Smart business owners plan for the orderly disposition and transfer of their interests in their companies in the event of their death, disability or retirement. Whether the business is a corporation, partnership or a limited liability company (LLC), a buy-sell agreement is usually the centerpiece of this planning, particularly when past and future owners are unrelated. Some form of permanent life insurance is usually needed to fund the agreement for a number of reasons, including the need for coverage for an extended period of time, perhaps right up to the death of one of the owners; business owners also often need supplemental retirement income and liquidity for estate-planning purposes.

In most cases, individual life insurance policies on each owner are purchased to fund the buy-out plan. But another type of life insurance — first-to-die (FTD) insurance — also can be used.

As a cash value policy, FTD simultaneously insures two or more lives (usually up to five lives) and pays its death benefit on the death of the first insured to die. It's a low-cost alternative to the traditional strategy of purchasing one or more single life policies on the life of each business owner; a single FTD policy insuring two individuals costs about 25 percent to 30 percent less than two single life policies. But because a single life insurance policy alone is used to fund the buy-sell agreement, the FTD policy presents some interesting planning and tax issues.

STOCK REDEMPTION

In the typical stock redemption plan with traditional funding, the C corporation or S corporation is the owner as well as the beneficiary of the life insurance policies on the lives of the owners. The annual premiums are paid with after-tax corporate funds and the death benefit should be received income tax free, pursuant to Internal Revenue Code Section 101, upon the death of the first of the insureds to die.

With an FTD policy, there are no special tax or legal issues regarding ownership of the policy. As in any stock redemption plan, the corporation is the owner and beneficiary of the FTD policy.

This type of plan with this type of coverage is particularly attractive to the owners of S corporations, as they are probably more likely to use the stock redemption plan than the owners of a C corporation. Partnerships and LLCs taxed as partnerships are treated for tax purposes very much like S corporations, meaning that FTD coverage to fund entity buy-outs is appropriate for them as well.

Certainly, stock redemption plans funded with life insurance in C corporations are not without their issues. There is the potential for a corporate alternative minimum tax (AMT) when a death benefit is paid to the corporation. In addition, the surviving owners generally enjoy no cost basis increase when a deceased or retiring partner is bought out. But these are generally not concerns for the S corporation, partnership, or LLC.

CROSS PURCHASE

In recent years, planners and attorneys seem to be favoring cross purchase plans, in large part because of corporate AMT and cost basis issues. In the usual case, each business owner is the owner and beneficiary of a policy on the life of the other. Each stockholder pays the annual premiums for the policy he owns with personal after-tax income.

When an FTD policy is used in a cross purchase arrangement, it presents an interesting planning challenge. Who should be the owner and beneficiary when there is only one life insurance policy? It is important that the ownership and beneficiary arrangement chosen by the business owners avoids any transfer-for-value problem and inclusion of the proceeds in the deceased stockholder's estate.

When an FTD policy funds a cross purchase agreement, insurance planners sometimes suggest that the insured owners own the policy jointly. The beneficiary is the surviving stockholder or stockholders. On its face such an arrangement appears to be an estate tax disaster. But of course the solution is not that simple.

Generally, IRC Section 2042 holds that proceeds of a life insurance policy are included in the estate of the insured if the insured owns any ownership interest in the policy at death. When an FTD policy is owned jointly by the stockholders, the death proceeds will be included in the deceased stockholder's estate under IRC Section 2042. That appears to be the case whether the policy is owned jointly with rights of survivorship or as tenants in common.

But if the policy's beneficiary or beneficiaries are obligated by agreement to use the death proceeds to purchase the decedent stockholder's stock, the executor of the decedent's estate should be able to reduce the value of the decedent's stock by the amount of the life insurance death benefit. If the life insurance is the precise amount of the value of the stock, the stock should have no value for federal estate tax purposes. Otherwise, if both the life insurance proceeds and the full value of the deceased stockholder's stock are included in the stockholder's estate, the estate tax result is almost punitive in nature.

This theory for being able to reduce the value of the decedent's stock interest in such situations is based largely on the 56-year-old case of Tomkins.1 Ray E. Tomkins was a partner in a partnership that owned a life insurance policy on his life. The policy beneficiary was Tomkins's partner. The partnership agreement essentially provided that when Tomkins died, his partnership interest would be purchased for the exact amount of the life insurance proceeds. Tomkins died in an accident, and the proceeds were paid to his executor in exchange for his interest in the partnership.

