Taxing Aspects of Life Insurance

Transcription

1 Taxing Aspects of Life Insurance Funded Buy-Sell Arrangements: Finding the Hidden Costs The Prudential Insurance Company of America 751 Broad Street, Newark, NJ Ed. 09/2009 1

2 Benefits of Buy-Sell Arrangement Enables business to be transferred by plan Prevents unwanted parties from acquiring an interest Creates a market for an owner s interest Helps avoid transfers that could negatively impact entity s formation or tax status Helps prevent disputes between heirs and survivors Relieves the heirs from the affairs of the business When funded with life insurance, helps provide estate liquidity, survivors income, or other family needs 2

3 Benefits of Buy-Sell Arrangement Provides a mechanism for determining a price. Fixes estate tax value as long as complies with IRC 2703 & case law developed around Treas. Reg : Agreement is binding during life and at death of owners, For a price that is determinable from the agreement, and Is not a testamentary device to transfer the business to members of decedent s family for less than adequate consideration. In family situations for agreements entered into (or substantially modified) on or after 10/08/1990, the terms are comparable to similar arrangements entered into by persons in arms-length transaction. (family owns more than 50% of 3 value)

4 Triple Tax Trap Family Buy-Sell Arrangements Problem: Below FMV arrangement in family business Estate tax at more than agreed price if arrangement fails to meet requirements to fix estate value Possible loss of marital deduction (PLRs , ) Taxable gift if fail to exercise the bargain option and if the option is exercised, there may be a taxable gift One Suggestion: Don t do a buy-sell in a family business. Pass business interest to family member(s) active in business and own insurance to provide income to the spouse and help equalize/compensate nonbusiness family members 4

5 Life Insurance Structure Structure is based on the form of buy-sell arrangement Cross purchase arrangement Surviving owners buy the departing owner s interest Individuals are policy owners, premium payers and beneficiaries Cash Business Interest Business Surviving Owner A B Insured A is Owner & Beneficiary Proceeds Premiums Insurer Departing Owner B A Insured B is Owner & Beneficiary 5

6 Life Insurance Structure Stock redemption/entity purchase/liquidation Business buys the departing owner s interest Business is policy owner, premium payer, and beneficiary Cash Business Business Interest Departing Owner B Business is Premiums Owner & Beneficiary B Insured A Insured Proceeds Surviving Owner A Insurer 6

7 Buy-Sell Tax Results Depend on form of business entity C corporation S corporation Partnership or limited liability company (LLC) Whether the agreement is: Cross purchase Redemption/entity/liquidation Role of life insurance in funding Let s start with the familiar... 7

8 C Corporation Buy-Sell Arrangements 8

9 C Corporation: Overview Tax Rules General Overview Corporate Taxation Entity concept of taxation. Corporation is treated as a taxable entity that is separate from its owners Separate corporate tax rates apply Subject to alternative minimum tax (AMT)(A qualifying small corporation is exempt from AMT) Subject to accumulated earnings tax on retained earnings in excess of reasonable business needs Double taxation: Transactions between owners and the entity are generally taxable events (dividend, ordinary income, or capital gains treatment) 9

10 C Corporation: Cross Purchase Cross Purchase Buy-Sell Arrangement General tax rule:sale of stock qualifies for sale/ exchange tax treatment Tax-free recovery of shareholder s basis (basis is allocated in proportion to the amount of stock sold) Capital gain/loss on balance Example: A & B are each 50% Shareholders. Each has 100 shares of stock with $100,000 basis. Assume B sells 50 shares of stock to A for $500,000. Result: Sale Price $500,000 Sold 50% of stock Minus Basis $50,000 Allocate 50% of basis B s Taxable Gain $450,000 10

11 C Corporation: Cross Purchase Tax consequence of stock sold by deceased shareholder Basis in deceased s stock adjusted to date-of-death value ( step-up ) Sale of stock by deceased: No tax if the amount received by the deceased is equal to basis (date of death value) Tax consequence of stockpurchased by surviving shareholder(s) Purchasing/surviving shareholder receives new basis in the stock purchased equal to the purchase price Purchasing shareholder acquires proportionate share of business earnings and profits (E &P) 11

12 C Corporation: Cross Purchase 50% Shareholder A 50% Shareholder B Business Value $1,000,000 $1,000,000 Stock Basis Before Death of Shareholder B $100,000 $100,000 Death Stock Basis $100,000 $1,000,000 ( step-up ) Life Insurance Proceeds Received by Shareholder A on B s life $1,000,000 Stock Basis After Insurance Proceeds $100,000 $1,000,000 Purchase of Shareholder B Stock at Date-of- Death Value Tax Results $1,000,000 No Tax Basis After Stock Purchase $1,100,000 Impact on E & P Acquires 12

