dies and the son, in fact, uses the policy proceeds to purchase the father’s stock.
Does the son take the insurance income tax free? At first glance, the answer seems to be yes: the father intends the transfer of the policy to be a gift to his son (even though the father enters into a buy-sell agreement) and even files a gift tax return on the transaction and pays a gift tax.
But wise practitioners will ask some additional questions. These include:
- Do the transfer of the policy and the execution of the agreement occur contemporaneously?
- How far apart do the two transactions occur? In other words, are the two events apart of the same transaction? If so, the IRS can argue that the son pays a price (kept the policy in force) as part of his agreement to buy the father’s stock.
- Is there further evidence (such as continued gifts from the father) that establishes an intent to make the life insurance transfer a gift rather than part of a business transaction?
- Is there an explicit agreement between the parties that the son will use the insurance proceeds to buy the father’s stock at his death?
The IRS may try to prove that, although the transaction is cast as a gift, it is really part of a larger arrangement in which the transfer of the policy was bargained for by the son. Could it then be argued that even if the son’s agreement constitutes some consideration for the transfer of the policy, so long as the son’s basis is—at least in part—determined by reference to his father’s basis, the proceeds retain their income tax free status? In the authors’ opinion this technique is dangerous unless the facts are exactly right.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM