Life Insurance to Fund a 303 Redemption
Even though Congress provided a means whereby estate liquidity can be provided, Section 303 is of no value if the corporation doesn't have access to enough cash to redeem the stock at a shareholder's death. The laws of virtually all states provide that a redemption may only be made out of capital surplus, and may not impair working capital.
Life insurance on the shareholder's life, owned by and payable to the corporation, is a generally appropriate method of guaranteeing subject to the continued claims-paying ability of the insurer (and the corporation pays all premiums when due, and does not take any substantial loans or withdrawals, which could significantly reduce the death benefit) that the needed funds will be available at the time they are needed.
The death proceeds may be received income tax-free if the Notice and Consent requirements of IRC Sec. 101(j) have been met. But corporate-owned life insurance will likely result in preference income for purposes of the corporate alternative minimum tax when the proceeds are paid to a C corporation (unless the business qualifies as a "small business corporation" exempt from the AMT). There are many other factors to be considered in determining whether this tax is levied.
Life insurance can also play an additional role in a family business. Insurance may help to:
- ensure an adequate income for the surviving spouse of a deceased owner;
- equalize inheritances between children of the business owner; and
- provide adequate estate liquidity.
The Double-Duty Arrangement (for Section 303 Stock Redemption)
The double-duty arrangement is an alternative to the traditional approach of funding a 303 redemption with a corporate-owned policy. Here, the corporation has sufficient surplus to avoid state impairment-of-capital statutes, but it has invested this surplus in illiquid assets. So, the employee's spouse owns a policy on the shareholder's life, and, at the insured's death, lends the death proceeds to the corporation in exchange for an interest-bearing note. The corporation carries out the 303 redemption with the cash.
The corporation repays the principal with interest over time until the note is retired, and deducts the interest portion of payments made to the spouse. The double duty lies in the fact that the insurance proceeds not only fund the 303 redemption but also help provide indirectly for the survivor income needs of the spouse.
Split-Dollar 303 Redemption
A regular 303 redemption has two limitations:
- any life insurance used to fund the redemption may increase the value of the decedent's stock, and
- Section 303 is only available for certain liquidity needs of the estate, not for survivor income needs.
A split-dollar 303 redemption addresses these limitations. The spouse of a shareholder-employee purchases a life insurance policy on the shareholder's life. (Make sure it is separate property in a community property state.) The spouse then enters into a split-dollar agreement with the employer, in which the company agrees to advance to the spouse each year an amount equal to the annual increase in cash value. The spouse collaterally assigns the policy to the corporation to secure the advances.
When the shareholder dies, the corporation receives a portion of the death proceeds equal to the greater of the cash value immediately before death, or the aggregate net premiums it has paid. The spouse receives the balance of the proceeds, which she lends to the corporation at interest. The corporation then carries out the 303 redemption with the proceeds, and retires the spouse's notes as they fall due.
In September 2003, the IRS issued final regulations on split-dollar life insurance arrangements.