13 C Corporation: Cross Purchase Life insurance considerations Multiple policies: Each shareholder is owner/beneficiary of a policy on the life of the other shareholder(s) Number of shareholders X (number of shareholders minus one) Premium payment: Paid by shareholders with after-tax nondeductible dollars Funding issues especially where disparity in age, health, and ownership interest in business Death proceeds: Generally received by the shareholder(s) income tax-free under IRC 101(a) and not subject to AMT Deceased is owner/beneficiary of policy(s) on life of the surviving business owner(s). Let s first explore a common issue... 13

14 Life Insurance Considerations Transfer-for-Value Transfer-for-Value Problem: If a policy, or an interest in a policy, is transferred for valuable consideration, a portion of the death proceeds will be taxed except where the transfer is to one of the exempt transferees Value broadly defined, cash not needed, reciprocal promise Change of beneficiary designation can trigger the rule Potentially applicable to any form of buy-sell but is more likely to occur in a corporate cross purchase arrangement. Examples: Restructure stock redemption to cross purchase Use existing coverage to fund cross purchase Acquire co-shareholder s policy from estate of decease shareholder 14

15 Life Insurance Considerations Transfer-for-Value Solution: Structure transfer to an exempt transferee: To insured, To a partner of the insured, To a partnership in which the insured is a partner, or To a corporation in which the insured is an officer or shareholder 15

16 Life Insurance Considerations Multiple Policies Multiple Policy Concerns: How can a cross purchase buy-sell be structured to avoid having multiple policies on each shareholder? Option #1: Trusteed Buy-Sell One Policy Per Shareholder Independent Trustee Holds shareholders stock Owner & beneficiary of policies on insureds: A, B, C ILIT Buy-Sell between shareholders Premiums Proceeds Insurer 45% Owner C 25% Owner A Dies 30% Owner B Problem:Transfer-for-value when there are more than 2 shareholders 16

17 Life Insurance Considerations Multiple Policies Transfer-for-Value Problem: In a trusteed buy-sell, this can occur at the death of a shareholder if the surviving owners acquire a greater interest in the remaining trust-owned policies. Solution:Structure the arrangement as a transfer to an exempt transferee under the transfer-for-value rule: Avoided where insured/shareholders are partners in a partnership/llc with each other or Use an LLC/partnership in place of a trust 17

18 Life Insurance Considerations Multiple Policies Option #2: LLC/Partnership Funded Cross Purchase Buy-Sell Independent Manager Holds stock & interest of LLC Owner & beneficiary of policies on insureds: A, B, C Cross purchase buy-sell between shareholders to purchase Corporation & LLC LLC capital account maintained using special allocation of premiums and death benefit LLC/Partnership Shareholders LLC and Corporation interest is same Premiums Proceeds 25% Owner A Dies Insurer 45% Owner C 30% Owner B Partnership must have a business purpose Premiums: Shareholders contribute their proportionate share, corporation makes taxable contribution to LLC on behalf of shareholders, corporation leases/rents property owned by LLC 18

19 Life Insurance Considerations Premium Payment Options Premium Payment Concerns: Business owners desire to deduct the premium expense Option #1 Defined Benefit Plan: Not recommended Structure: Shareholder A s plan is owner of policy on A with shareholder B as beneficiary (cannot have A s plan own policy on B) Issues: Transfer-for-value, potential estate inclusion of both death proceeds and business interest, need spousal waiver, insurance limited by incidental benefit rule, reduces retirement funds Option #2 Profit Sharing Plan: Possible but Structure: Shareholder A s plan is owner/beneficiary of policy on B, plan must permit purchase of insurance on another and in-service distributions. During life, A reports tax on economic benefit amount on B s policy. At B s death, A makes distribution of net death benefit Issues: Reduces retirement benefit, need spousal waiver, insurance limited to incidental benefit rule, complexity of rollout 19

20 Life Insurance Considerations Premium Payment Options Option #3: Section 79 Group Term Cross Purchase: Not recommended Structure: Shareholder A s plan is owner of policy on A with shareholder B as beneficiary Issues: Transfer-for-value, may not be eligible for Section 79 treatment Redemption: Not recommended Structure: Shareholder A s plan is owner of policy on A with business as beneficiary Issues: Deduction disallowed under IRC 264 because employer is beneficiary, may disqualify plan under some state law where there is a requirement that plan benefits employee 20

21 Life Insurance Considerations Premium Payment Options Desire to use business funds to help pay premium expense Option #1: Bonus/Section 162 Plan Structure: Business increases shareholder s income (compensation or dividend). Compensation is deductible to business and taxable to shareholder. Policy is controlled by the shareholder. Option #2: Split dollar Structure: Business advances nondeductible premium. Arrangement structured as either shareholder paying interest or economic benefit Considerations: Tax bracket, bonus favored if corporation is in higher bracket than shareholder, split dollar favored if business is in lower bracket Desire for simplicity, bonus favored Desire for business control, split dollar favored 21

22 Life Insurance Considerations Treatment of Survivor s Policy Survivor s Policy Concerns: Situation #1:Survivors often want to acquire policy on other surviving owner s life from the estate/departing owner to help fund increased buy-sell obligation B is Owner & Beneficiary C Insured A Insured Departing Owner B Surviving Owner A Problem: Transfer-for-value Surviving Owner C Solution: Structure the transfer as a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder 22

