10.3 Specific Considerations

• Library: A Lawyer's Guide to Estate Planning: Fundamentals for the Legal Practitioner (ABA) (2018 Ed.)

10.3 Specific Considerations

10.31 Insurance

Life insurance often is used to provide a fund to meet the financial obligation under a buy-sell agreement that arises on the death of an owner. Four factors must be considered. First, with either type of agreement the insurance premiums are not a deductible business expense.⁴ Thus, the premiums will be paid with after-tax dollars. The insurance proceeds are not subject to income tax,⁵ however; and because the policy is not owned by the decedent, no estate tax is owed on the life insurance proceeds.⁶

Because the insurance premiums are paid with after-tax dollars, the income tax brackets of both the corporation and the owners are a consideration in choosing which type of buy-sell agreement to select. If the corporate bracket is lower, then a redemption may be more appropriate For example, the top individual income tax rate is 37%, whereas the top corporate income tax rate is 21%.⁷ This may favor a redemption for some individuals.

Second, a related consideration with a cross-purchase agreement is that the premiums paid by each owner on the insurance policies on the lives of the other owners will vary owing to age differences. The younger owners will be paying a higher premium than the older owners. This disadvantage can possibly be offset by salary adjustments.

A third consideration is the number of life insurance policies required with a cross-purchase agreement. Each owner must carry a policy on the life of each of the other owners; therefore, the number of policies can get rather large. For example, a three-owner business will be purchasing six life insurance policies under a cross-purchase agreement instead of just three policies under a redemption agreement. If there are five owners, the number of policies will be twenty with the cross-purchase agreement rather than just five with the redemption agreement. Although this is not a terribly difficult problem, it does merit consideration.

Fourth, the death of an owner creates an administrative consideration when a cross-purchase agreement is used. The deceased owner's estate will own a life insurance policy on the life of each of the remaining owners. To avoid this problem, the cross-purchase agreement should require the estate to sell all policies subject to the agreement of the other owners. The sales price is the present fair market value of the policies, which is the interpolated terminal reserve value plus the unearned premiums. This value can be obtained from the insurance company, just as is done when valuing a life insurance policy for gift tax purposes. (See Chapter 3, at 3.61, Planning Pointer 6.)

Planning Pointer 2

When a cross-purchase agreement is used, the deceased owner's estate must report and pay an estate tax on the fair market value of each of the policies the decedent owned on the lives of the other owners.⁸ If (as suggested earlier) the agreement provides that the estate sell the policies to the other owners, no income tax will be owed because the sales proceeds will be the same as the estate tax value. This is because the estate tax value also establishes the income tax basis in the policies. Because both values are the same, there is no gain on the sale of the policies. An estate tax will be owed or a portion of the unified credit of the decedent's estate will be used, however, because the value of the policies is includable in the decedent's gross estate for federal estate tax purposes. This certainly does not fit in particularly well with other estate planning.

A solution is for the life insurance policies that the decedent owns on the lives of the other owners to name the decedent's surviving spouse as the secondary owner. Another possibility is for the owner to specifically bequeath the policies to his or her surviving spouse. Under either approach, the marital deduction will shield the policies from estate tax, and the subsequent sale will not result in any income tax to the surviving spouse because the basis in the policies will be stepped up to the date-of-death value. Thus, in following this approach there will be no adverse income or estate tax consequences. This suggestion requires that the surviving spouse sign the buy-sell agreement or an addendum to it to bind the surviving spouse to sell the policies to the other surviving owners.

Caution: A problem exists with a cross-purchase agreement involving three or more corporate owners. On the death of the first stockholder, the insurance policies he or she owns on the other stockholders will normally be purchased by the other owners; that is, each surviving stockholder purchases policies insuring the other surviving stockholders (which were owned by the deceased stockholder). The problem is due to an income tax rule known as the "transfer for value" rule.⁹ Basically, this rule modifies the normal exemption of life insurance from income taxation. It provides that when a policy has been sold, the death...