The Internal Revenue Service argued that both the life insurance proceeds and the partnership interest should be included in Tomkins's estate for federal estate tax purposes. The Tax Court disagreed. The court said the life insurance was included in the estate under the predecessor to IRC Section 2042, but the partnership interest should not be included because, at the time of Tomkins's death, his interest in the partnership under the partnership agreement was limited to the amount of the life insurance proceeds. The Tax Court did not elaborate, but relied heavily on the reasoning of a line of cases dating back to 1934's Boston Safe Deposit.2 The IRS acquiesced to the Tomkins decision in 1950.

How reliable is this 56-year-old Tax Court decision? Since 1950, there's been little other published authority on this issue. This lack of authority might suggest that this silence is evidence of the decision's reliability. Most practitioners agree that the Tomkins decision is fair, and its result is reasonable for the taxpayer.

To avoid the double inclusion problem associated with this type of planning, taxpayers sometimes offer another argument: The insured may not be deemed to hold incidents of ownership in a policy on his life if he's also a party to a binding buy-sell agreement in which he is precluded from independently exercising any of the policy ownership rights. In other words, if the buy-sell agreement restricts the insured's rights in a policy owned by the insured, the insured may still avoid the reach of IRC Section 2042. This reasoning is based on a 1966 federal appeals court ruling in First National Bank of Birmingham v. U.S.3 But this decision is binding only in the Fifth Circuit and therefore probably not the sole strategy that many lawyers would rely on in planning a stock purchase plan. Rather, it stands as another argument against double inclusion.

TRUSTEED ARRANGEMENT

Can the risk of the double inclusion be reduced or even eliminated by having the FTD policy owned by the trustee of a trusteed cross purchase buy-sell agreement? Many experts think so.

Presumably, one role the trusteed agreement plays in this instance is to enable a stockholder to avoid holding one or more incidents of ownership in the FTD policy at the time of death. There is some concern that the reach of IRC Section 2042 may not be avoided if a trust agreement is created by the stockholders and revocable by one of them, or even by all acting in concert. But when single life policies are used in the trusteed arrangement, the agreement probably can still be written in such a way that the insured does not own any interest in the policy on his life, even if the agreement is revocable. When considering a trust in these circumstances, ask these two questions: Does a trusteed buy-sell agreement help at all under these circumstances? If so, what kind of trust should be used?

If the Tomkins decision was correct, a trust arguably serves no real tax purpose in this arrangement. Presum-ably, a trust would be used only for non-tax purposes, such as assuring that the buy-sell plan will be completed in a timely fashion following one of the triggering events specified in the buy-sell agreement. In that instance, the document probably should be a revocable trusteed agreement of some kind, and should direct the trustee to collect the death proceeds on behalf of the surviving stockholder-insured and to complete the purchase accordingly. Even then, the executor of a deceased stockholder's estate might argue that the decedent did not possess an interest in the policy at the time of death, but merely had a contingent beneficial interest in a trust. But if the Tomkins decision is right, such an argument should be unnecessary.

Some practitioners might see an irrevocable trusteed arrangement as the better choice. Even though irrevocable agreements are relatively rare in such circumstances, an irrevocable trust was used in the case described in Private Letter Ruling 9622036.4 In that case, a trust owned a policy on the life of Stockholder B that was originally owned by Stockholders A and C. A trust also owned a joint first-to-die policy insuring A and C and that policy was originally owned by Stockholder B. The agreement directed the trustee to distribute the proceeds from each policy to the surviving stockholders on the death of the insured. The IRS ruled that the proceeds of neither policy would be included in the estates of the stockholders under IRC Section 2042(2).

Presumably, when there is an irrevocable trusteed cross purchase plan with an FTD policy, the executor of a deceased stockholder's estate excludes the death proceeds of the FTD policy from the decedent's estate tax return and reports the full value of the decedent's stock. Were the IRS to argue that the proceeds should be included in a deceased stockholder's estate, the executor could rely on the Tomkins rationale to reduce the value of the decedent's stock.