23 Life Insurance Considerations Treatment of Survivor s Policy Situation #2: Business owners often want the buy-sell agreement to give them the right to acquire policy on their life from the estate/departing owner Applicable to all buy-sell and business forms Incident of Ownership Issue: Does the insured s right to acquire policy on his/her life from policy owner cause the proceeds to be included in estate? Yes Rev. Rul Right to prevent cancellation by purchasing policy is an incident of ownership No PLRs , , Where right to acquire policy arises as a collateral consequence of acts of independent significance, there is no incident of ownership 23

24 Summary C Corporation: Cross Purchase Advantage Any amount of stock can be sold and qualify for capital gain tax treatment. Flexibility in allocating ownership. No AMT concerns and usually no IRC 101(j) issues Purchaser receives a new basis in the stock purchased Disadvantage Less ability to compel completion of the transaction Multiple policy management issues Premium payment structure issues and concerns What to do with policy (policies) owned by deceased on surviving owner s life (owners lives) 24

25 C Corporation: Stock Redemption Stock Redemption Arrangement General tax rule:irc 301, 302 Redemption of stock is taxed as a distribution Ordinary income to the extent of E&P Then tax-free to extent of shareholder s basis (total basis) Capital gain/loss on balance However, it is possible to have a redemption qualify for sale/exchange tax treatment Tax-free recovery of shareholder s basis (basis is allocated in proportion to the amount of stock sold) Capital gain/loss on balance 25

26 C Corporation: Stock Redemption Example: A & B are each 50% Shareholders. Each has 100 shares of stock with $100,000 basis. The corporation has E & P of $220,000. Assume the business redeems 50 shares of B s stock for $500,000. Result: Redemption Subject To: Distribution Treatment Sale/Exchange Treatment Amount Realized $500,000 $500,000 Ordinary Income (E& P) All E & P $110,000 N/A Minus Basis All Basis $100,000 $50,000 Taxable Gain/Loss $290,000 $450,000 Taxable Ordinary Income $110,000 0 In both situations corporate E & P is reduced 26

27 C Corporation: Stock Redemption Tax consequence of business redemption of stock to the deceased/redeeming shareholder Basis in deceased s stock adjusted to date-of-death value Redemption of stock result depends on whether: Tax asdistribution: Taxable to extent of corporate E & P Tax assale/exchange: No tax to extent the amount received is equal to the shareholder s stock basis 27

28 C Corporation: Stock Redemption Objective: In a C corporation with substantial E & P, typically want to qualify a redemption triggered by death as a sale/ exchange. Example: At 50% shareholder A s death, the business completely redeems his stock for $500,000 the value of his stock at his death. The business has E & P of $220,000. Redemption Subject To: Distribution Treatment Sale/Exchange Treatment Amount Realized $500,000 $500,000 Ordinary Income (E & P) $110,000 N/A Minus Basis $500,000 $500,000 Taxable Gain/Loss 0 0 Taxable Ordinary Income $110,000 0 How do you qualify for sale/exchange tax treatment? 28

29 C Corporation: Stock Redemption Three possible ways to get sale/exchange tax treatment Redemption not equivalent to a dividend Redemption that is substantially disproportionate Redemption in complete termination of a shareholder s entire interest PROBLEM Family attribution rule 29

30 C Corporation: Stock Redemption Family Attribution: A redeeming shareholder is deemed to constructively own the stock owned by: Spouse, children/grandchildren, parents Entity attribution rules (inbound/outbound) Attribution rules can prevent a redemption from qualifying as a complete termination of interest. And, in a family business, it may be difficult to meet the substantial disproportionate test. Result: Causes redemption to be taxed as a distribution subject to ordinary income to the extent of E &P The attribution rules can be waived undercertain conditions. 30

31 C Corporation: Stock Redemption IRC 303 Redemption Alternative route to sale/exchange treatment E & P reduced by proportionate stock redeemed (tax-free distribution of taxable E & P) Redemption limited to the amount of death taxes, interest, funeral and estate administrative expenses Stock must be included in the decedent s gross estate Value of the stock must exceed 35% of decedent s adjusted gross estate 31

32 C Corporation: Stock Redemption Tax consequence of business redemption of stock to the surviving shareholder No basis adjustment:surviving owner(s) does not receive new stock basis even though he/she has (they have) a larger interest Earning and profits (E& P) reduced 32

33 C Corporation: Stock Redemption 50% Shareholder A 50% Shareholder B Business Value $1,000,000 $1,000,000 Stock Basis Before Death of Shareholder B $100,000 $100,000 Death Stock Basis $100,000 $1,000,000 ( step-up ) Life Insurance Proceeds Received by Business Insurance Provides Funds. No Basis Impact. Stock Basis After Insurance Proceeds $100,000 $1,000,000 Redemption ofshareholder B Stock at Date-of-Death Value Tax Result Depends on Whether Redemption Taxed Is Sale/Exchange or Distribution Basis After Stock Purchase 100,000 Impact on E & P $1,000,000 No Tax -Taxable to Extent E & P Reduced 33

