The Life Insurance Advantage

As long as premiums are paid when due and there have not been significant loans or withdrawals, the business may have funds to help purchase a deceased owner's business interest. By contrast, building an investment or reserve fund takes time; if an owner dies "too soon," the business may not have the funds it needs to purchase the deceased owner's business interest.

Taxation of Entity Buy-Sell Agreements

Premiums paid for life insurance used to fund an entity or stock redemption buy-sell agreement are not tax-deductible by the business. Policy death proceeds may be exempt from the federal income tax if the Notice and Consent requirements of IRC Sec. 101(j) have been met. However, in some situations, a C corporation may be subject to the corporate alternative minimum tax on part of the proceeds it receives. Further, under a corporate stock redemption agreement, there is no increase in basis for a surviving owner's business interest, as there is with the cross-purchase agreement.

Distributions from a corporation to a shareholder are generally taxed as dividends unless a special exception is available under tax law. For the shareholder's estate or heir to avoid dividend treatment, a stock redemption must qualify as one of the following:

• not essentially equivalent to a dividend (a facts-and-circumstances test of limited use in planning),
• substantially disproportionate (a strict mathematical test under which the shareholder's percentage interest in the corporation must decline by specified minimum amounts),
• a complete termination of the shareholder's interest in the corporation, or
• a qualifying partial redemption under Section 303.

If the corporation's distribution in payment of its buy-sell obligation fits one of these categories, the transaction will be treated as the sale of a capital asset and not as a dividend distribution. While most long-term capital gains and dividends now are taxed at the same 15% rate, there will usually be little or no capital gain to report if a redemption is carried out shortly after the shareholder's death, due to stepped-up basis (through 2009).

Stepped-up basis is scheduled to be repealed for one year beginning on January 1, 2010, and then reinstated on January 1, 2011. A limited step-up will be available in year 2010.