The situation is familiar: Two brothers owned a building supply company. If one brother died, the other would buy out his share. That could take a large amount of cash, and so the company bought a life insurance policy on the life of each brother. Insurance pays the surviving brother, company stays in the family, life goes on – right?
Well, yes – but a June 6 Supreme Court decision changed the potential tax outcome of the situation by stating that “a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.”
In our example of the building supply company brothers, that means the life insurance payout must be included in the value of the company for the purpose of determining the taxable estate of the deceased brother. Almost certainly, as a result, the estate will owe more taxes because of the Connelly V. United States decision.
Q: Is this true even if the company owned the insurance policies, not the brothers?
A: Yes, because the estate tax will be based in part on the value of the company, which will be higher because it will now include the life insurance death benefit.
Q: Aren’t life insurance death benefits generally not subject to income tax?
A: Yes, but it’s not really the death benefit that’s being taxed here, it’s the valuation of the company that increases by the amount of the death benefit. Put another way, the company becomes a bigger pie – and the estate’s slice is bigger as a result.
Q: How can my business avoid this situation?
A: If you have a buy-sell agreement and life insurance to fund it, make sure the life insurance death benefits are held in a way that will keep it out of the company valuation. It may be necessary to modify the buy-sell agreement as well.
Consider a cross-purchase agreement instead. In these agreements, owners themselves buy insurance on each other’s lives, providing cash to buy out their partners without involving the company or its valuation. If there are multiple partners, life insurance can be set up in a separate entity, which distributes the proceeds to the surviving shareholders.
You bought life insurance to be prepared for the unexpected. This is a great time to be proactive and make sure your policies will still protect you and your business. Contact Brad Mueller at Monarch Insurance Partners or set up a phone call here.
Monarch Insurance Partners does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.