34 C Corporation: Stock Redemption Life insurance considerations Premium: Paid by the business and is not tax-deductible Do not have to manage multiple policies. Fewer concerns over disparity in premium payment. Death proceeds: AMTapplies, causing a portion of death benefit (and possibly cash value increase) to be subject to tax IRC 101(j)applies, causing death proceeds in excess of premiums paid to be subject to income tax except where employee notice and consent was acquired and certain safe harbor rules apply Questions regarding impact of the life insurance proceeds on the value of the business 34

35 Life Insurance Considerations Treatment of Life Insurance Proceeds Question #1:Will corporation s ownership of policy on the business owner s life cause the proceeds to be included in business owner s estate? Treas. Reg No Where proceeds are paid to corporation Yes In controlling shareholder (more than 50%) situation to the extent the proceeds are not payable to the corporation(i.e., business owner and spouse beneficiary) 35

36 Life Insurance Considerations Treatment of Life Insurance Proceeds Question #2: Will the proceeds received by business to fund a buy-sell be included in determining the estate value of the business? Estate of Blount Yes Tax Court Proceeds should be considered in value of business, but not necessarily on a dollar-for-dollar basis. Customary principles of valuation apply. But on appeal No 11 th Circuit Court of Appeal Insurance should not be included to determine estate value to suggest that a reasonably competent business person interested in acquiring a company would ignore liability defies any sensible construct of fair market value. 36

37 Life Insurance Considerations Treatment of Life Insurance Proceeds Question #3: How should life insurance proceeds received by a business be considered in determining value for a deceased owner s shares? Valuation treatment of life insurance should be addressed specifically in the buy-sell agreement. If the agreement is silent and proceeds are significant in relation to the value of the business, litigation may occur. Treatment #1: Proceeds are a funding vehicle and are not considered a separate non-operating corporate asset Treatment #2: Proceeds are treated as a corporate nonoperating asset and added to the value of the business 37

38 Summary C Corporation: Stock Redemption Advantage Fewer policies one per shareholder Business pays expense Policies are corporate assets Disadvantage Surviving owners do not get basis adjustment for stock Possibility of AMT and 101(j) taxation Possible impact of life insurance on business valuation Family attribution problem ordinary income tax to deceased shareholder to the extent of E & P is likely when other shareholders are family members 38

39 S Corporation Buy-Sell Arrangements 39

40 S Corporation: Buy-Sell Overview The need for a buy-sell may be more important S corporation status is available only to qualifying businesses Limited types of shareholders Limited number of shareholders S tax treatment can be revoked by vote of shareholder(s) owning more than 50% interest Voting and nonvoting counted Once S corporation election is terminated or revoked, it normally cannot be re-elected for 5 years Tax attributes of S corporation create opportunities and pitfalls that are significantly different from buy-sell arrangements in a C corporation 40

41 S Corporation: Overview of Tax Rules General Overview S Corporation Taxation Hybrid concept of taxation Treated as a separate tax entity for some purposes, such as filing of returns and determining income, and an aggregate for other purposes, such as passing income to owners Available only to qualifying small business corporations that actively elect to be taxed under Subchapter S rules S Corporation Generally no income tax some exceptions (i.e., built-in gain) Shareholders Taxed on their pro rata share of S Corporation s net earnings Potential for taxation on S Corporation distributions 41

42 S Corporation: Overview of Tax Rules Current Earnings of S Corporation Shareholders must be taxed on the pro rata share of the corporation s income, gain, deductions Shareholders are taxed even if earnings retained by business Losses are limited to a shareholder s adjusted basis Tax character of earnings generally passes to shareholders Generally taxed on a per-share, per-day basis (per diem). However, at the complete termination of a shareholder s interest, earnings can be allocated based on earnings to date of termination (short-year election) Undistributed earnings of an S corporation: Increase shareholders stock basis and, if taxable, impact S corporation s AAA (accumulated adjustment account ) 42

43 S Corporation: Overview of Tax Rules S Corporation Distribution Shareholders are taxed on actual distributions of property or cash, including redemption of S stock The tax character of an S distribution depends on: Source of distribution whether from AAA or E&P and Shareholder s adjusted basis in S stock 43

44 S Corporation: Overview of Tax Rules E & P:Undistributed C Corporate Earnings Earnings retained by C corporation that have not been taxed to the shareholders Generally taxed to shareholder when distributed Once business becomes an S corporation this account does not increase, but continues on the books until distributed Generally, a business that has always been an S corporation will not have E & P. Rather AAA: Undistributed S Corporate Earnings Earnings previously taxed to shareholders Generally not taxed when distributed to shareholders Value increase/decrease based on the activity of the business S corporation that was a C corporation can have both 44

