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A Life Insurance-Funded Redemption Agreement Gone Bad

Oct 22, 2024 | Business Planning, General Estate Planning, IRS / Tax Guidance, Podcasts

“A Life Insurance-Funded Redemption Agreement Gone Bad,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

Case Overview: Connolly v. United States

This is Margaret Van Houten, ACTEC Fellow from West Des Moines, Iowa.

The U.S. Supreme Court issued a ruling in Connolly v. United States in June of this year. The Supreme Court held that more than one million dollars of estate tax was due relating to stock redemption by a shareholder that was funded by life insurance.

ACTEC Fellow Steve Gorin from St. Louis, Missouri explains the risk of any such redemption agreement in a family-controlled business and how to do a life insurance-funded cross-purchase agreement as the Supreme Court suggested.

Welcome, Steve. Thank you, Margaret. It’s a pleasure to be here and talk about this important case.

Explanation of the Connolly Case

Steve Gorin: In Connolly, we had a life insurance that got paid to a corporation. The corporation used the life insurance to buy out the deceased shareholder and the buy-sell agreement basically set the amount equal to a fixed price and that price was a bargain. It actually isn’t quite as simple as that, there were a lot of flaws in the way the case went.

A lot of people may dismiss this as a bad facts case, that they didn’t follow the agreement quite correctly, and the agreement violated Internal Revenue Code Section 2703. The ramifications of violating 2703 is to ignore the buy-sell agreement, and then you need to value the company based on the true value. And so, the question is: is the life insurance the business receives included in the business’s value?

Ramifications of Violating 2703

So the Supreme Court held, yeah, it’s an asset of the business, so it’s got to be included in the business’s value. It overruled essentially a holding in another case called Blount which is the 11th Circuit opinion- it indirectly overruled that. So there’s a big risk here when you have life insurance payable to a company that is redeeming the deceased shareholder if you might violate Code Section 2703.

It would be much safer not to have that life insurance go into the company for the redemption. Now some people will say- before I go into this idea of the safer alternatives- some people might say, “Well, IF the buy-sell had been implemented correctly and they dotted all their I’s and crossed all their T’s, proved all these different prongs, then they could have won the 2703 argument and a redemption would have been okay.”

The Risk of Life Insurance-Funded Redemption Agreements

And the answer is, well, theoretically, yes. But, I did another podcast called Huffman Case Endangers Buy-Sell Agreements in which I explained that any time you have a buy-sell agreement that’s governed by a Code Section 2703- which is basically when you have one or more family members who have a majority of the equity interest in the company- then you have a risk that the IRS will say that your buy-sell agreement is not comparable to what unrelated third parties are doing and therefore we don’t need 2703 and we get to disregard it.

And no matter how well you document it, the IRS could say, “I don’t agree that it was comparable,” because that’s a case of proving the evidence, and Huffman was lost because the taxpayer was not able to prove by evidence sufficient to the court to persuade it that the agreement was comparable. So no matter how good you are, you have a potential litigation risk, and when you have a redemption agreement, you’re handing this risk to the IRS, go and argue with me about comparability.

Safer Alternatives: Cross-Purchase Agreements

Now, anytime you have a buy-sell, you’re going to have the risk. The thing is that by having the life insurance paid to the company, you are compounding that risk that the life insurance would be included in the company’s value. If you have the life insurance payable to the other business owners, then the life insurance is not an asset of the business and then you don’t have the risk that the life insurance is going to get added to the business’s value. This is what we mean by a cross-purchase is when the other owners of the business separately hold the life insurance and then they are required by the buy-sell agreement to take that life insurance and use it to buy out for cash the deceased owner’s interest.

And the Supreme Court in fact said, “Hey, you could have avoided this problem using the cross-purchase. You wouldn’t have had the life insurance counted as an asset.” Of course, the Supreme Court also recognizes that there were some potential drawbacks to a cross-purchase as well. I’m going to mention for a minute some of those drawbacks.

Drawbacks of Cross-Purchase Agreements

Suppose you have owners A, B, and C and then you’re going to have a policy on A.. We’re going to keep it simple just one owner at a time. So B and C have a policy on A. So what happens if C leaves the business and D comes in? Well, is D going to be able to get a new policy on A? Or is C going to sell the policy to D? If C sells the policy to D, there might be tax consequences to that sale.

Also, when you have a transfer of life insurance policy, you may have something called the transfer for value rule. If you violate that rule, the death benefit is subject to income tax. Normally life insurance death benefit is not, but if you violate that rule, then it may be subject to income tax. So you’ve got to watch out for the possible need to buy a new policy, the possible income tax on the sale of the policy, and the transfer for value rule.

Solution: Life Insurance LLC

One way to centralize all of this is to have a life insurance LLC that holds the policies. B and C, in my example, would own a life insurance LLC on A, and then the life insurance LLC would receive the death benefit. I would have an independent manager in there to receive the proceeds and make sure that B and C don’t do anything wrong with it. You make A’s beneficiary B, a third-party contractual beneficiary to the LLC operating agreement, just for purposes of making sure that the use in the buy sale doesn’t get jeopardized. Then, having the life insurance LLC, you have the centralization. You have an independent party involved. You have protection to A’s family. And, if C leaves, all you need to do is bring in D as a new member of the LLC. You’re not transferring the life insurance to anyone. You’re simply having partners coming and going from the life insurance LLC, and so you have minimal tax consequences.

I would encourage people to avoid a redemption that’s funded by life insurance. Instead, have it be a cross-purchase and consider using a life insurance LLC to help with any of the rough edges of a cross-purchase. I hope this has been helpful and look forward to future contact with you.

Margaret Van Houten: Thank you, Steve, for your excellent explanation of this decision, particularly how we can deal with its repercussions.

Additional Resources

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