AMT imposed on life insurance proceeds in a buy-sell agreement.

• Author: Markhoff, Harris

Many taxpayers have redemption agreements under which the corporation agrees to purchase the stock of a deceased stockholder. In some of these cases, the purchase price is funded with life insurance. If the corporation is a C corporation rather than an S corporation, the collection of life insurance proceeds may trigger an alternative minimum tax (AMT) that could be as much as 15% of the proceeds received.

One technique to avoid the imposition of AMT has been to adopt a cross-purchase agreement, under which each stockholder agrees to maintain life insurance on the other stockholders and then use the proceeds to purchase the stock on a stockholder's death. The technique has always worked if there were only two stockholders. However, with three or more stockholders, a cross-purchase technique did not work after the first stockholder died because of a rule known as the transfer for value rule. If one stockholder were to die, and if the insurance policies owned by that deceased stockholder insuring the surviving stockholders were transferred to the surviving stockholders to fund their eventual buyout, that transfer was deemed to be a transfer for value, and the proceeds when received were taxable as ordinary income.

In a series of letter rulings, the IRS has authorized an approach that appears to solve both the problems of transfer for value and the AMT. The stockholders should form a partnership, whose sole purpose would be to own the life insurance policies on all the stockholders. if stockholder A in a three-stockholder corporation were to die, for example, the partnership would collect the life insurance proceeds on A and credit them to the capital accounts of stockholders B and...