Buy-sell agreements are commonly used by business owners to ensure the continuity of the business upon the death, disability or departure of a business owner.  Where the agreement obligates the business itself to buy-out the owner’s interest, this is called an “entity purchase” or a “stock redemption” agreement if the business is a corporation.  If the owners are personally obligated to buy each other out, it’s called a “cross purchase” agreement.  The buy-sell agreement is usually funded by life insurance on the owners so that the funds will be available to complete the agreement upon the death of an owner.   When the business is sold or closed, or a business owner voluntarily departs the business, the buy-sell agreement may be terminated and the life insurance distributed out to the insured owners.  Also, depending upon legal and tax considerations, it may be desirable to change a buy-sell arrangement from an entity purchase to a cross purchase, or vice versa.   But, are there any adverse tax consequences in doing so and what can be done to prevent it?

Beware the Transfer-for-Value Rule

As a general rule, the beneficiary of a life insurance policy pays no income taxes on the benefits received.  There is no dollar limit to that rule.  This makes life insurance one of the most attractive financial planning tools there is and ideally suited to fund a buy-sell agreement.  Occasionally, however, the buy-sell agreement is terminated or an owner departs the business during lifetime.  Provisions are usually included in the buy-sell agreement that cover the disposition of the life insurance policy.  But beware a rule known as the “transfer-for-value” rule which may subject a portion of the death proceeds to income taxes.  The rule basically states that if a policy is transferred for “valuable consideration”, the death proceeds will generally be exempt from taxes only to the extent of the consideration paid by the transferee and net premiums paid by the transferee after the transfer.  The balance of the proceeds is taxable as ordinary income.  “Valuable consideration” could mean, amongst other examples, money paid or contractual obligations.

Fortunately, there are some exceptions to that rule, one of which involves some situations where life insurancepolicies are transferred into and out of corporations, partnerships, limited liability companies (“LLCs”) and other business entities, or to business co-owners.  Those transfers must be examined carefully to see if they violate the “transfer-for-value” rule.  The rule was designed to discourage “gambling” on human life (i.e., buying a policy from someone who already owns the policy, and not from an insurance company, just as if they were impersonal investments).

The rule does not apply to transfers of life insurance policies to:

1. the insured;
2. a partner of the insured;
3. a partnership* if the insured is a partner;
4. a corporation, if the insured is a shareholder or an officer.

(*Since the overwhelming numbers of LLCs have elected to be taxed as partnerships, the rules applicable to partners and partnerships generally apply to LLCs and their owners.)

Oddly enough, however, although a transfer to a partner of the insured is protected, a transfer to a corporate co-shareholder of the insured is not.  For example, if a corporation owns life insurance policies on shareholders A and B to fund a stock redemption, and they now wish to enter into a cross-purchase agreement, the company should not transfer the policies it owns to the respective shareholders.  The cross purchase arrangement would necessitate the company transferring the policy on A’s life to B, and on B’s life to A, in order to properly fund the cross purchase arrangement.  This is a violation of the rule.  The remedy would be for the corporation to retain the policies and use the policies for other business purposes, such as key employee insurance or for executive benefit arrangements.  Shareholders A and B would purchase new policies on each other to fund their obligations under the cross purchase agreement.

Note, however, that if the shareholders were also partners in a separate partnership, then the policy transfer would NOT violate the transfer-for-value rule.
 Conversely, if you owned a policy on your own life or on the life of your co-owner, and transferred the policy to the business to fund an entity buy-out agreement, this would NOT violate the transfer-for-value rule.  As noted before, the law protects transfers to a partnership where the insured is a partner, and to a corporation, if the insured is a shareholder or an officer.  So, if you started out with a cross-purchase arrangement and now wanted to switch to a stock redemption or partnership entity buy-out, the individuals could transfer their policies to the business with no worries.

One other exception to the transfer-for-value rule exists and that involves what the tax laws call “carryover basis.” Normally, when you buy property (not just life insurance) you get what is called a “cost basis.”  When you later sell the property for more than what you paid, you have a gain for tax purposes.  But there are various parts of the Internal Revenue Code that say your basis is not what you may or may not have paid, but rather what the basis of the former owner was.  One example is in a tax-free corporate reorganization.  If EastPencil, Inc. and WestPencil, Inc. merge and become All-Borough Writing, Inc., that is typically a tax-free transaction.  All-Borough will get the same basis in any policies transferred by the two former companies, as those old companies had.  These then are protected from the transfer-for-value rule.
 So, when unwinding buy-sell agreements or converting the arrangement from an entity purchase to a cross purchase, beware of the transfer-for-value rule to avoid adverse tax consequences.