Advanced Underwriting Consultants

Question of the Day – November 29

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: I have two clients who own an S corporation.  They want to change their buy-sell agreement from redemption to cross-purchase, and need to switch ownership and beneficiaries of their life policies at the same time.  What tax issues do they need to be concerned about?

Answer: Since the transfer of the policies is related to business, the transaction will be treated as a sale and purchase.  There are three potential tax issues:

  • The transfer will be treated as a surrender of the policies by the business for income tax purposes,
  • The transfer to the non-insured shareholder will be treated as compensation or a dividend for tax purposes, and
  • The transaction may violate the transfer for value rules.

The business will be treated as surrendering the life policy at the time it makes the transfer.  Any cash value in excess of the company’s basis will be taxed as gain.

When the company transfers the policy to the owner, the policy’s value is either taxable compensation (if the owner is an employee) or taxed as an owner’s distribution.  If the business is a corporation, an owner’s distribution is generally a dividend.

The third issue—the transfer for value problem—is the biggest potential downside for the transaction.

Internal Revenue Code Section 101 (a) (1) says that life insurance death proceeds are usually income tax free.  Code Section 101 (a) (2) creates the so-called transfer for value rule.  The rule says the death benefit of a life policy will be income taxable to the extent it exceeds basis if the contract is transferred for valuable consideration—for example, money or loan forgiveness.

The transfer for value rule itself has exceptions.  If the transfer of a life policy is made to one of the following, the transfer for value rule does not apply.

  • The insured
  • A partner of the insured
  • A partnership including the insured
  • A corporation of which the insured is an officer or shareholder

The problem of the transfer for value rule comes up often in the context of buy-sell planning.  For example, say that Dusty and Lucky are the owners of Western Enterprises, Inc., a C corporation.  Say also that they have a buy-sell agreement in place structured as a redemption arrangement.  To fund the death-time buyout of the deceased owner’s shares, the company owns and is beneficiary of insurance on the lives of Dusty and Lucky.

After talking to their tax advisors, Dusty and Lucky decide to change their buy-sell arrangement from redemption to cross-purchase.  They also decide to transfer each of the existing corporate-owned insurance policies to the non-insured shareholder.

A transfer to a co-shareholder of the insured is not an exception to the transfer for value rule.  That change in policy ownership would cause the death benefit of the policy to be income taxable.

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