Situation: One of the most frequent questions posed to DBS’s in-house Advanced Marketing Attorney by financial representatives concerns the appropriate owner and beneficiary designation of a life insurance policy for a business buy-sell arrangement. Frequently, business owners want their business paying the premiums and they mistakenly believe that this means the business needs to be the owner of the policy. Sometimes the business owner wants to accomplish two insurance goals, a personal and a business need for coverage, with one policy by having two beneficiaries on a policy. Unfortunately, when life insurance is purchased to help with the funding of a buy-sell agreement mistakes happen. Furthermore, it may not be possible to simply change the owner or beneficiary designation with a carrier owner/beneficiary change form.
Problem: Ownership and beneficiary designations should be carefully considered to ensure that the arrangement is consistent with the form of buy-sell agreement and do not result in unintended tax consequences.
Solutions: When life insurance is used to help fund a buy-sell agreement the policy structure should match the form of buy-sell arrangement. While there are several ways to structure a buy-sell arrangement the two most popular are the entity purchase (also called redemption agreement) and cross-purchase agreement.
With an entity-redemption agreement the business purchases the interest of the departing owner. Consequently, in this form of buy-sell the business purchases separate life insurance contracts on the
lives of each business owner, pays the premiums, and is the owner and beneficiary of all the policies. In addition, with this form of buy-sell arrangement when the insurance application is completed a separate form, called employer notice and consent or 101J, must be completed for the policy proceeds to be received income-tax free by the business. When an owner passes away, the business receives the proceeds and uses the death benefit to help purchase the deceased owner’s business interest.
In a cross-purchase buy-sell agreement, each owner of a business agrees to purchase a portion of a departing owner’s business interest. So, with a cross-purchase buy-sell arrangement, each business owner purchases a policy on the life of the other owner(s). Each business owner will be the premium payer, policy owner and beneficiary on a policy insuring each of the other business owners. For example, if there are three business owners, “A”, “B”, and “C”, “A” would be the premium payer, owner and
beneficiary of two policies one insuring “B” and the other insuring “C”. Similarly, “B” would be the premium payer, owner and beneficiary of two policies one insuring “A” and the other “C”. Finally, “C” would be the premium payer, owner and beneficiary of two policies one insuring “A” and the other insuring “B”. When one of the business owners dies, the surviving business owner(s) receive the death benefit which is used to purchase the deceased owner’s business interest.
As long as these insurance structures are used with the appropriate buy-sell arrangement the party responsible for purchasing the interest will receive income-tax free proceeds to complete the obligation to purchase the business from the estate of the deceased business owner. Unfortunately, financial advisors periodically stray from these owner/beneficiary structures.
For example, recently a financial representative asked about a structure where the proposal was for the business to own policies on two business owners with the beneficiary on each split with 50% going to the insured’s spouse and the remaining 50% the business. The business owners hoped to avoid having two policies, one personal for the family and the other for the business buyout. Of course, where you have three different parties on a contract, the insured, owner, and beneficiary, you have what is known as the
“unholy triangle” or “Goodman tax trap.” It may also be considered an undocumented endorsement split dollar. Such a structure in a business situation can cause the death benefit to be subject to income taxation.
To avoid the problem with having three parties on the policy the financial representative proposed having the insured own their own policy and have the business and spouse each listed as 50% beneficiaries. While this structure avoids the “Goodman” concerns is raises other problems. First, as the owner of their policy the insured can change beneficiaries at any time and defeat the funding of the buyout. While the owners are on good terms one might believe this will not happen, but what happens
if circumstances change? You could end up in a situation where the spouse receives both 100% of the insurance proceeds and the business interest. Furthermore, as owner of the policy the insured business owner’s estate will include both the value of the business and the face value of the insurance policy potentially triggering unnecessary estate taxation.
Result: Bottom line, it’s best to follow the time tested owner beneficiary arrangements when funding a buy-sell arrangement with life insurance.