45 S Corporation: Overview of Tax Rules Shareholder s basisand AAAof business move up and down based on activity of the business Basis Increase Taxable Income Taxable Income Tax-exempt Income AAA Decrease Losses or deductions Losses or deductions (other than associated with tax-exempt) Nondeductibleexpenses not changed to capital account Nontaxable return of capital Nondeductibleexpenses not changed to capital account (other than associated with taxexempt) Nontaxable return of capital 45

46 S Corporation: Overview Tax Rules Tax character of S distribution S Corporation with NoE & P Distribution Amount Tax Character Extent of basis Tax-Free Excess of basis Capital Gain S Corporation with E & P Distribution Amount Tax Character AAA (to extent of basis) Tax-Free Remaining AAA Capital Gain Extent of E & P Ordinary Income Remaining Basis (if any) Tax-Free Excess of Basis Capital Gain 46

47 S Corporation: Cross Purchase Cross Purchase Buy-Sell Arrangement Tax consequences of the stock sale and life insurance issues are similarto C corporation General tax rule: Sale of stock qualifies as a sale/ exchange: Tax-free recovery of shareholder s basis (basis is allocated in proportion to amount of individual s stock sold) Capital gain/loss on balance 47

48 S Corporation: Cross Purchase Tax consequence of stock sold by deceased shareholder Basis in deceased s stock adjusted to date-of-death value ( step-up ) Sale of stock by deceased: No tax if the amount received by the deceased is equal to date-of-death value Tax consequence of stockpurchased by surviving shareholder(s) Purchasing/surviving shareholder receives new basis in the stock purchased equal to the purchase price Purchasing shareholder acquires proportionate share of business AAA and E &P 48

49 S Corporation: Cross Purchase 50% Shareholder A 50% Shareholder B Business Value $1,000,000 $1,000,000 Stock Basis Before Death of Shareholder B (lifetime adjustments for retained earnings) $250,000 $250,000 Death Stock Basis $250,000 $1,000,000 ( step-up ) Life Insurance Proceeds Received by Shareholder A $1,000,000 Stock Basis After Insurance Proceeds $250,000 $1,000,000 Purchase of Shareholder B Stock at Date-of- Death Value Tax Results Basis After Stock Purchase $1,250,000 Impact on AAA and E & P Acquire $1,000,000 No Tax 49

50 S Corporation: Cross Purchase Life insurance considerations: Transfer-for-value, multiple policy management issues, premium payment structure issues, and concerns on how to handle policy (policies) owned by deceased on surviving owner s life (owners lives) Same concerns as a C corporation 50

51 Summary S Corporation: Cross Purchase Advantage Any amount of stock can be sold and qualify for capital gain tax treatment. Flexibility in allocating ownership. No IRC 101(j) issues Purchaser receives a new basis in the stock purchased Disadvantage Less ability to compel completion of the transaction Multiple policy management issues Premium payment structure issues and concerns What to do with policy(s) owned by deceased on surviving owner(s) life 51

52 S Corporation: Stock Redemption Stock Redemption Arrangement Results are different from a C corporation especially when funded with life insurance General tax rule: IRC 1368 Redemption of stock taxed as a distribution, the tax character depends on: Source of distribution whether from AAA or E&P and Shareholder s adjusted basis in S stock However, it is possible to have a redemption qualify for sale/exchange tax treatment Tax-free recovery of shareholder s basis Capital gain/loss on balance 52

53 S Corporation: Stock Redemption Tax consequence to the deceased/redeeming shareholder Basis in deceased s stock adjusted to date-of-death value Redemption of stock by business result depends on whether taxed under: General rule as a distribution S corporation has E & P S corporation has no E & P Or qualifies for sale/exchange treatment Recall, in a C corporation redemption Objective -qualify for sale/exchange treatment to avoid tax on E & P Problem - family attribution rule prevented the qualification What happens in an S corporation when the family attribution rules cause a redemption to be taxed as a distribution? 53

54 S Corporation: Stock Redemption Scenario I: Distribution in S Corporation with E & P Distribution Amount AAA (to extent of basis) Remaining AAA Extent E & P Remaining Basis(if any) Excess of Basis Tax-Free Capital Gain Ordinary Income Tax-Free Capital Gain Tax Character Issues for an S corporation with E & P are the same as C corporation (i.e., taxation of E & P, family attribution) However, where the S corporation has no E & P... 54

55 S Corporation: Stock Redemption Scenario II: Distribution in S Corporation with No E & P Distribution Amount Tax Character Extent of Basis Excess of Basis Tax-Free Capital Gain At death, distributiontreatment for redeeming shareholder where there is no E & P is the same as sale/exchange treatment. No problem with family shareholders. The attribution rules are not a concern. 55

