Mitigate the Tax Impact of the Death of an Owner/Shareholder

By Michael C. DeFillipo, CLU, ChFC 

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For many owners of closely held businesses, their largest asset – and the one that is perhaps most difficult to value – is their interest in their business. With the current estate tax exemption levels set to sunset at the end of 2025 (if not before), business owners and their CPAs may need to take appropriate steps in the tax and legacy planning process. A key factor to framing a solution is to first understand how the owner’s interest in the business will affect their overall net worth and potential estate tax exposure. 

A buy-sell agreement is critical to any business owner’s exit strategy. When properly drafted, this agreement between a business and its owners clearly outlines how a significant event (such as a partner’s death, disability, or retirement) affects the business and future management. The agreement also identifies each owner’s interest and establishes its fixed value. 

The general methods for determining the value of a business include a mutually agreed-upon value, fair market value (generally obtained via independent appraisal), or a predetermined formula. To meet IRS standards, business owners and their representatives should use a methodology that establishes a value no less than the fair market value to avoid triggering gift, estate, or generation-skipping taxes when transferring an interest.  

One of the most common triggering events – and the least predicable in terms of timing – is death. This makes life insurance a preferred funding mechanism for the transfer of business interests. Insurance premiums, paid either by the business or the other owners, are generally not tax deductible, but in most cases the life insurance death benefit proceeds are received tax-free in the form of cash upon the death of the insured. 

Further, permanent insurance allows for the build up of equity on a tax-preferred basis. Cash value, when properly structured, can be accessed in a tax-free manner. When the policy is owned by the business, the cash value is an asset on the balance sheet and can be used as collateral or for other business planning purposes. 

Cross-purchase – This is an agreement between owners (the business itself is not party to the agreement) to purchase the shares of a departed owner. An advantage is that the purchasing owners receive an increased cost basis in the acquired shares as a result of the purchase price paid to the departed owner. If the purchase price is equal to the value of the business at death, there is no income tax payable at death for the deceased owner.   

When using life insurance, each partner is the owner, payor, and beneficiary on a separate insurance policy for each other partner. With three or more owners/stockholders, a cross-purchase agreement may become overly complicated as multiple policies are necessary. For example, in a situation where there are six partners, 30 policies would be necessary. 

A business may use an insurance partnership to mitigate multiple policies. In this scenario, the shareholders in an S or C corporation transfer ownership interest to a trusteed limited liability company (insurance LLC) and fund the insurance LLC to pay the premiums. The insurance LLC is the owner, beneficiary, and payor of the life insurance owned on each LLC member. Surviving members acquire LLC interests with a stepped-up basis.  

Entity redemption – This is an agreement in which the business is required to purchase a departing owner’s shares. Each remaining shareholder will not receive a stepped-up basis for the purchased shares. However, the life insurance death benefit proceeds received by the S corporation may automatically increase the basis of each shareholder proportionate to his or her basis in the corporation. 

The primary advantage is that a limited number of life insurance policies is necessary. Since the business is the owner, payor, and beneficiary, only one policy on each owner/shareholder is necessary. Premiums paid by the company are generally nondeductible business expenses, but the equity in a cash-value permanent life insurance policy is an asset of the company, with several favorable tax attributes. 

Wait-and-see – This is an agreement where the business decides whether to purchase all or a portion of the departed owner’s interest. If the business decides not to purchase such interest, the remaining owners can choose to purchase it. If any business interest remains, the business is obligated to complete the purchase until 100% of the departed owner’s interest is transferred. 

While this structure offers more flexibility for the remaining owners/shareholders to select a desired buyer and amount of interest, it may lead to additional tax complications. Multiple decision points may delay or extend the transfer of interest to the remaining parties and the departed owner’s estate/heirs. The business may not know how to properly own the insurance due to the uncertain ultimate buy-sell structure, creating uncertainties regarding the source of future buy-out proceeds and related tax treatment.  

Each individual should consult his or her CPA and legal adviser regarding their specific situation. Any new or modified plan should be reviewed to meet standards at the time of implementation or modification.