How life insurance funds business buyouts

By Richard C. Wilson

Three separate questions shape the tax review: whether death proceeds qualify for income tax exclusion, how the transaction affects shareholder basis, and whether proceeds belong in the insured's gross estate. An income tax exclusion does not settle estate inclusion, and a surviving owner's purchase cost basis is different from an S corporation shareholder's basis adjustments.

Planning review: Ask an estate attorney and CPA to review the ownership agreement, policy records and proposed transaction together. Include the policy owner, insured person, premium payer, beneficiary and intended buyer of the business interest.

Company redemption: the estate buyout exception

Insurance proceeds used to buy an interest from the insured's estate can qualify for an exception to the employer owned policy exclusion limit. The written notice and consent requirements must be met, and proceeds must purchase an equity, capital or profits interest in the applicable policyholder from the insured's estate. The amount must be paid or used by the policyholder's return due date, including extensions, for the taxable year in which the death benefit is treated as received. The exception applies only to the qualifying amount.

Without a qualifying exception, §101(j) caps the exclusion for a covered employer owned policy at premiums and other amounts paid by the policyholder. Separate status exceptions include employment at any time during the 12 months before death or director status at issuance. Each still requires written notice and consent compliance. These are selected exceptions rather than an exhaustive list.

A corporate redemption does not give surviving shareholders purchase price basis in the redeemed shares. An S corporation's tax exempt insurance income can nevertheless increase a particular shareholder's stock basis through income allocated to that shareholder. Other adjustments matter, including decreases for nondeductible expenses not chargeable to capital, and a net increase first restores prior debt basis reductions before increasing stock basis.

For the distinct valuation question, read the question about a redemption obligation and company life insurance. Review the policy coverage rules and written notice and consent requirements before relying on an exclusion exception.

Owner purchase: purchase price and basis

In an ordinary taxable cross purchase where a buyer acquires shares for a purchase price, the acquired shares generally take cost basis. Other applicable basis rules, including corporate and partnership rules, still apply. The purchase cost rule concerns shares acquired by the buyer and does not give surviving shareholders purchase price basis in shares redeemed by a corporation.

Insurance funding has its own tax questions. Death proceeds received under a life insurance contract because of the insured's death are generally excluded from federal gross income, subject to §101(a)(2) and (3), (d), (f) and (j), including the policy transfer and employer owned policy limitations explained below. Interest paid under an agreement retaining excluded proceeds is taxable. Premiums are not deductible when the taxpayer is directly or indirectly a beneficiary under the policy.

Use the policy count question to compare the policy inventory with the ownership roster and purchase obligations. Record the owner, insured, beneficiary and premium payer for each policy, and review proposed policy assignments under the transfer rules below.

Insurance LLCs: policy transfers and partnership substance

An LLC label supplies no exception to the reportable policy sale test. An indirect acquisition of an interest in an entity holding a policy can fall within that test, just as a direct acquisition of a policy interest can. Detailed formation, allocations and capital account questions belong in a specialist review of the proposed arrangement.

Policy transfers and exclusion limits

A transfer of a life insurance policy or policy interest for valuable consideration, by assignment or otherwise, generally limits excluded death proceeds to the consideration paid plus premiums and other amounts subsequently paid by the transferee. Other amounts include policy debt interest disallowed under §264(a)(4).

Exceptions apply if the transferee's basis is determined wholly or partly by reference to the transferor's basis. Exceptions also apply to transfers to the insured, the insured's partner, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. A fellow shareholder alone is not a listed recipient. These exceptions do not apply to a reportable policy sale.

A reportable policy sale is a direct or indirect acquisition of a policy interest when the acquirer has no substantial family, business or financial relationship with the insured apart from the policy interest. Indirect acquisition includes acquiring an interest in a partnership, trust or other entity holding a policy interest. An LLC label supplies no exception to this test.

Partnership substance and business purpose

The partnership anti abuse framework requires a bona fide partnership. Each transaction or related series must have a substantial business purpose, and its form must be respected under substance over form principles. Results must accurately reflect the partners' economic agreement and clearly reflect their income.

