Question: When discussing the pros and cons of using a life insurance funded cross purchase buy-sell agreement, I keep hearing the admonition that with multiple owner plans it is important to avoid the application of the transfer-for-value rule. Can you be more specific as to how and when this rule becomes a concern in this planning scenario?

Answer: Most certainly. But let’s start with a quick review of how the transfer-for-value rule works and why it’s application can be so detrimental to any buy-sell planning situation.

Life insurance proceeds are generally excluded from the income of the beneficiary, even if the policy is used to fund a buy-sell agreement and even if the buyer uses the proceeds to complete the buy-out.

However, IRC §101(a) provides that all or part of the death benefit proceeds under a policy transferred for valuable consideration will be taxed as ordinary income, unless the transfer falls within an exception to this general rule. Life insurance policies transferred for valuable consideration are generally income taxable to the extent that the policy proceeds exceed the policy owner’s basis.

Consideration is defined broadly, and does not need to be cash or property. A mutual or reciprocal promise can trigger the transfer-for-value rule. Herein lies the problem for many buy-sell scenarios – but more on that later. First, a look at the exceptions to the transfer-for-value rule…

These include transfers made to the following exempt transferees: 

1) The insured, 
2) A partner of the insured, 
3) A partnership in which the insured is a partner, 
4) A corporation in which the insured is an officer or shareholder, or, 
5) Any person where the transferee’s basis in the policy is determined in whole or part by reference to the basis of the transferor i.e. carryover basis transferees.

So with the basics in place let’s take a look at why the transfer-for-value rule so clearly needs to be avoided in buy-sell planning.

The unexpected taxation of a large lump sum payment of policy proceeds raises financing problems for the buy-sell arrangement. If only the after-tax proceeds are available to buy the deceased’s business interest, under-funding of the purchase obligation may result and the buyer may not be able to effect the purchase for cash or may be forced to seek funds elsewhere.

Let’s look at some common situations that often give rise to transfer-for-value problems:

Shifting policy ownership. Circumstances change and the business entity may discover that structuring the buy-sell as a stock redemption was not the best strategy so they restructure it as a cross-purchase; or vice-versa. In addition, in a wait-and-see buy sell when the ultimate decision is made as to who will be the buyer (entity vs. individual), policies may have to be shifted to place the financing where it is needed to effect the buy-out. When the ownership on existing policies is shifted to accommodate a change in the format of a buy-sell agreement – beware of transfer-for-value problems.

For example, suppose that ABC Inc. owns two $2 million life insurance policies on each of its stockholders to fund a stock redemption agreement. The decision is made to end this agreement and to fund a new cross-purchase arrangement. Furthermore, to fund the new cross-purchase agreement, owner “A” intends to buy from ABC Inc. the policy on owner “B’s” life; and owner “B” will buy the policy on “A”. As structured this scenario does not fit into one of the safe harbor exceptions to the transfer-for-value rule. For the results- read on.

Let’s assume that “A” pays $40,000 to purchase the policy on “B” and then pays additional premium of $50,000 and at this point “B” dies. “A” received $2 million in proceeds but $1,910,000 ($2,000,000 - $40,000 - $50,000) will be taxable as ordinary income. Furthermore, assuming a tax rate of 35 percent, “A” will have only $1,241,500 left to pay the $2 million purchase price. The final result – an under-funded buy-sell.

The solution – perhaps the corporation retains the policies to provide key person coverage, and new policies are purchased by “A” and “B” using a bonus plan or a split-dollar agreement to help minimize personal costs.

Another solution – take a safe harbor route. If “A” and “B” are partners in a bona fide partnership, there will be no ordinary income taxation as the policies qualify for the transfer to a partner exemption.

When shifting policies from individual ownership to corporate ownership (often the case in a wait and see buy sell agreement) transfer-for-value issues are only circumvented if the insured is a shareholder or officer in the corporation – a transfer exemption.

Using existing policies to fund a cross-purchase agreement. Often when business owners want to create a cross-purchase buy sell, they attempt to use existing policies as the financing vehicle. This might not be the best decision, as the Service, relying on the Code’s broad definition of “value” have repeatedly taken the position that reciprocal promises under a buy-sell agreement constitute “consideration.”

For example, in Monroe v. Patterson, where a corporate owned policy was transferred to a trust established to administer a cross-purchase buy-sell and the shareholders were required to pay continuing premiums on the policy the U.S. district court held that there had been a transfer for value. The court found two forms of consideration: the mutuality of the agreed upon obligations (the agreement to buy), and the actual cash consideration paid by the surviving beneficiary shareholder in premiums.

In PLR 7734048, the Service reached a similar adverse conclusion where policies were simultaneously transferred from the insureds to their co-shareholders to fund a cross-purchase arrangement. Here, two shareholders each owned a policy on their own lives. After they established a cross-purchase arrangement, they transferred the policies to each other. At the time of the transfer, the policies were in their first year and had no cash value.

The Service held that there was “consideration” even though no cash changed hands. The reason: the reciprocal transfer of the policies. Note that it made no difference that the policies had no value at the time of the transfer. Under this reasoning even if the policies are term policies they would be subject to the transfer-for-value rule.

Often the unwary suggest that the corporation gift the policy to a shareholder to avoid the transfer-for-value rules. However, the Service is not likely to view this transaction as a gift when done in a business context. Rather it will probably be treated as policy distribution i.e. as a dividend or as compensation to the receiving shareholder and the transfer-for-value rules will apply.

It is also unlikely that the transfer-for-value problem can be avoided if the insured buys the policy from the corporation and then gifts it to the other shareholder. The Service could contend that the two transfers should be treated as a single transfer i.e. a collapsible step transaction. In addition, the Service could claim that reciprocal promises (the promise by each shareholder to acquire the policy on his/her life and then to give it away) create valuable consideration. See the discussion of the “Estate of Rath v. United States” that follows.

