life insurance
Lifesaver in water

By Michael Geeraerts

Small business owners should have buy-sell agreements that cover various scenarios regarding the succession of their businesses. A common triggering event for buyouts in buy-sell agreements is the death of an owner. Most buy-sell agreements should also have other triggering events for a buyout, but death is in nearly all agreements. For businesses with three or less owners, a cross purchase arrangement is common, where the surviving owners agree to purchase a deceased owner’s business interest. Of course, the surviving owners have to come up with the cash to purchase the deceased owner’s interest, which could be valued at $100,000, $1,000,000, or more. Business owners often purchase life insurance on their co-owners lives to fund the cross purchase arrangement. This is a sound planning strategy, as having a buy-sell agreement is a good thing, but having a funded buy-sell agreement is a much better one.

The issue (which is not really a bad thing) is when the owners do not die. A common occurrence is for the business owners to “swap” the policies. For example, Ann and Barbara are in business together and have a cross purchase buy-sell agreement. Ann owns a whole life insurance policy insuring Barbara’s life and Barbara owns a whole life insurance policy insuring Ann’s life. When Ann and Barbara exchange policies so that each own the policy insuring their own lives, there are some income tax issues to address.

Swapping Policies

While life insurance is afforded favorable income taxation, many people do not realize that this does not carry over to the “swapping” of policies. First of all, this is not a tax-free exchange of life insurance policies under IRC § 1035. Second, this is not likely to be classified as a gift under IRC § 102(a) because the exchange is taking place in a business context, not out of “detached and disinterested generosity.” It is a taxable exchange under IRC § 1001(a), which states that “The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis . . . .” In calculating the gain or loss on the exchange, one must look at the value of the policy received in the exchange compared to the basis in the policy being given up in the exchange.

Before calculating the gain or loss upon a “swap” of policies, there are some preliminary questions to answer. First, what is a life insurance policy’s fair market value for tax purposes? It is often assumed that a policy’s fair market value is equal to its cash value. However, that may not be the case. In the context of a business transaction, the Internal Revenue Service (IRS) provided safe harbor formulas for determining a policy’s fair market value in Revenue Procedure 2005-25, which states that “the fair market value of an insurance contract . . . may be measured as the greater of: A) the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, and B) the product of the PERC amount . . . and the applicable Average Surrender Factor.”

However, other factors may impact the valuation of a life insurance policy and the overriding theme when valuing a life insurance policy, or any property, is that “the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Policy owners should obtain the fair market value of their policies from the issuing insurance company, an appraisal company, the secondary market, or other sources, and consult with their tax advisor. For purposes of the examples in this article, it is assumed that the policy owners have established the policies’ fair market values.

Policy Owner’s Basis

A second question is, what is the policy owner’s basis in the life insurance contract? As a general rule, a policy owner’s basis will be equal to the cumulative premiums paid; however, there are various transactions (e.g., withdrawals and dividends taken in cash) that can impact a policy owner’s basis. As the “swapping” of policies is a taxable exchange (akin to a sale), Revenue Ruling 2009-13 must be reviewed to determine the policy owners’ respective bases in their policies. Under Revenue Ruling 2009-13, a policy owner who sells a life insurance policy must reduce his or her basis for the cost-of-insurance charges. If a policy owner paid $70,000 in total cumulative premiums, but the cost-of-insurance charges were $10,000, the policy owner’s basis for purposes of determining gain or loss on a sale is $60,000. Note that under Revenue Ruling 2009-13, the cost-of-insurance charges do not reduce a policy owner’s basis when determining the gain or loss on a surrender of the contract. The examples in Revenue Ruling 2009-13 dealt with the sale of a policy by the insured, but presumably the cost-of-insurance basis reduction would also apply to a policy owner other than the insured. For purposes of the examples in this article, it is assumed that the policy owners have made all appropriate adjustments to their bases in their policies.

Examples of “Swapping” Policies

Let’s assume that the policy Ann owns on Barbara’s life has a fair market value of $100,000 and Ann has a $75,000 basis in that policy, and the policy Barbara owns on Ann’s life has a fair market value of $80,000 and Barbara has a $65,000 basis in that policy.

Ann Owns Policy on Barbara         Barbara Owns Policy on Ann

FMV $100,000                                 FMV $80,000

Basis $75,000                                   Basis $65,000

 

The income taxation of the policy “swap” is as follows:

Taxation for Ann

FMV of policy Ann receives (policy insuring Ann’s life)            $80,000

Basis in policy Ann gives up (policy insuring Barbara’s life)    $75,000

Gain                                                                                                      $5,000

 

Taxation for Barbara

FMV of policy Barbara receives (policy insuring Barbara’s life)  $100,000

Basis in policy Barbara gives up (policy insuring Ann’s life)        $65,000

Gain                                                                                                          $35,000

 

After the exchange, Ann’s basis in the policy insuring her life is $80,000. Barbara’s basis in the policy insuring her life is $100,000.

Since the policy insuring Barbara’s life has a higher fair market value, Ann and Barbra may agree that the exchange is not equal and that Barbara should pay Ann the difference between the two policies’ fair market values. If Barbara were to pay Ann $20,000 to “equalize” the exchange, the taxation would be as follows:

Taxation for Ann who receives $20,000 of additional cash

FMV of policy Ann receives (policy insuring Ann’s life)        $80,000

Cash received                                                                                  $20,000

Basis in policy Ann gives up (policy insuring Barbara’s life)$75,000

Gain                                                                                                  $25,000

Taxation for Barbara who pays $20,000 of additional cash

FMV of policy Barbra receives (policy insuring Barbara’s life)   $100,000

Cash paid                                                                                                $20,000

Basis in policy Barbara gives up (policy insuring Ann’s life)      $65,000

Gain                                                                                                        $15,000

After the exchange, Ann’s basis in the policy insuring her life is $80,000. Barbara’s basis in the policy insuring her life is $100,000.

