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Buy-Sell Agreements
Funding a Buy-Sell Agreement with Life Insurance? A Partnership May Make the Best Policy Owner
Estate Planner May-June 1997
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A buy/sell agreement provides that a deceased shareholder's shares in a closely held business either will be redeemed by the corporation or purchased by the remaining shareholders. Life insurance is often used to provide the necessary cash to buy or redeem the shares. But who should own the insurance? A partnership is often a good choice for several reasons.

Avoid the AMT

If a C corporation owns insurance on the lives of the shareholders to fund a redemption agreement, the insurance proceeds paid to the corporation may be subject to the alternative minimum tax (AMT). As a result, the net proceeds may be less than what is needed to fund the stock redemption. A partnership can solve this problem. In various private letter rulings, the Internal Revenue Service (IRS) has sanctioned the transfer of life insurance currently owned by the corporation to an affiliated partnership, such as a partnership of shareholders that owns the real estate where the business operates. The partnership can be the designated beneficiary of the policies on the lives of the other partners. Because the proceeds are not payable to the corporation, the AMT is avoided. The transfer out of the corporation may be a dividend.

Avoid the Transfer-for-Value Rule

Although life insurance proceeds generally are excluded from income, if a life insurance policy is transferred for valuable consideration, the proceeds are subject to income tax. Partnerships can avoid this problem, however. If the transfer is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer, the proceeds payable are not subject to income taxation.

Avoid Incidence of Ownership

Insurance proceeds generally will be included in the insured's estate if he or she possesses any right to receive, alter, revoke or affect the economic benefits of the insurance policy. Such rights are referred to as incidence of ownership. Partnerships, however, may avoid this problem. The IRS has ruled that if a general partnership is the owner and beneficiary of life insurance policies on the life of each general partner, the partner does not have incidence of ownership as long as the proceeds are used for the benefit of the partnership. The value of the decedent's partnership interest may include his or her proportionate share of the death proceeds, but the deceased partner's estate will not include the balance of the death benefit.

Avoid Multiple Policies

Cross-purchase plans are common in buy/sell agreements. Each shareholder purchases a life insurance policy on each other owner's life. When an owner dies, each shareholder uses the proceeds from his or her policy on that owner's life to purchase that owner's shares. However, this system can become quite complicated when there are more than a few shareholders because so many policies are required. For example, a business with five shareholders would require four policies on each partner's life -- one owned by each other partner -- for a total of 20 policies. With a partnership, the partnership can own the policies so only one policy is needed on each life.

How Is Insurance Held?

The life insurance partnership can be a valuable business planning tool. For example, the proceeds can be used to purchase interests in several entities owned by the partners, eliminating the need to have separate agreements and separate policies for each entity. Shareholders often don't realize until it's too late that the life insurance they purchased to fund a buy/sell agreement is not being held in the most tax-efficient way possible.