Some form of irrevocable trust may comfort business owners and their attorneys with respect to the IRC Section 2042 implications of funding a cross purchase buy-sell arrangement with an FTD policy. But an irrevocable trust may lead to other issues in which there is scant authority and where practitioners have little practical experience. For example, the PLR did not discuss how premium payments were to be handled.

Because the only guidance in the drafting of trust agreements used in a buy-sell context comes from a private ruling, lawyers will undoubtedly have differing opinions on the terms and provisions of such a document. Unsurprisingly, the drafting of such a document should be left to experienced counsel.

TRANSFER-FOR-VALUE

The other important issue to consider in the case of an FTD policy funding a cross purchase plan is the possible transfer-for-value issue at death. This issue should be considered whether the policy is owned individually by the stockholders or in some form of trust agreement.

Ordinarily, pursuant to IRC Section 101, a beneficiary receives the death proceeds of a life insurance policy free of income tax. However, the transfer of a policy or an interest in a policy for valuable consideration results in the loss of this income tax exclusion for a portion of these proceeds.

The transfer-for-value problem is most often associated with the transfer of ownership or an ownership interest in a life insurance policy. But the IRS also has applied it to the payment of death proceeds in certain circumstances.5 Could the same reasoning be applied to the case of an FTD policy? If the FTD policy is owned in an irrevocable trust, does any transfer occur at all?

One of the exceptions to the transfer-for-value rule is a transfer to the insured. With an FTD policy, it could be argued that the surviving stockholder is also an insured under the policy and the exception to the rule should apply to avoid income taxation. Naturally, if the FTD policy is owned individually by the stockholders, the insured exception to the rule will have to be relied upon.

Conversely, when the policy is owned by an irrevocable trust, the parties should be able to argue that no transfer of an interest in a policy occurs. This is an issue that should be carefully considered by the client's tax advisers in the design of the cross purchase plan.

PROCEED WITH CAUTION

The use of an FTD policy in the buy-sell plan is an interesting funding option for attorneys and business planners. But the design of the plan and the ownership arrangement for the FTD policy should be carefully considered.

The FTD policy seems ideally suited to the stock redemption or entity purchase plan. In such cases, the policy should be owned by and payable to the corporation or other business organization.

When the cross purchase plan is the plan of choice, the stockholders' attorney or other tax advisor should carefully consider the ownership of the FTD policy. If stockholders will individually own the policy, it's critical that they enter into a binding agreement in which the beneficiary is obligated to use the death proceeds of the policy to purchase the deceased stockholder's stock or other business interest. This ownership arrangement should be used only if the client and his advisor are comfortable with the legal authority supporting it.

Endnotes

  1. Estate of Ray E. Tomkins v. Comm'r, 13 TC 1054 (1949).
  2. Boston Safe Deposit & Trust Co. v. Comm'r, 30 BTA 679 (1934).
  3. First National Bank of Birmingham v. U.S., 358 F.2d 625 (5th Cir. 1966).
  4. PLR 9622036 (March 4, 1996).
  5. For example, see Monroe v. Patterson, 197 F. Supp. 146 (ND Ala. 1962) and Reg. 1-101-1(b)(4).

EDITOR'S NOTE

Trusts & Estates has a strict policy against running articles that primarily serve to advertise their authors' products or services. Although The Phoenix Companies, Inc. is among the carriers offering first-to-die life insurance, T&E advisory board members concluded that Second Vice President Brian K. Titus's article on using FTD policies in buy-sell agreements is balanced, objective, informative and therefore worthy of publication. But the board required that all carriers of FTD be listed near the article.

According to the 2004 National Underwriter's Who Writes What, FTD life insurance is available from 12 companies in the United States. They are, in alphabetical order:

  • Ameritas Acacia Companies;
  • CJA & Associates, Inc.;
  • Elite Marketing Group;
  • Financial Brokerage, Inc.;
  • Genworth Financial;
  • Innovative Underwriters;
  • New York Life Insurance Company;
  • Northwestern Mutual Financial Network;
  • Pan-American Life Insurance Co.;
  • Phoenix Life Insurance Company;
  • PRIMARY Financial Group; and
  • Roster Financial LLC.

Comments on the decision to run Titus's article or T&E's policy are welcome. Please email Rorie Sherman, editor in chief, at:
rsherman@primediabusiness.com.