Succession Funding: Paying for an Ownership Transition, With and Without Life Insurance

When Succession Funding With Life Insurance May Not Fit

A policy adds little when there is no ongoing death risk to cover. Situations like these are typical:

• The whole price is paid in cash at closing, so there is no payment period.
• The successor or the departing owner cannot obtain coverage, or the cost of coverage is out of proportion to the risk.
• The business has enough liquid assets or credit to absorb a death during the transition.
• The timeline is short enough that the parties accept the remaining risk without a policy.

Each of these depends on facts no general explanation can know, such as health, cash reserves, credit terms and the parties' tolerance for risk.

Tax Treatment: How Federal Rules Apply to the Policy and the Proceeds

The starting rule is section 101(a)(1) of the Internal Revenue Code. It 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." Two limits matter in business planning.

Transfer for value. Under section 101(a)(2), when a policy is transferred "for a valuable consideration," 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." Death proceeds above that amount are not covered by the exclusion. The limit does not apply where the transferee's basis carries over in whole or in part from the transferor. It also does not apply to 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 co-shareholder of the insured is not on that list.

Employer-owned contracts. For an employer-owned contract, section 101(j)(1) caps the exclusion at "the sum of the premiums and other amounts paid by the policyholder for the contract." The cap is lifted only when both of these conditions are met:

1. A section 101(j)(2) exception applies. One exception is based on the insured's status. The other covers amounts paid to the insured's heirs or used to buy an equity interest from them.
2. The written notice and consent required by section 101(j)(4) were given "before the issuance of the contract."

Neither condition works alone. Notice 2009-48 states that Form 8925 is filed by an applicable policyholder that owns employer-owned contracts "issued after August 17, 2006." Its answers A-1 and A-3 address which contracts count as employer-owned, and A-5 addresses who counts as an employee.

Premiums. Section 264(a)(1) provides that no deduction is allowed for "premiums on any life insurance policy... if the taxpayer is directly or indirectly a beneficiary under the policy." How this rule applies to a particular payer turns on the facts. The income-tax rules on the death benefit are covered in more depth on the site's business life insurance tax treatment page.

The sale itself. How the departing owner's installment payments are taxed depends on what interest is sold and how the price is allocated. Section 453 governs the installment method, and section 1060 governs price allocation in an applicable asset acquisition, a transfer of assets that constitute a trade or business.

Potential Advantages of Using Life Insurance in a Succession Plan

Each possible advantage depends on how the arrangement is built:

• Liquidity at a death. If a key party dies during the transition, the death benefit can provide cash to complete the transfer. The business then does not depend on selling assets or taking on emergency debt.
• Protection for a seller-financed note. Where a policy on the successor's life names the note holder, or the note's payment, as the use of proceeds, the death benefit may be structured to pay off the remaining balance.
• Settling the estate's claim. A policy on the departing owner's life can give the successor or the business funds to settle the estate's claim on the interest.
• Cash value. Permanent policies carry cash value, a contract feature that the policy owner may be able to access during the transition under the contract's terms. Access reduces what the policy can pay later. The types of business life insurance differ in whether they carry this feature.

None of these outcomes is assured. Each depends on premiums being paid and on the agreement and the policy being aligned.

Important Considerations: Risks and Limits of This Approach

Cost comes first. Premiums are a recurring cash obligation, and a policy may lapse if they stop, leaving the death risk uncovered.

Insurability is the second limit. Coverage depends on the insured's health and age at the time of application, and rates and underwriting outcomes vary from insurer to insurer.

Alignment is the third. Policy ownership and beneficiary designations that do not match the transition agreement can produce tax or contractual results the parties did not intend.

Valuation is the fourth. The amount of coverage tracks the value of the interest being transferred, and that value is a separate, fact-specific determination. Business valuation for this purpose needs individual review by a qualified valuation and tax professional.

Finally, insurance rules vary by state.

Tax and Legal Coordination: What Professionals Typically Review

A funded succession usually involves several professionals working in parallel. Qualified legal counsel typically drafts and reviews the transition documents: an asset purchase agreement, a stock purchase agreement or an installment note. No general explanation substitutes for that review.

A qualified tax professional typically examines how the sale is taxed. Two federal rules often come up:

• Installment sales. Section 453(e) can treat the amount realized on a later resale by a "related person" as received by the original seller, if the resale happens before the seller has received all payments on the first sale. For property other than marketable securities, this generally applies only if the resale occurs within 2 years of the first sale.
• Asset sales. Section 1060 requires the consideration in an applicable asset acquisition to be allocated among the assets, and a written allocation agreement is "binding on both the transferee and transferor" unless the IRS determines it is not appropriate. Separately, under section 1060(e), when a "10-percent owner" transfers an interest in an entity and, in connection with the transfer, enters into an agreement with the transferee such as an employment contract or a covenant not to compete, the owner and the transferee must furnish the information the Secretary may require.

The policy's ownership, beneficiary and face amount are typically matched to the agreement. Section 101(j) notice and consent, where it applies, is a pre-issue step. A transfer of a policy for valuable consideration is what section 101(a)(2) addresses. Entity type also changes how the sale proceeds are taxed and how a policy fits: partnership, S corporation and C corporation transitions are each handled differently.

Alternatives: Other Ways to Fund Business Succession

Several funding methods use no insurance:

• Cash purchase. The successor pays the full price at closing from savings, a third-party loan or both. There is no payment period to cover.
• Third-party financing. A bank or SBA-backed loan funds the purchase. Whether a lender asks for a policy or a collateral assignment depends on the lender's own policy and, for an SBA loan, on the program's stated circumstances; any such terms are confirmed with the lender.
• Seller financing without insurance. The departing owner carries the note and accepts both the credit risk and the death risk.
• Employee stock ownership plan (ESOP). An ESOP is a qualified defined contribution plan designed to invest primarily in qualifying employer securities. Using one to buy an owner's interest is a separate strategy with its own rules.
• Earnout. Part of the price depends on the business's future results. This reduces the cash needed at closing but leaves the departing owner uncertain about the final amount.

Each alternative carries its own tax, legal and practical consequences.

Example (Hypothetical): A Staged Management Buyout With a Life Insurance Hedge

This example is hypothetical. It describes no reader's situation.

Assumptions:

• A sole owner of a closely held S corporation agrees to sell 100% of the stock to a management team over five years.
• The agreed price is $2,000,000.
• The team pays $400,000 at closing.
• The team signs a seller-financed note for the rest, payable in equal annual installments.
• Interest and taxes are ignored.

The note:

• $2,000,000 − $400,000 = $1,600,000 note
• $1,600,000 ÷ 5 years = $320,000 per year

The death risk. Suppose the lead manager dies after the year-two payment:

• $1,600,000 − $320,000 − $320,000 = $960,000 still owed

The business may lack the cash to keep paying.

The hedge. The team or the business owns a $1,600,000 level-term or decreasing-term policy on the lead manager's life. If the manager dies in year two, the death benefit provides funds to pay the $960,000 balance. How any remaining proceeds are used is set by the agreement.

The tax result depends on who owns the policy, who is the beneficiary, and whether section 101(j) applies. Actual figures and structure call for professional review.