The proper reflection requirement is satisfied to the extent a specific provision clearly contemplates the transaction and its ultimate tax results, taking all relevant facts and circumstances into account. That exception still requires a bona fide partnership and respected substance. The IRS can recast a transaction when a principal purpose is substantially reducing the present value of the partners' aggregate federal tax liability inconsistently with subchapter K. The analysis depends on the facts and supplies no insurance LLC valuation safe harbor.

Estate inclusion and shareholder basis are separate questions

Income tax exclusion of death proceeds does not resolve estate inclusion. Section 2042 includes proceeds receivable by the executor and proceeds payable to others when the insured held incidents of ownership at death, alone or jointly. A reversionary interest counts only if its value exceeded 5% of policy value immediately before death.

Section 2035(a) also applies when rights transferred or relinquished within three years of death would have caused inclusion under §2042 if retained. Bona fide sales for adequate and full consideration in money or money's worth are excepted. Review beneficiary designations, ownership rights and recent assignments alongside the proposed buyout.

Shares purchased by a surviving owner

Purchase cost basis applies generally to shares a buyer acquires for a purchase price in an ordinary taxable cross purchase, subject to other applicable basis rules, including corporate and partnership rules. Identify the buyer and the shares acquired before comparing that result with a corporate redemption.

Inherited S corporation shares

Where inherited S corporation stock has basis otherwise determined under §1014, that basis is reduced by the portion of stock value attributable to income in respect of the decedent. This inherited stock rule is separate from a surviving buyer's purchase cost basis and from the shareholder adjustments for an S corporation's tax exempt income.

The income tax basis guide covers general inherited property basis, valuation elections and basis consistency questions. Take the inheritance records and shareholder basis schedules to that review.

Policy tax requirements and records

Keep the policy, assignments, ownership history, written notices and consents together. Compare those records with the purchase agreement and identify any proposed change in policy ownership before completing the transaction.

Income tax exclusion and premium deductions

Death proceeds received under a life insurance contract because of the insured's death are generally excluded from federal gross income. The exclusion is subject to §101(a)(2) and (3), (d), (f) and (j), including transfer and employer owned policy limitations. Interest paid under an agreement retaining excluded proceeds is taxable. Estate inclusion remains a separate question.

Life insurance premiums are not deductible when the taxpayer is directly or indirectly a policy beneficiary. A business buyout purpose supplies no exception under §264(a)(1). This rule addresses premiums rather than policy loan interest.

Which employer owned policies face the exclusion limit?

Section 101(j) limits the exclusion for a covered employer owned policy unless a qualifying exception applies. A covered policy is owned by a person engaged in a trade or business, with that owner or a specified related person directly or indirectly a beneficiary, and insures an employee of the applicable policyholder's business at issuance. The insured must be a covered United States citizen or resident. Issuance timing, qualifying exchanges and material changes also determine applicability, as explained in the applicability notes in Sources.

Employee includes an officer, director or highly compensated employee under §414(q). Both covered individuals count on a joint life contract. Related persons include relationships specified in §267(b) or §707(b)(1), and common control relationships under §52(a) or (b).

A qualifying §1035 exchange of an older protected contract retains transition protection unless a material increase in the death benefit or another material change, apart from changing the issuer, creates a new contract. Increases under §7702 or the existing contract's terms are not material changes if insurer consent is not required. Administrative changes, changes between general and separate accounts, and exercise of an option or right in the original contract are also excluded from material changes. Under a master contract, adding covered lives creates new contracts only for those additional lives.

What written notice and consent are required?

Employer owned policy exclusion exceptions require written notice and consent before issuance. The employee must receive written notice of the intent to insure, the maximum face amount and the applicable policyholder's beneficiary status. The employee must give written consent to being insured and to coverage continuing after employment ends.

For this purpose, issuance is the latest of the application date, coverage effective date or formal issuance date. The contract must be issued before the earlier of one year after consent or termination of employment with the applicable policyholder's business. Disclose an actual amount or salary multiple reasonably expected to be purchased during the employee's tenure.

Additional notice and consent are required if aggregate coverage exceeds the amount disclosed and consented to. A wholly owned corporation's owner employee is not exempt. An employee's irrevocable transfer of an existing policy to the employer satisfies notice and consent, but later face amount increases require written notice and consent.

