Reducing Death Tax With a Cross Purchase Buy-Sell Agreement
By Robert J. Saalfeld
SAALFELD GRIGGS PC
An often overlooked problem that can arise, however, is that at B’s later death the entire company and the life insurance on B’s life (if purchased by B) is includable in B’s estate for death taxes. In cases where B’s estate is not sheltered by available death tax exclusions, this results in a liquidity problem for the business and B’s estate, and reduces the amount to B’s heirs.
Can A’s interest be purchased without increasing B’s death tax? Yes. A and B could each form an irrevocable life insurance trust with A’s trust owning the policy on B’s life and B’s trust owning the policy on A’s life. At A’s death, B’s trust uses the insurance proceeds on A’s life to purchase A’s business interest. Since B’s business interest is then owned by A’s trust, this business interest is not part of B’s estate for death taxes. The trust we are talking about is an irrevocable life insurance trust, as distinguished from a revocable living trust. B’s spouse can be a beneficiary of the insurance trust.
If B wishes to purchase the life insurance on his life that A’s trust owns, B’s trust could purchase this policy for its cash value. However, this would run afoul of the “transfer for value” rule as it is not a transfer to the insured. This would subject the policy proceeds to income tax. There is an exception to the transfer for value rule, however, for transfers to a partner of the insured. The parties could qualify this exception if A, B and their insurance trusts formed a partnership, such as one that leased equipment to the company. Because B’s trust is a partner in a partnership with the insured, there is no transfer for value problem. In this way, the proceeds of the policy that B’s trust purchased from A’s trust are free from income tax and death tax.
In summary, in cases where the surviving business owner in a cross purchase buy-sell agreement wishes to keep the purchased interest free of death tax, consider having each life insurance trust be the owner of the policy instead of the individual business owner. In this way, the surviving business owner’s life insurance trust can purchase the interest of the deceased owner and thereby avoid death tax on the purchased interest. Also, through the use of a partnership, the policy on the surviving owner can be purchased in a manner that keeps the proceeds income tax free. This is a complex strategy that will not be appropriate in some cases. You should thus consult with your team of advisors to determine if it is a viable alternative to the traditional cross purchase arrangement in your case.
In the typical cross purchase buy-sell agreement, shareholder (or partner) “A” owns a life insurance policy on shareholder (or partner) “B.” When A dies, A’s estate sells A’s interest in the business to B. B can thus manage the entire business free of any involvement from A’s heirs. Also, unlike a redemption agreement where the entity owns the policy, B does receive a stepped up income tax basis for his purchase. Also, if B desires and has the cash, B can purchase the policy on his life that is owned by A’s estate for its cash value. So far, so good.