56 S Corporation: Stock Redemption Tax consequence to the surviving shareholder Life insurance Premium: Paid by the business, is not tax-deductible Shareholders have tax burden in proportion to stock ownership Because the payment is a nondeductible expense, shareholders stock basis decreases. Generally, the basis decrease is in proportion to stock ownership. Premium payment does not impact AAA Death proceeds: IRC 101(j) applies AMT does not apply Proceeds do not impact AAA Proceeds increase the shareholders stock basis. The interaction between basis and life insurance proceeds is one of the selling points of using life insurance 56

57 S Corporation: Stock Redemption Tax consequence to the surviving shareholder (cont.) Redemption of stock by business Business AAA and E & P is reduced based on whether the redemption qualifies for sale/exchange treatment or is taxed as a distribution Basis Adjustment: The redemption of stock does not by itself increase owners basis It s the life insurance proceeds received by the business that will increase the basis of the shareholder s (shareholders ) stock The amount of basis adjustment will depend on whether the business is using per diem or has made a short-year election Let s take a closer look at the interaction of life insurance in a redemption... 57

58 S Corporation: Stock Redemption Example: Assumes per diem allocation of earnings, June 30 redemption of B s stock, $1 million proceeds 50% Shareholder A 50% Shareholder B Business Value $1,000,000 $1,000,000 Stock Basis Before Death of Shareholder B $250,000 $250,000 Death Stock Basis $250,000 $1,000,000 ( step-up ) Life Insurance Proceeds Receivedby Business $750,000 $250,000 Stock Basis After Insurance Proceeds $1,000,000 $1,250,000 Insurance proceeds received by the S corporation increase shareholders basis, partially eliminating lack of basis adjustment in a stock redemption 58

59 S Corporation: Stock Redemption Short -Year election (IRC 1377) Works only with cash basis S corporations Deceased shareholder s stock is redeemed for a note leaving only the surviving shareholders as owners The tax year is closed pursuant to valid short-year election Death proceeds are received by the S corporation increasing only the surviving shareholders basis The life insurance is used to pay off the note 59

60 S Corporation: Stock Redemption Example: Assumes short-year election, June 30 redemption of B s stock, $1 million proceeds 50% Shareholder A 50% Shareholder B Business Value $1,000,000 $1,000,000 Stock Basis Before Death of Shareholder B $250,000 $250,000 Death Stock Basis $250,000 $1,000,000 ( step-up ) Life Insurance Proceeds Receivedby Business $1,000,000 Stock Basis After Insurance Proceeds $1,250,000 $1,000,000 The combination of life insurance funding and shortyear election permits the surviving shareholders to receive a full basis increase 60

61 Summary S Corporation: Stock Redemption Advantages Fewer policies one per shareholder Business pays expense Policies are corporate assets No AMT Life insurance funding provides surviving owners some basis adjustment Disadvantages Possibility of 101(j) taxation Possible impact of life insurance on business valuation Family attribution problem where S corporation has E & P ordinary income tax to deceased shareholder 61

62 Partnership Buy-Sell Arrangements 62

63 Partnership: Buy-Sell Overview Tax attributes of partnerships create opportunities and pitfalls that are significantly different from buysell arrangements in C and S corporations. In a partnership, the differencesbetween entity and cross purchase approaches are not as distinct as they are with corporations Entity/liquidation approach may be more complex but offers more opportunities for negotiation Theinteraction between basis and life insurance proceeds is one of the selling points of using life insurance as a funding vehicle 63

64 Partnership: Overview Tax Rules General Overview of Partnership Taxation Greater Flexibility. Terms of the partnership agreement control or affect many aspects of partnership taxation. Hybrid concept of taxation. The entity and aggregate principles are very intertwined in partnership taxation. Partnership Incurs no federal income tax. No business entity serves so completely as a conduit. Partners Taxed on their distributive share of partnership operations Taxed on tax-significant activities of the partnership 64

65 Partnership: Overview Tax Rules Partner s Distributive Share Partners are taxedon their distributive share of the partnership s income, gain, deductions, losses Partner is taxed even if earnings retained by the business Losses are limited to partner s adjusted basis Tax character of earnings generally passes to partners Unlike S corporation, allocations do not have to be pro rata. The partnership s operating agreement determines the allocation but for special allocations to be respected they must have substantial economic effect. For special allocations to be respected, the economic effect must follow the tax allocation Capital account isestablished to make sure the amount reported by partners for tax purpose reflects the economics 65

66 Partnership: Overview Tax Rules Partner s Capital Account For special allocations to be respected: Capital accounts must be maintained Generally, liquidation/redemption distributions must be in accordance with the capital account Partner must make up any deficit in the capital account Plays a fundamental role in determining tax amount reported by partners Represents partner s equity in the partnership. Tracks partner s allocation of income and losses, contributions, and distributions. (Measured using FMV) It is separate and district from a partner s basis 66

67 Partnership: Overview Tax Rules Partner s and Partnership s Basis & Adjustments Partner s basis in a partnership interest (outside basis) Partner s basis in partnership interest is equal to money and adjusted basis of property contributed. Contributed property subject to liability: Partner s basis is reduced by liability assumed by other partners Adjusted annually: Increase Decrease Distributive share of taxable and tax-exempt partnership income Share of partnership liability assumed by partner Additional contributions Share of partner s liability assumed by partnership Distributions of money and adjusted basis of property Share of nondeductible expenses not charged to the capital account Share of partnership losses 67

