Taxation and Business Uses of Insurance - Structure and Tax Considerations of Buy-Sell Agreements
As with any contract, a buy-sell agreement must be structured properly to insure its effectiveness. There are several different ways to structure and fund the agreement. But, all agreements should contain and provide for the following.
- The agreement must contain commitment of the parties involved. As stated, the agreement is contractual and should state clearly the obligation of all interested parties in the contract.
- The agreement must state the purpose of the arrangement.
- The agreement must state or provide a formula dictating the purchase price of the business interest. The price must provide a value for the selling and buying price of the business.
- The agreement should specify how it should be funded.
- An agreement can be funded by life insurance, cash, installment payments, and borrowing. If funded with life insurance, the agreement should state the type of life insurance and how the life insurance is to be paid for.
- The agreement should also contain transfer restrictions. This restricts the owners of a business from transferring interest in the business while all parties to the agreement are still living.
There are several different forms to a buy-sell agreement. The following are the three most commonly used forms.
- Cross purchase agreement - (Stockholder Purchase) This is an agreement between two or more owners or shareholders stating that in the event ownership must be transferred the other owners of the company will purchase the business interest. This is the most common form of agreement.
- Entity purchase agreement - (Stock Redemption) This is an agreement that states the ownership in the business will be purchased by the entity. This agreement is more beneficial for larger businesses with several interested parties.
- Hybrid agreement - This agreement is a cross between a cross purchase agreement and an entity purchase agreement. In this agreement the withdrawing owner can first offer ownership to the entity. If the entity is unable to purchase or declines to purchase the ownership then the other owners or shareholders in the business may purchase the ownership themselves. The ownership can also be offered the other owners or shareholders first and then offered to the entity.
The following are several tax considerations that should be made when funding an agreement with life insurance
- Premiums used to fund a buy-sell agreement are not tax deductible
- Death proceeds are received income tax free regardless of who owns the policy. Unless the proceeds are payable to certain C corporations. The proceeds received by the C corporation can generate an alternative minimum tax. Also, proceeds may not be received income tax free if there is an exchange for valuable consideration.
- The payment of premiums made by a business in which the shareholder or owner is the insured are not considered taxable income. For example, if ABC Corporation pays $25,000 a year in premiums on a policy owned by ABC Corporation where John Example is the insured and the corporation is the beneficiary the premiums of $25,000 are not considered taxable income to John.
- In a cross purchase agreement the cash value of the policies owned by the decedent on the other shareholder's lives is considered in the decedent's estate. But, the policies owned by the other shareholder's on the decedent's life are not considered in the decedent's estate.
- No gift tax occurs upon the execution of a buy-sell agreement
- In a cross-purchase agreement one must be weary of the transfer for value rule.
As stated earlier, one of the major benefits of a buy-sell agreement is for estate tax purposes. The agreement can establish a value of interest in a business. For the value to be properly established and considered accurate, the IRS requires that the following criteria be met.
- The agreement must be a bona-fide business arrangement.
- The agreement must not be a device to transfer property to a decedents' family for less than full value.
- The terms of the agreement must be similar and comparable to those entered into in an arm's length transaction.
ABC Corporation has 15 shareholders each owning 1,000 shares of the corporation. One year ago, the 15 shareholders entered into an entity purchase buy-sell agreement funded with life insurance. The corporation purchased 15 life insurance policies to fund the agreement. Each policy requires a premium of $10,000 paid annually. Harry (a shareholder in the corporation) has come to you for advice. He would like to know how much, if any of the $10,000 premium paid on his behalf by the corporation is to be included in his taxable income for the year.
E. None of the above
Any premiums paid by a corporation on a policy owned by the corporation on the life of a shareholder are not includable as taxable income by the shareholder.