Estate Liquidity for Business Owners: Life Insurance and a Closely Held Business Interest

When It May Not Fit: Conditions That Limit or Complicate This Approach

The approach is limited or complicated in several situations:

• Insurability or cost. The owner cannot be insured, or coverage is not available at a cost in proportion to the need.
• No buyer. No co-owner or successor will purchase the interest, so the policy would have no purchase to fund.
• The source of the need. The estate's liquidity need comes mainly from personal assets rather than the business interest.
• Corporate redemption valuation. Where a corporation owned the policy in a redemption structure, Connelly held that the redemption obligation did not offset the insurance proceeds in valuing the shares. The opinion decided that one valuation question on its facts.
• Complex ownership. Multiple classes of stock or tiered entities make it harder to align policy ownership with the agreement.

Whether a particular structure meets the liquidity need depends on facts this page does not have. Those facts include the agreement, the policies, the entity's form and the estate's other assets.

Tax Treatment: Section 101(a), Section 2042, and Employer-Owned Contract Rules

The death benefit and the estate are governed by separate sets of rules.

Income tax. Section 101(a)(1) of the Internal Revenue Code provides that "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured." The exclusion has limits that matter in business planning:

• Transfer for value. Under section 101(a)(2), after a transfer "for a valuable consideration," the exclusion is limited to the consideration paid plus premiums and other amounts the transferee paid afterward. Section 101(a)(2)(B) excepts transfers "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 co-shareholder is not on that list. Section 101(a)(2)(A) separately excepts a transfer where the transferee's basis is determined in whole or in part by reference to the transferor's basis.
• Employer-owned contracts. Under section 101(j)(1), the exclusion for an employer-owned contract is capped at "the sum of the premiums and other amounts paid by the policyholder." The cap lifts only when a section 101(j)(2) exception applies and the section 101(j)(4) notice and consent requirements were met "before the issuance of the contract." The exceptions are based either on the insured's status or on amounts paid to the insured's heirs. Notice and consent alone do not lift the cap, and neither does an exception alone. Section 101(j)(3) defines these contracts as owned by a person engaged in a trade or business that is directly or indirectly a beneficiary and covering the life of an insured who is an employee on the date the contract is issued, and section 101(j)(5)(A) provides that "employee" includes "an officer, director, and highly compensated employee."

Estate tax. Section 2042 includes proceeds "receivable by the executor," and proceeds receivable by other beneficiaries if the decedent possessed at death "any of the incidents of ownership, exercisable either alone or in conjunction with any other person." Treasury Regulation § 20.2042-1(c)(2) says incidents of ownership 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." The same regulation refers to its paragraph (c)(6) for "the circumstances under which incidents of ownership held by a corporation are attributable to a decedent through his stock ownership." That corporate attribution rule bears on policies owned by a corporation.

Premiums. Section 264(a)(1) provides that no deduction is allowed for premiums "if the taxpayer is directly or indirectly a beneficiary under the policy."

Estate inclusion under section 2042, employer-owned contract notice and consent, and transfers between owners each need individual review of the contracts involved with a qualified tax professional. Income-tax treatment is covered in more depth under business life insurance tax treatment.

Potential Advantages: What This Approach Can Accomplish

Timing is the main feature. A death benefit is a defined amount that becomes payable at the moment the liquidity need arises. When the design and documents support it, the arrangement may:

• allow the estate to transfer the interest to co-owners or the entity without a distressed sale;
• give the estate a cash payment and the business a clear ownership transition through the buy-sell or redemption agreement;
• reduce the need to liquidate other business or personal assets to meet estate obligations.

On the income-tax side, the beneficiary's receipt is excluded from gross income under section 101(a)(1). That exclusion is subject to the transfer-for-value limit of section 101(a)(2) and, for employer-owned contracts, the section 101(j) cap.

Each of these outcomes depends on how the policy, the agreement and the ownership structure are designed and documented. None follows automatically from buying coverage.

Important Considerations: Ownership, Valuation, and the Connelly Decision

Retained rights come first. If the insured holds any incident of ownership at death, section 2042 includes the proceeds in the gross estate even when someone else is the named beneficiary. The rights listed in Treas. Reg. § 20.2042-1(c)(2) are broad, and the regulation says the term "is not limited in its meaning to ownership of the policy in the technical legal sense." Under paragraph (c)(3), a reversionary interest also counts, but only if its value immediately before death exceeded 5 percent of the value of the policy.

Corporate ownership raises the attribution question under Treas. Reg. § 20.2042-1(c)(6). That rule addresses when a corporation's incidents of ownership are attributed to a shareholder through stock ownership. It attributes them to a decedent who is the sole or controlling stockholder, meaning one who owned stock possessing more than 50 percent of the total combined voting power, but not to the extent the proceeds are payable to the corporation.

