The transition plan must be coordinated with the parent’s life insurance planning. In many family businesses, life insurance provides essential liquidity to pay death taxes to cover the cash needs of the family and to free of cash burdens that otherwise might adversely impact the operations of the company or threaten its survival.
A central challenge in the planning process is to ensure that the life insurance proceeds are not taxed in the parent’s estates. If the insurance is not estate tax protected, nStevey half of the debt benefit may end up going to the government. Usually, but not always, the best strategy to accomplish this essential tax objective is to put the ownership of the policy in an irrevocable family trust that has no legal connection to the corporation.
However, in many situations, the cash flow pressures of funding the premiums on the insurance and the interest of the other shareholders result in the policy having close ties to the business. In every situation of this type, the policy ownership and beneficiary designations need to be carefully evaluated upfront to eliminate tax problems and weird unintended consequences. This usually requires some basic what-if analysis to avoid blunders that can undermine the entire effort.
The following 5 traps need to be avoided:
Trap 1: Constructive Premium Dividend Trap. To illustrate how this trap surfaces, assuming our case study that Steve and Betty, owners of 90% of the company’s stock, enter into a cross purchase agreement with Dave, the owner of the remaining 10%. The agreement gives Dave the right to buy Steve and Betty’s stock when they die to ensure funding of the cross-purchase on the death of a shareholder. The parties agree that corporate resources will be used to fund life insurance policies on Steve and Dave. Dave, the minority shareholder, owns a $9 million policy on Steve’s life to cover the 90% of the stock owned by Steve and Betty. Steve and Betty own a $ 1 million policy on Dave’s life to cover the stock owned by Dave.
Absent careful planning, it is likely that the payments made by the corporation to fund the premiums on these policies owned by the shareholders will be treated as distributions tied to their stock ownership.
In a C Corporation, these payments could trigger constructive taxable dividends, a big added tax burden. In an S corporation, it is possible that the arrangement which produces larger distributions for the benefit of the minority shareholder, Dave, could possibly be considered a second class of stock that would kill the S selection, an absolute bombshell.
Cash pressures often require the corporate resources be used to fund premiums on policies that are going to be owned by other parties. Whenever this common condition exists, great care must be exercised to structure compensation and other arrangements that account for such premium payments in the most tax efficient manner possible. It adds complexity particularly if compensation arrangements are used, but the complexity often is essential in the situation.
Trap 2: The Lopsided Disaster. Assume the same cross purchase scenario as previously described except the parties have eliminated the constructive dividend threat by implementing a compensation structure to account for the premium payments. Steve then dies and Dave uses the tax-free $ 9 million death benefit that he receives to acquire Steve and Betty’s stock. Soon after Dave acquisition of the stock, he sells the company for its $ 10 million value. The income tax hit to Dave on the sale is peanuts because of the high stock basis resulting from his purchase of the stock. Dave walks from the sale with roughly $ 9.8 million after tax.
In contrast, Steve and Betty’s heirs, including Dave, collectively net less than $6 million from Steve and Betty’s 90% stock interest after the estate tax hit on the $9 million purchase price is absorbed. Dave, having shared the business, nets a monstrous benefit from the company compared to his siblings, a result Steve and Betty likely would have never intended. The simple lesson is to carefully factor in family dynamics before ever adopting a buy-sell or insurance structure commonly used by unrelated parties. In this situation, undoubtedly, fundamental family objectives would have been immeasurably improved by having a life insurance trust own the policy on Steve’s life under a structure that insured freedom from all income estate and generations skipping taxes.
Trap 3: the Shareholder Trap. Assuming the prior example, that in order to facilitate corporate funding of the premiums on the policy that ensures Steve’s life, the corporation actually owns the policy. Thus, the corporation pays the premiums on an asset that it owns. The corporation as the policy owner then names Dave as the beneficiary. If Steve owns more than 50% of the corporation’s outstanding voting stock on his death, then the entire death benefit paid under the policy will be taxed in his estate because he will be deemed to have retained incidence of ownership in the policy by virtue of his majority stock position in the company. Steve’s gross taxable estate will have mushroomed even though the death benefit is paid to Dave.
This trap kicks in whenever the death benefit on a corporate owned policy insuring the life of a majority share holder is paid to a party other than the corporation. This trap can be avoided by naming the policies corporate owner as the policy’s sole beneficiary or by making absolutely certain that the insured, Steve in our case, does not own the majority of the corporation’s outstanding voting stock.
Trap 4: Corporate Ownership Traps. As previously mentioned, if the corporation is the named beneficiary of a corporate-owned policy that insures the life of the majority shareholder, the death benefit pay to the corporation on the death of the majority shareholder will not be included in the shareholder’s estate.
But this is not the end of the story. The corporation’s ownership of the policy may trigger other burdens.
First, the family usually needs to get the insurance proceeds out of the corporation to satisfy cash objectives of the family. This often creates unpleasant dividend income tax burdens when a C Corporation is involved. The same burdens exist but usually not to the same degree for an S Corporation that has undistributed earnings and profits from a prior C Corporation existence.
Second, the death benefit may trigger an alternative minimum tax for the corporation in this situation.
Finally, although the death benefit of an insurance policy owned by and payable to the corporation will not be included in the taxable estate of the insured shareholder, the value of the stock in the insurance taxable estate may be adversely impacted by the corporation’s receipt of the insurance proceeds, that is, the value of the stock may go up resulting in higher estate taxes. The valuation impact will vary in each situation but in most cases, the proceeds will not have a dollar-for-dollar impact.
Trap 5: the Transfer-For-Value Trap. Unraveling a corporate ownership life insurance structure may trigger what is called a transfer-for-value trap that will destroy the income tax-free receipt of the death benefit. Assume in our case that the corporation is both the owner and the beneficiary of the policy insuring Steve’s life, and that the family later determines that the tax problems created by having the death benefit paid to the corporation are just intolerable. To remedy the situation, the corporation transfers ownership of the policy to Dave as additional compensation or as part of the dividend distribution. This shift in ownership will trigger a special rule called the “transfer-for-value” rule that effectively destroys Dave’s capacity to receive the death benefit income tax-free. It’s a disaster. The lesson is to carefully set the best insurance structure upfront. Changes can be costly and sometimes tax-prohibited.
So how does one avoid all these insurance traps?
As previously mentioned, often the smartest life insurance strategy is to use an irrevocable trust that has no legal ties to the corporation. The trust is both the owner and the beneficiary of the policy. The identity and rights of the trust beneficiaries need to be carefully coordinated with the entire transition plan to protect the respective interest of the inside and the outside children. This structure avoids corporate ownership traps and tax burdens. If done right, it protects the death benefit from estate tax exposure and for many income tax problems.
The premium funding burden might still exist. Careful planning will be necessary to get funds out of the corporation and into the trust to cover the premiums and the policy. Often, this will require compensation payments for S Corporation distributions to the parents followed by annual gifts to the trust that are carefully structured to be gift tax protected.