For exchanges of covered contracts issued after the statutory cutoff with prior compliance, no further notice and consent are required if existing consent remains valid or the exchange makes no material change in the death benefit or contract. See the exchange qualification in Sources. Notice and consent alone do not establish an exclusion exception.

Can proceeds used for an estate buyout qualify for an exception?

Yes, to the extent qualifying proceeds purchase an equity, capital or profits interest in the applicable policyholder from the insured's estate and the written notice and consent requirements are met. The amount must be paid or used by the policyholder's return due date, including extensions, for the taxable year in which the death benefit is treated as received. The exception applies only to the qualifying amount.

Separate status exceptions include employment at any time during the 12 months before death or director status at issuance. Each still requires compliance with the written notice and consent requirements. These are selected exceptions rather than an exhaustive list. Without a qualifying exception, the exclusion remains capped at premiums and other amounts paid by the policyholder.

Must the policyholder file Form 8925?

Yes, a policyholder owning one or more covered employer owned policies issued after the statutory cutoff must file Form 8925 annually with its income tax return and retain adequate supporting records, subject to the qualifying exchange exception below. The applicability notes in Sources identify the cutoff and protected contracts.

Report employee and insured employee counts at year end, total coverage in force at year end, the policyholder's name, address, taxpayer identification number and business type, and valid consent status or the number of insured employees without consent.

Qualifying §1035 exchanges of older protected contracts are excepted, subject to the material change and master contract limits described above. A related person that does not own a contract need not file merely because it is an applicable policyholder. Filing does not replace compliance with written notice and consent requirements.

When is relief available for a notice and consent failure?

Relief is limited to a failure that was inadvertent, where the policyholder made a good faith compliance effort and discovered and corrected it by the return due date for the policyholder's year of issuance. Section 101(j) has no statutory correction provision, and missing written consent cannot be corrected after the insured employee dies.

Can policy ownership cause estate inclusion?

Yes, proceeds payable to others are included under §2042 when the insured held incidents of ownership at death, alone or jointly. Proceeds receivable by the executor are also included. A reversionary interest counts only if its value exceeded 5% of policy value immediately before death.

Rights transferred or relinquished within three years of death trigger inclusion under §2035(a) if retaining those rights would have caused inclusion under §2042. Bona fide sales for adequate and full consideration in money or money's worth are excepted from that transfer rule. Income tax exclusion does not resolve these estate inclusion tests.

Comparing the tax questions for several owners

For owners comparing a taxable share purchase with a corporate redemption, start with the shares each surviving owner would acquire. A buyer's acquired shares generally take cost basis in an ordinary taxable purchase, subject to other applicable basis rules, including corporate and partnership rules. A redemption does not give surviving shareholders purchase price basis in the redeemed shares.

For an S corporation, review allocated tax exempt insurance income separately. That income can increase a particular shareholder's stock basis, but other adjustments matter, including decreases for nondeductible expenses not chargeable to capital. A net increase first restores prior debt basis reductions before increasing stock basis.

For a proposed policy assignment or insurance LLC transaction, review the policy transfer limitations and reportable policy sale test before assuming an exception applies. Review estate inclusion separately from income tax exclusion, using the insured's ownership rights, beneficiary designations and transfer history.

Common questions

Resources to check out

• IRC §101: Life insurance death benefits: The income tax exclusion, policy transfer limitations and employer owned policy provisions.
• IRS Notice: Employer owned life insurance: Questions and answers on policy coverage, exchanges, notice, consent and exclusion exceptions.
• IRS Form 8925: Form and instructions: Annual reporting and supporting recordkeeping instructions.
• Employer policy reporting statute: Required employee counts, coverage information, identification and consent reporting.
• IRC §264: Premium deduction restrictions: The premium deduction restriction for a taxpayer who is a policy beneficiary.
• Purchase cost basis statute: Cost basis and its express preservation of other applicable basis rules.
• S corporation income allocation statute: Shareholder allocations, including tax exempt income.
• S corporation basis adjustment statute: Stock and debt basis adjustments and the inherited stock rule.
• Partnership anti abuse regulation: Business purpose, substance, proper reflection and IRS recasting standards.
• Life insurance estate inclusion statute: Executor proceeds, incidents of ownership and reversionary interests.
• Estate inclusion for certain transfers: The three year transfer rule and bona fide sale exception.