Life Insurance for Shareholders of Closely Held Corporations

Ownership, Premiums, and Beneficiary Arrangements

Section 264(a)(1) is the starting point for premiums. It provides that "No deduction shall be allowed for ... Premiums on any life insurance policy ... if the taxpayer is directly or indirectly a beneficiary under the policy." In a redemption plan, the corporation is owner, payor and beneficiary, so the rule applies to it directly. In a cross-purchase plan, each shareholder owns, pays for and is beneficiary of the policy on the other owner, so the same rule applies to the shareholder. The page on the tax treatment of key person insurance premiums explains the rule further.

The beneficiary who receives the proceeds is the one who looks to the section 101(a)(1) exclusion. Two limits apply to that exclusion: the transfer-for-value rule and section 101(j). For a contract that is employer-owned, section 101(j) can limit the exclusion, generally to the premiums and other amounts paid. The limit is lifted only if an exception in section 101(j)(2) applies and the notice and consent requirements were met. The exceptions include one based on the insured's status, such as an employee during the 12 months before death or a director at issue, and one for amounts paid to the insured's heirs or used to buy their equity interest. Neither an exception alone nor notice and consent alone is enough.

Notice 2009-48, as of its date, offers guidance on several points. A-1 states that a contract "owned by the owner of an entity ... (such as for purposes of financing the purchase of an equity interest of another owner)" is not employer-owned. A-3 states that, if a contract is otherwise described in section 101(j)(3), ownership by a partnership or sole proprietorship does not keep it from being employer-owned, but a contract a sole proprietor owns on his or her own life is not employer-owned. A-7 states that even a wholly-owned corporation and its employee-owner are not excused from written notice and consent. Notice and consent, premium deductibility and any transfer of a policy between owners depend on the contracts involved and are matters for a qualified tax professional.

Key Factors That Shape the Tax and Planning Outcome

Four facts usually do most of the work in deciding how an arrangement is taxed.

Voting stock held. Treas. Reg. § 20.2042-1(c)(2) defines incidents of ownership to include "the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy, etc." It also points to separate rules on "the circumstances under which incidents of ownership held by a corporation are attributable to a decedent through his stock ownership." Under paragraph (c)(6), a decedent is not treated as a controlling stockholder unless, at death, the decedent owned stock with more than 50 percent of the total combined voting power, so the size of the stake matters.

Transfers. Under section 101(a)(2), after a transfer for value the exclusion "shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee." A co-shareholder is not on the exception list.

Valuation method. The price or formula in the buy-sell agreement sets how much cash a purchase needs, and so how much coverage is considered.

Who counts as an employee. Notice 2009-48 A-5 states that for section 101(j) "employee" includes "an officer, director, and highly compensated employee."

Estate inclusion under section 2042 and business valuation for buy-sell funding need individual review by a qualified tax professional and, where policies are involved, the insurers.

Potential Advantages of Shareholder Life Insurance

Liquidity is the advantage most often cited. Section 101(a)(1) generally excludes death proceeds from the gross income of the beneficiary, whether that is the corporation or a co-shareholder. The exclusion is subject to the transfer-for-value rule and, for employer-owned contracts, to section 101(j).

A funded buy-sell agreement can give the surviving shareholders a defined way to acquire the deceased owner's shares. They do not need to look for outside financing at a difficult time, and the estate has a buyer for stock that might otherwise be hard to sell.

Permanent policies owned by a corporation may build cash value. Cash value is a contract feature, an amount the owner may reach through loans or surrender under the policy's terms. How and when it can be reached varies from insurer to insurer.

In Connelly v. United States, the Supreme Court described a trade-off. A cross-purchase agreement would have sent the proceeds "directly" to the surviving brother rather than to the corporation, but would have required each brother to pay the premiums on the policy for the other, "creating a risk that one of them would be unable to do so." Corporate ownership of the policies meant they would remain in force, and also that the corporation received the proceeds, which increased the value of the deceased owner's shares.

Each of these outcomes depends on how the arrangement is structured and on the facts of the specific contracts. None is assured.

