Succession Funding for a Closely Held Business: How Life Insurance Fits the Plan

Short Answer: Why a Closely Held Business Needs a Funded Succession Plan

A closely held business has few owners and no ready market for their shares, so when an owner dies, someone has to be the buyer and someone has to have the cash. Owners can settle both questions in a written agreement in advance. Life insurance is one way to fund that agreement, paying cash at the death that triggers the purchase.

A closely held business here means a corporation, partnership or limited liability company (LLC) owned by a small number of people whose interests are not publicly traded. At an owner's death, the surviving owners or the business generally need liquid funds to buy the deceased owner's interest; otherwise the estate may struggle to settle without a forced sale. This page explains the federal tax and structural rules that shape the insurance used for that funding. State insurance rules vary by state.

Why Succession Funding Is a Distinct Problem for Closely Held Businesses

Listed stock has quoted selling prices on an exchange. Treasury regulations value such stock by its trading data: where "there is a market for stocks or bonds, on a stock exchange, in an over-the-counter market, or otherwise," value is generally the mean of the high and low selling prices on the valuation date (26 C.F.R. § 20.2031-2(b)). A closely held interest generally has no such quotes. Where actual sale prices and bona fide bid and asked prices are lacking, the regulation instead considers "the company's net worth, prospective earning power and dividend-paying capacity, and other relevant factors" (26 C.F.R. § 20.2031-2(f)). A buy-sell price, by contrast, can be agreed in advance, set by a formula or determined by appraisal.

The owner's estate also carries an estate inclusion issue. Section 2042 of the Internal Revenue Code includes in the gross estate insurance "receivable by the executor," and insurance receivable by other beneficiaries where the decedent "possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person." The regulation says incidents of ownership refer to "the right of the insured or his estate to the economic benefits of the policy" (26 C.F.R. § 20.2042-1(c)(2)). For a controlling shareholder, the regulation also points to rules on when incidents held by a corporation are attributed to the decedent through stock ownership. The estate may then hold a taxable but illiquid interest.

This page focuses on death and insurance funding. A buy-sell agreement and a succession plan are related but different instruments; the buy-sell and succession plan comparison explains the difference.

Typical Ownership Structure of a Closely Held Business

Entity form comes first, because it decides which tax rules can apply. Closely held businesses can operate as C corporations, S corporations, general or limited partnerships, or LLCs taxed as a partnership or as a corporation.

Ownership may be concentrated in a few individuals. Shareholder agreements, operating agreements and partnership agreements can restrict transfers, for example through rights of first refusal or consent requirements, and can require the business or the remaining owners to buy a departing owner's interest.

Value is the hard part. The IRS Business Valuation Guidelines in IRM 4.48.4 state that "the three generally accepted valuation approaches are the asset-based approach, the market approach and the income approach," and that "consideration should be given to all three approaches." Those guidelines also list factors such as the market prices of comparable actively traded companies and a reasonably foreseeable later sale of the interest.

Professional practices add another layer. Rules on who may own a licensed practice, or keep an interest after a death, vary by state and are not addressed here.

The Triggering Event: An Owner's Death Without a Funded Plan

Consider what follows a death when nothing is funded. The deceased owner's interest passes to the estate and then to heirs, who may have no role in the business or knowledge of it. The surviving owners may find themselves in business with an heir they did not choose. Alternatively, the heir may demand a buyout that operating cash cannot cover.

Federal estate tax may be owed on the value of the interest. With no buyer and no cash, the estate may have to sell quickly and at a discount.

Policy ownership can make this worse. If the deceased owner held incidents of ownership in a policy on his or her own life, section 2042(2) and 26 C.F.R. § 20.2042-1(c) include the proceeds in the gross estate. The same dollars meant to fund the buyout can then enlarge the taxable estate. Whether that happens turns on who owned the policy, who was the beneficiary and what the agreements say. The interaction of policy ownership, estate inclusion and the funding mechanism needs individual review of the contracts involved by the insurers and a qualified tax professional.

How Life Insurance Funds a Closely Held Business Succession

The agreement sets the terms and the buyer. The insurance supplies the cash to carry out the agreement when the trigger occurs. Two structures are described here, and the mechanics of succession funding are covered in more depth elsewhere on Business Life Insurance.