68 Partnership: Overview Tax Rules Partner s basis is determined at end of partnership s tax year except in year of sale or complete liquidation Partnership s basis (inside basis) Partnership s basis in contributed property is generally equal to the partner s basis at the time of contribution (i.e., carryover basis) Partnership s basis in property purchased from an unrelated third party is generally its cost basis Generally, partnership s inside basis in property is not adjusted even when a distribution or sale results in a partner recognizing gain/loss. Result: Tax timing and character distortion when gain/loss is recognized by a departing partner Section 754 election provides partnership an inside basis adjustment 68

69 Partnership: Overview Tax Rules Section 754 Election Allows partnership to make an optional irrevocable election to adjust the inside basis of partnership property Once made, it applies to all subsequent tax years Applies to entity purchase/liquidations and cross purchase Tax provisions are in IRC 734 (lifetime) and IRC 743 (death). Different rules with different effects. Where a Section 754 election is in place: If gain is recognized by the departing owner, the basis of the partnership s capital assets are adjusted upwards If loss is recognized by the departing owner the basis of the partnership s capital assets are adjusted down Section 754 adjustments go both ways 69

70 Partnership: Overview Tax Rules Tax year when an owner sales/liquidates entire interest Partner stax year ends if sells or liquidates entire interest Partnership stax year does not end except in a technical termination (sale of at least 50% in 12 mo.) The departing partner will be taxed on his/her share of partnership s income, gain, loss either by: Closing the books on the date of the sale and allocating income or Keeping the books open and making allocation of income/loss based on the number of days in the year the seller owned the partnership interest Buy-sell negotiation point 70

71 Partnership: Cross Purchase Cross Purchase Buy-Sell Arrangement Tax results differ significantly from the stock sale in a corporation (C or S) General tax rule: IRC 741 Treated as a sale/exchange of partnership interest Tax-free recovery of shareholder s outside basis Capital gain/loss on balance Except hot assets taxed as ordinary income/loss(section 751(a) property). 71

72 Partnership: Cross Purchase Tax consequence of deceased/selling partner Distributive share of partnership profit/loss is reported Basis in deceased s partnership interest is adjusted to date of death value Sale of partnership interest: No tax if the amount received by the deceased is equal to date-of-death value (partner s outside basis) Saleattributed to hot assets: IRC 751(a) results in ordinary income/loss (if seller is an estate treated as IRD assets). Hot assets include: Inventory (Note: broader inclusion than in a liquidation) Unrealized receivables: Generally, amount due for goods and services rendered that have not been included in income 72

73 Partnership: Cross Purchase Tax consequence purchasing/surviving partner(s) Purchasing/surviving partners outside basis is adjusted to equal the purchase price plus share of partnership liabilities allocable to the interest being acquired Hot assets: Partnership gets an income tax deduction for value paid to offset income it will recognize on collection Goodwill: No special treatment regardless of agreement, capital gain not deductible Insidebasisof the assets retained by the partnership: generally no impact Except where there is a Section 754 election in effect Inside basis adjustments will only affect the purchasing partners 73

74 Partnership: Cross Purchase Life insurance considerations: Multiple policy management issue and premium payment structure issue are easier to address: Transfer-for-value not as much of a issue because of the partner, partnership exceptions Multiple policy management issue can be addressed using the trusteed arrangement by making the trust a partner in the partnership Premium payment: More distribution flexibility than a corporation. Use of guaranteed payments to gain partnership deduction. 74

75 Summary Partnership: Cross Purchase Advantage Flexibility in allocating ownership. No IRC 101(j) issues Purchaser receives a new basis in the stock purchased Disadvantage Likely that part of the payment received by the departing partner will be ordinary income (similar to entity purchase) Less flexibility to negotiate terms with different tax results Less ability to compel completion of the transaction Multiple policy management issues Premium payment structure issues and concerns What to do with policy (policies) owned by deceased on surviving owner s life (owners lives) 75

76 Partnership: Entity Purchase Entity Purchase/Liquidation Payment made by a partnership to purchase a partner s entire interest is usually called a liquidation Tax results differ significantly from a stock redemption in a C or S corporation General tax rule: IRC 736 Payments are divided into the following categories: Partnership property Hot assets Goodwill Other property (IRC 736(a) property) 76

77 Partnership: Entity Purchase Tax consequences of deceased/withdrawing partner Partner s outside basis is adjusted to date-of-death value Payments attributed to partnership property : real estate, building equipment, inventory Taxed as distributions by the partnership Tax-free up to a partner s outside basis with excess treated as a capital gain/loss Carryover basis taken in any property distributed Result: No tax if the amount received by deceased is equal to date-of-death value. Note: Recognition of gain/loss is deferred until property received is sold or receive cash/marketable securities in excess of partner s outside basis. 77