Important Considerations and Risks

Estate inclusion. Section 2042(2) includes in the gross estate proceeds receivable by other beneficiaries under policies on the decedent's life "with respect to which the decedent possessed at his death any of the incidents of ownership." Treas. Reg. § 20.2042-1 adds rules on when a corporation's incidents of ownership are attributed to a shareholder.

Estate-tax value of the shares. In Connelly v. United States, the Supreme Court held that the corporation's "contractual obligation to redeem Michael's shares did not diminish the value of those shares," because redemption obligations "are not necessarily liabilities that reduce a corporation's value" for estate-tax purposes. Proceeds received by the corporation increased that value in that case. The Court also noted that a redemption agreement's price "is ordinarily not dispositive" for estate-tax valuation, citing 26 U.S.C. § 2703.

Transfer for value. Selling an existing policy to a co-shareholder can limit the exclusion under 26 U.S.C. § 101(a)(2) to the consideration plus later premiums. A co-shareholder is not a listed exception.

Premiums. Section 264(a)(1) allows no deduction for premiums when the taxpayer is directly or indirectly a beneficiary under the policy.

State law. Insurance rules vary by state.

Funding gaps. If coverage falls behind the agreement's price, the proceeds may not cover the full purchase.

When to Review the Shareholder Insurance Plan

Change in the business, in its owners or in the law is what typically prompts a fresh look. Common triggers include:

• a new investor joins, or an existing shareholder is bought out;
• the corporation's value moves enough that coverage no longer matches the buy-sell formula;
• a shareholder's ownership percentage changes in a way that may affect attribution of corporate-held incidents of ownership under Treas. Reg. § 20.2042-1;
• the corporation makes or ends an S election;
• a shareholder dies, becomes disabled or leaves, triggering the agreement;
• federal tax law affecting section 101(a), section 264 or section 2042 changes.

Under section 2703(a), property is valued without regard to any option, agreement or other right to acquire it at a price less than fair market value, or any restriction on the right to sell or use it, unless the arrangement meets each requirement of section 2703(b): it is a bona fide business arrangement, it is not a device to transfer the property to members of the decedent's family for less than full and adequate consideration in money or money's worth, and its terms are comparable to similar arrangements entered into by persons in an arms' length transaction. Under Treas. Reg. § 25.2703-1(c)(1), if the terms of a right or restriction require periodic updating, the failure to update is presumed to substantially modify it unless it can be shown that updating would not have resulted in a substantial modification. Review timing depends on the agreement itself and the insurers involved.

Hypothetical Example: Two-Shareholder Redemption Plan

This example is hypothetical, uses round figures and illustrates mechanics only.

Assumptions (hypothetical):

• A C corporation is owned 50% by Shareholder A and 50% by Shareholder B.
• The buy-sell agreement values the corporation at $2,000,000 and requires the corporation to redeem a deceased shareholder's stock at that agreed value.
• The corporation owns, pays for and is the beneficiary of a $1,000,000 policy on each shareholder.
• No policy was ever transferred.

Step 1. Shareholder A dies. The corporation receives $1,000,000 in death proceeds.

Step 2. Under section 101(a)(1), the proceeds are generally excluded from the corporation's gross income. This assumes the transfer-for-value rule does not apply and that any section 101(j) limit is avoided because an exception applies and notice and consent were met.

Step 3. The redemption price is $2,000,000 × 50% = $1,000,000.

Step 4. The corporation pays $1,000,000 to A's estate for A's shares. B now owns 100% of the corporation.

Estate-tax caveats (hypothetical). Following Connelly v. United States, the $1,000,000 of proceeds received by the corporation may raise the value of A's shares for estate-tax purposes above the agreed $1,000,000 price. Under Treas. Reg. § 20.2042-1(c)(6), the corporation's incidents of ownership in A's policy are not attributed to A to the extent the proceeds are payable to the corporation, and A owns 50 percent of the stock, which on these assumptions is not more than 50 percent of the voting power. This example does not represent any reader's result.