Entity purchase (redemption). The business owns each policy, pays the premiums and is the beneficiary. At an owner's death it receives the proceeds and redeems the deceased owner's interest from the estate. The estate receives cash and surrenders the interest.

Cross-purchase. Each owner owns, pays for and is the beneficiary of a policy on each other owner. At a death, the survivors receive the proceeds and buy the deceased owner's interest from the estate.

Section 101(a)(1) generally provides that gross income "does not include amounts received ... under a life insurance contract, if such amounts are paid by reason of the death of the insured." That exclusion has limits. Under the transfer-for-value rule in section 101(a)(2), when a policy is transferred "for a valuable consideration," the exclusion generally cannot exceed the consideration plus later premiums. The exceptions are a carryover-basis transfer and a transfer "to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer."

A business-owned policy on an employee can be an employer-owned life insurance contract under section 101(j)(3): the business, or a related person, must be directly or indirectly a beneficiary, and the insured must be an employee on the date the contract is issued. Notice 2009-48 (A-5) confirms that "employee" includes "an officer, director, and highly compensated employee." For such a contract, the exclusion is capped at premiums and other amounts paid unless a section 101(j)(2) exception applies and written notice and consent were given before issue. Neither condition lifts the cap alone.

On premiums, section 264(a)(1) allows no deduction for premiums on any life insurance policy "if the taxpayer is directly or indirectly a beneficiary under the policy."

Ownership Structure: Who Owns the Policy and Why It Matters

Three tax questions turn on ownership: estate inclusion, transfer for value and employer-owned treatment.

The insured owns the policy. The regulation lists incidents of ownership as including "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" (26 C.F.R. § 20.2042-1(c)(2)). Holding any of these at death brings the proceeds into the gross estate under section 2042(2).

The business owns the policy. The insured holds no incidents directly. For a controlling shareholder, however, the regulation's stock-attribution rules still need attention. In addition, sections 101(j) and 264(a)(1) may apply. For a contract otherwise described in section 101(j)(3), Notice 2009-48 (A-3) adds that "ownership of the contract by a partnership or sole proprietorship does not prevent the contract from being treated as an employer-owned life insurance contract."

The co-owners own the policies. The insured does not own the policy on his or her own life. Notice 2009-48 (A-1) says a contract "owned by the owner of an entity engaged in a trade or business (such as for purposes of financing the purchase of an equity interest of another owner)" is not an employer-owned life insurance contract. Reassigning policies later raises transfer-for-value questions. The section 101(a)(2)(B) list names a partner of the insured and a partnership in which the insured is a partner, but it does not name a co-shareholder. Whether a given LLC counts as a partnership for this purpose is a question for a qualified tax professional.

Ownership is a fact-specific determination that turns on the policies and on the entity's governing documents.

Coverage and Funding Considerations

The face amount follows the price. A buy-sell or succession agreement may fix a price or a formula, and coverage can be sized to fund that obligation rather than an arbitrary figure. How a price or formula is reached is a valuation question, taken up above.

An agreed price does not automatically bind the IRS. Section 2703(a) generally values property "without regard to" any option or agreement to acquire it below fair market value, or to any restriction on its sale. Section 2703(b) provides that subsection (a) does not apply to an option, agreement, right or restriction that meets each of three requirements: it is "a bona fide business arrangement"; it is "not a device to transfer such 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." The regulation adds that "each of the three requirements ... must be independently satisfied" (26 C.F.R. § 25.2703-1(b)(2)). It also provides that a right or restriction is considered to meet all three requirements if more than 50 percent by value of the property subject to it is owned directly or indirectly by individuals who are not members of the transferor's family, and that property is subject to the right or restriction to the same extent as the transferor's property (26 C.F.R. § 25.2703-1(b)(3)).

Policy type matters too. Term, whole life and universal life contracts differ in how long coverage lasts, how premiums are structured and whether cash value, a contract feature, builds. When a business grows, the gap between the agreed value and the face amount can widen. Underwriting, forms, procedures and premiums vary from insurer to insurer and are confirmed with the insurers involved.