Connelly showed how corporate-held proceeds can raise a share's estate tax value in a redemption. The Court noted that a share redemption agreement "is ordinarily not dispositive for valuing the decedent's shares for the estate tax." It also said cross-purchase agreements carry "drawbacks" and "tax consequences" of their own.

Section 2703(a) generally disregards, in valuing property, an option, agreement or other right to acquire property at less than fair market value and any restriction on the right to sell or use it. Section 2703(b) excepts an arrangement only if it meets each of three requirements: it is "a bona fide business arrangement," it is "not a device" to pass property to family members for less than full consideration, and its terms are "comparable to similar arrangements entered into by persons in an arms' length transaction." How value interacts with coverage appears in business valuation and life insurance.

Three further points apply. Entity-owned policies on an employee may be employer-owned contracts, which brings in the section 101(j) cap and its notice-and-consent and exception conditions. Under section 264(a)(1), no deduction is allowed for premiums if the taxpayer is directly or indirectly a beneficiary under the policy. Moving a policy between owners can trigger section 101(a)(2), subject to its exceptions.

Tax and Legal Coordination: What Needs to Be Aligned

Alignment is typically settled before issue rather than after a death. The agreement, the policy owner, the beneficiary designation and the premium arrangement are typically documented together before the policy is issued, because several rules look at facts as they stood on that date.

The coordination usually covers several points:

• Section 101(j). For an employer-owned contract, the written notice and consent occur "before the issuance of the contract." An exception must also apply. Employer-owned contracts issued after August 17, 2006 are reported on Form 8925, and the reporting requirements are confirmed with a qualified tax professional.
• Section 2703. The agreement's valuation method is weighed against the three requirements of section 2703(b). Under Treas. Reg. § 25.2703-1(c)(1), a right or restriction that is "substantially modified" is treated as created on the date of the modification. Where the terms require periodic updating, "the failure to update is presumed to substantially modify the right or restriction unless it can be shown that updating would not have resulted in a substantial modification."
• Corporate attribution. For corporation-owned policies, the payee terms are read alongside Treas. Reg. § 20.2042-1(c)(6).
• Connelly. For redemption structures, the valuation effect of corporate-held proceeds is part of the review.

Policy forms, premium structures and contract terms vary by insurer, and insurance rules vary by state. Both are confirmed with the insurers involved.

Alternatives: Other Approaches to the Estate Liquidity Problem

Insurance is not the only route, and other approaches sometimes work alongside it:

• Section 6166 installment payment. Section 6166 provides an "extension of time for payment of estate tax where estate consists largely of interest in closely held business." Under section 6166(g), the extension generally ends if dispositions and withdrawals reach "50 percent of the value of such interest," and the unpaid tax then becomes due on notice and demand. A distribution in a section 303 redemption is generally not counted as a distribution or withdrawal for that purpose, but only if tax of at least the amount distributed is paid within the time section 6166(g)(1)(B) sets. Qualification and election requirements need individual review.
• Section 303 redemption. Under section 303(b)(2)(A), the rule applies only where the value of the decedent's stock in the corporation that is included in the gross estate "exceeds 35 percent of the excess" of the gross estate over the deductions allowable under sections 2053 and 2054. Distributions must fall within the stated time periods. The rule applies only to the extent the shareholder's interest bears the taxes and expenses.
• Installment sale. Co-owners or successors pay the estate over time under the buy-sell agreement, funded by operating cash flow.
• Sinking fund. The business builds a reserve to fund the buyout. A reserve does not provide a defined amount at an unpredictable time the way a death benefit does.

Each alternative carries its own tax, legal and practical requirements, and the choice among them turns on facts specific to the business and the estate.

Example (Hypothetical): A Two-Owner S Corporation

This example is hypothetical and simplified.

Assumptions:

• Owners A and B each own 50 percent of an S corporation valued at $4,000,000.
• A buy-sell agreement sets the price.
• Each owner owns, pays for and is the beneficiary of a $2,000,000 policy on the other owner.
• Neither policy was ever transferred.
• Neither owner holds any incident of ownership in the policy on his or her own life.
• The policies are assumed not to be employer-owned contracts. Whether a co-owner's policy is one turns on the section 101(j)(3) definition.

Step 1. $4,000,000 × 50% = $2,000,000, the value of each owner's interest.

Step 2. At A's death, B receives the $2,000,000 death benefit.

Step 3. B pays $2,000,000 to A's estate for A's interest. The estate now holds $2,000,000 in cash in place of the stock.

Step 4. Under section 101(a)(1), B's $2,000,000 is excluded from gross income, given the assumptions above. A transfer between the shareholders would be different, because a co-shareholder is not listed in section 101(a)(2)(B).

Step 5. A held no incidents of ownership in the policy on A's life, so the proceeds paid to B are not included in A's gross estate under section 2042. A's interest, now converted into the cash sale price, remains part of the estate.

Actual results depend on the specific documents and facts. The arithmetic and tax treatment of any real arrangement depend on the contracts involved.