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Major References:
I.R.C. §§101, 1367, 1371, 1377.
INTRODUCTION
Closely held businesses often involve buy-sell arrangements to control the ownership and disposition of ownership interests, especially upon events such as the death of an owner. Life insurance is often obtained in connection with buy-sell arrangements among the owners of closely held businesses. In these situations either the business entity purchases insurance on the lives of the owners or the owners purchase insurance on each other. When an owner dies the insurance then provides the funds to purchase his or her shares, and allows the survivor(s) minimize the cash drain or debt that might otherwise be incurred in connection with the purchase.
The purpose of this memorandum is to provide an overview of the tax and nontax considerations involved in implementing buy-sell arrangements for S corporations, especially arrangements that involve life insurance funding. While these arrangements are commonplace, the interplay of special rules governing the taxation of life insurance, the flow through nature of S corporations, and the importance of stock basis to S corporation shareholders during the life of the corporation can produce results that are not always intuitive. In any case, a knowledge of how these rules work together can facilitate pre-mortem and post-mortem planning that will maximize the tax positions of the interested parties, and help avoid traps that might otherwise create problems.
BASIC PRINCIPLES OF LIFE INSURANCE TAXATION
Any review of the tax considerations involved in funding an S corporation's buy-sell agreement with life insurance must start with an understanding of certain basic tax rules that apply generally to the payment of life insurance premiums and the receipt of life insurance proceeds.
The first important rule is a simple one. A taxpayer may not deduct life insurance premiums if the taxpayer is directly or indirectly a beneficiary under the policy.1 Second, life insurance death proceeds generally are not includible in the gross income of the beneficiary.2 This general rule is subject to a significant exception that applies if the policy (or interest in a policy) is not newly issued and is acquired in a transfer for valuable consideration - commonly referred to a "transfer for value" - in which case death benefits are excludable only to the extent of the "actual value"...