78 Partnership: Entity Purchase Tax consequences of deceased/withdrawingpartner (cont.) Payments attributed to hot assetsirc 751(b):generally results inordinary income/loss Purpose is to prevent partners from shifting ordinary income among themselves. (Does not apply to pro rata distributions, normal distribution rules apply, capital gain) Hot assets include: Substantially appreciated inventory: Inventory where the fair market value exceeds 120% of its adjusted basis Unrealized receivables: Generally, amount due for goods and services rendered that have not been included in income Payments for hot assets cannot be reported on installment. 78

79 Partnership: Entity Purchase Tax consequences of deceased/withdrawingpartner (cont.) Goodwill: Capital intensive partnership: Normal distribution rules apply, generally capital gain Noncapital intensive partnerships Stated price: Normal distribution rules, generally capital gain Unstated goodwill: Taxable as ordinary income Buy-sell negotiation point: Where not stated, purchaser may be willing to pay more because buyer will get a deduction Other Property: Distributive share of partnership s income and guaranteed payments taxable as ordinary income Guaranteed payments are payments made to partners without regard to the income of the partnership (i.e., salary) 79

80 Partnership: Entity Purchase Tax consequence to the surviving partner(s) Life insurance Premium expense: Special allocations charged to the partners who will benefit from the death proceeds Lowersthe outside basis andcapital accounts of the partners to whom the expense is allocated Tax burden will be assessed against the partners to whom the expense is allocated Death proceeds: IRC 101(j) applies AMT does not apply Increases theoutside basis andcapital accounts of the partners who were allocated the costsunder special allocations 80

81 Partnership: Entity Purchase Tax consequence to the surviving partner(s) Generally no gain/loss is recognized by the partnership on the distribution of partnership property Outside basis in survivors partnership interest is not adjusted by the distribution. However, the life insurance proceeds allocated to the surviving partners will cause an increase (possibly the same as a cross purchase) as long as special allocation rules have been followed. Insidebasisof the assets retained by the partnership: generally no impact Except where there is a Section 754 election in effect Inside basis adjustments will affect all the surviving partners 81

82 Partnership: Entity Purchase Tax consequence to the surviving partner(s) (Cont.) Goodwill: Noncapital intensive partnerships where the payment for goodwill is not stated: Partnership gets a tax deduction Other situations: Not deductible Buy-sell negotiation point: Where not stated, purchaser may be willing to pay more because buyer will get a deduction Other property: Guaranteed payments: Generally deductibleby the partnership Distributive share: Reduces income passing to survivors 82

83 Life Insurance Considerations Treatment of Life Insurance Proceeds Will a partnership s ownership of policy on a partner s life, where the partnership is the beneficiary, cause the proceeds to be included in the partner s estate? Why the confusion? Rulings from the IRS have not used a consistent analysis, switching between entity and aggregate theories. No Entity approach analogous to corporate context where business is owner and beneficiary. Partners have no rights in the policy. The value of the policy is reflected in the business value. Note: The proceeds may be included in a partner s estate if the policy is owned by the business and the beneficiary is not the business but instead is a third party. 83

84 Life Insurance Considerations Treatment of Life Insurance Proceeds Yes Aggregate approach partner is an agent of the partnership and his/her acts bind the partnership. Partner has incident of ownership. Suggested structure? Valid partnership with business purpose and activity Danger if insurance is the only asset in the partnership Provision in partnership agreement prohibiting an insured from participating in any decision involving life insurance on such partner s life 84

85 Summary Partnership: Entity Purchase Advantage Fewer policies one per shareholder Business pays expense No AMT No family attribution problem Flexibility to negotiate terms with different tax results Life insurance funding can provide surviving owners outside basis adjustment as long as special allocation rules followed Disadvantage Possibility 101(j) taxation Possible impact of life insurance on business valuation 85

86 Disclosure This presentation is designed to provide general information to licensed financial representatives and clients advisors in regard to the subject matter covered. It should be used with the understanding that we are not rendering legal, accounting or tax advice. Such services should be provided by the client s advisors. Accordingly, any information in this document cannot be used by any taxpayer for purposes of avoiding penalties under the Internal Revenue Code. 86

87 Disclosure Insurance is issued by The Prudential Insurance Company of America, Newark, NJ, and its affiliates. All are Prudential Financial companies. Each is solely responsible for its own financial condition and contractual obligations. Our policies contain exclusions, limitations, reductions of benefits, and terms for keeping them in force. A licensed financial professional can provide you with costs and complete details. 87

88 Disclosure Insurance and Security Products: Not Insured by FDIC or Any Federal Government Agency. May Lose Value. Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate. Prudential, Prudential Financial, the Rock logo, and the Rock Prudential logo are registered service marks of The Prudential Insurance Company of America and its affiliates. The Prudential Insurance Company of America 751 Broad Street, Newark, NJ Ed. 09/09 88