Note that while this is a transfer for valuable consideration under IRC § 101(a)(2), the policies are being transferred to the respective insureds, which is an exception to the transfer for value rule under IRC § 101(a)(2)(B); therefore, the entire death benefit would remain income tax-free (assuming no future transfer for value of the policies).

Are there options to avoid this income taxation upon “swapping” policies?

If Ann and Barbara plan ahead when establishing their cross purchase arrangement, they can possibly time the “swap” of the policies so that there is no gain recognized. If they know when the policies’ fair market values (FMV) and bases will “equalize,” then no gain will be recognized. For example, Ann and Barbara know when the policies’ numbers will “equalize” based on the policy illustrations and discussions with their insurance advisor.

Ann Owns Policy on Barbara           Barbara Owns Policy on Ann

FMV $40,000                                      FMV  $30,000

Basis $30,000                                     Basis  $40,000

The income taxation of the policy “swap” is as follows:

Taxation for Ann

FMV of policy Ann receives (policy insuring Ann’s life)          $30,000

Basis in policy Ann gives up (policy insuring Barbara’s life)  $30,000

Gain                                                                                                    $0

Taxation for Barbara

FMV of policy Barbara receives (policy insuring Barbara’s life)      $40,000

Basis in policy Barbara gives up (policy insuring Ann’s life)            $40,000

Gain                                                                                                              $0

However, this strategy requires very close monitoring of the policies’ fair market values and each policy owners’ basis in the policies. In reality, it would be difficult to perfectly time the “swap” so that there is no gain recognized, although the gain recognition can probably be minimized by timing the “swap” fairly well. The other problem with this strategy is that if the policies are still needed to fund the cross purchase arrangement, it is probably not a good idea to “swap” them until the insurance funding is no longer needed.

Using the Partnership

Another possibility is to use a partnership (or limited liability company taxed as a partnership) to own the life insurance policies. Under partnership tax rules, a distribution from the partnership to the partners would not result in an immediate taxable event and the partners would have a transferred basis in the policy equal to the partnership’s basis in the policy. However, under partnership tax rules, nondeductible expenses that do not result in creating an asset on the partnership’s books reduce the partners’ bases in their partnership interests.[4] What this means for a whole life insurance policy owned by a partnership is that each year’s premium that is in excess of each year’s increase in the policy’s cash value reduces the partners’ bases in their partnership interests (according to the partners’ allocations). Further, when a partner receives a distribution of property from a partnership (e.g., a liquidating distribution), the partner’s transferred basis in the property received cannot exceed the partner’s basis in his or her partnership interest. Therefore, the reduction of a partner’s basis due to the nondeductible life insurance premiums could result in the partner taking a reduced basis in the policy after the policy is distributed.

For example, assume that Ann and Barbara formed a partnership to own the life insurance policies that are funding their cross-purchase agreement. For purposes of the example and to highlight the point, assume the partnership has no other assets, income, or expenses other than the two whole life insurance policies – one on Ann’s life and one on Barbara’s life.[6] After 15 years of being in business together, and having a funded buy-sell agreement, Ann and Barbara are selling their business to a third-party and they wish to distribute the life insurance policies that are owned inside of their partnership to be owned by themselves personally. Assume that after 15 years the partnership’s basis in Ann’s and Barbara’s policy is $300,000 and $150,000, respectively. However, due to the nondeductible life insurance premiums paid over the years that reduced Ann’s and Barbara’s basis in their partnership interests, assume that Ann’s and Barbara’s basis in their partnership interest is $165,000 and $100,000, respectively. Despite the partnership having a basis of $300,000 in the policy insuring Ann, when she receives the policy from the partnership, her basis in the policy will be $165,000. When Barbara receives her policy from the partnership, her basis in the policy will be $100,000, despite the partnership’s basis before the distribution being $150,000. There is no gain or loss recognized on the distribution from the partnership, which may be a better result than “swapping” cross owned policies, but it is possible that Ann and Barbara will lose some basis in the policies upon the eventual distribution of the policies from the partnership. Therefore, when possible, it is a good idea to use high, early cash value policies when using a partnership to own the life insurance policies for buy-sell funding because that will minimize the loss of policy basis upon a distribution.

 

Trade-offs

There are trade-offs to each type of policy ownership arrangement. Business owners are in a better position with funded buy-sell agreements so that a buyout of a deceased owner’s interest can take place in a timely and effective manner. Business owners should understand the tax implications of each type of arrangement and what happens if and when that arrangement needs to be unwound. As many business owners who have funded buy-sell agreements will not die and will want to take the life insurance policy insuring their life with them upon exiting the business, they should understand what, if any, tax implications may arise upon the unwinding of the business and the life insurance policy ownership arrangement.

Michael Geeraerts, CPA, JD, CLU, CGMA, is an advanced markets consultant at The Guardian Life Insurance Company of America, where he works with advisors on estate, business and overall tax planning. Guardian, its subsidiaries, agents and employees do not provide tax, legal or accounting advice. Consult your tax, legal or accounting professional regarding your individual situation. For more information, visit Guardian’s website, Facebook page, and Twitter: @GuardianLife.