Death of a Shareholder. In a cross-purchase arrangement, a transfer-for-value issue may occur where a shareholder dies owning policies on the surviving shareholders. The representative of the deceased owner’s estate will probably consider it in the beneficiaries’ best interest to sell the policies. A major tax disaster can result if the surviving shareholders are the purchasers and the transfer-for-value rule applies. One solution for transferring the policies to the surviving shareholders (who are not the insured) without transfer-for-value implications – make certain that they are also partners in a bona fide partnership.

Other potential solutions: the estate could sell the policies to the corporation to fund a stock redemption; the policies could be surrendered for cash; or the survivors could buy the policies on their own lives and continue them as personal insurance.

Terminating a buy-sell agreement. When a stock redemption agreement is terminated, if the policies are no longer needed for a business purpose, the corporation may wish to distribute the policies to the respective insureds. A distribution of the policy to the insured qualifies as one of the five safe harbors and the transfer-for-value rules will not apply.

Problems arise because many shareholders do not want to own the policy personally because of estate inclusion issues and the resulting estate tax. Is there a way to circumvent the transfer-for-value rules and still escape estate inclusion? Can a transfer be made to the insured’s trust and does this qualify for the safe harbor exemption as a transfer to the insured?

The Estate of Rath v. United States is a lesson on how not to do it. Under the buy-sell agreement the shareholder-insured had the right to have the policy assigned to himself or his nominee if the corporation decided to terminate the agreement. At the termination of the redemption agreement, the corporation sold the policy to the shareholder’s wife.

When the Service held that there was a transfer for valuable consideration, the wife argued that in reality her husband had exercised his option to have the policy transferred to him (a protected party) and then he had gifted the policy to her (an exception to the transfer-for-value rule). The court ignored this two-step argument holding that the fact that the insured could have acquired the policy himself and then transferred it to his spouse, retaining the exclusion of the proceeds at his death, did not warrant the court recharacterizing what had actually occurred.

It is important to note, even if a taxpayer could convince the Service that the he/she had acquired the policy directly and then transferred it as a gift to a spouse, the risk of estate inclusion of the policy proceeds still exists for three years after the transfer.

Many planners believe that the shareholder can avoid both estate inclusion and the transfer-for-value rule by distributing the policy to a grantor trust where the insured is treated as the owner of the trust under the grantor trust rules in IRC §§ 671-677. However, if the grantor is not a 100% owner of the trust (both principal and income) this exception will apply only to the extent of the grantor’s interest in the trust.

Another solution to potential transfer-for-value problems when distributing the policy to an irrevocable life insurance trust (an ILIT) is to use the partnership exemption i.e. have the ILIT and the insured both be partners in a partnership that has a valid business purpose.

Trusted Buy-Sell. While transfer-for-value problems can arise in many buy-sell planning scenarios, problems often occur in cross purchase agreements where multiple policies are required. Remember each owner purchases a policy on the life of each of the other owners.

For the funding to be effective in a cross-purchase buy-sell arrangement, the policies must be maintained and managed – a task that becomes complicated with numerous policies and personal ownership. In addition, with multiple policies and owners it is difficult to ensure that the surviving owners honor the buy-sell arrangement and exchange death benefit proceeds for the deceased’s ownership interest. One purposed solution to this dilemma is to use a trusted buy-sell.

Under a trusteed arrangement, a trust is used to hold the stock of the various shareholders as well as the life insurance policies. Typically the trustee purchases just one policy on each owner. This “one policy per shareholder” scenario creates potential transfer-for-value problems and is clouded with tax uncertainty.

The problems begin with the first shareholder’s death. At this point in time, although there is no physical transfer of the policies within the trust, the beneficial interest in the decedent’s share of the policies on his co-shareholders’ lives has essentially been shifted to the surviving shareholders. The shift of this beneficial interest will more than likely be seen by the Service as valuable consideration ties to reciprocal promises i.e. it can be assumed that a policy owner would not allow the interest in a policy he/she owned on another shareholder to pass through the trust’s ownership to the other shareholders unless the other shareholders agreed to do the same.

The solution to this dilemma is to make use of the partnership transfer-for-value safe harbor i.e. make certain that the shareholders who are beneficiaries of the trust are also partners in a bona fide partnership. It is important to note that several private letter rulings have confirmed that the partnership does not have to have a connection with the corporation whose shares are subject to the buy-sell arrangement.

Another approach is to substitute a partnership for the trust i.e. a bona fide partnership will be the owner and beneficiary of the policies and will complete the buy-out terms upon the death of a shareholder. Again by using the partnership safe harbor exception, transfer-for-value issues can be avoided.

Of course, as in any advanced planning scenario, other considerations arise. One issue of concern when using the partnership as the holding tool is the potential for inclusion of the policy proceeds in the insured’s estate. There are no regulations dealing with the incidents of ownership held by a partner through a partnership as there are for a controlling shareholder. The general belief is that where the partnership is both the owner and beneficiary of a policy on the partner’s life, the partner’s estate includes just his/her proportionate share of the partnership interest i.e. the value that reflects a proportionate share of the death proceeds.

In Summary: In any buy-sell scenario if the needed financing is to be available at the death of the shareholder, care must be taken to be certain that the transfer-for-value rules do not apply. Additional scrutiny should be given to any buy-sell scenario were existing policies are brought into the buy-sell, or policy ownership is shifted. Many of these situations can be resolved through the use of the safe harbor exemptions.

It is important to remember that the mere presence of reciprocal promises has been viewed by the Service as valuable consideration resulting in unexpected and unwanted tax results.

And last but not least, the use of the partnership exemption to the transfer-for-value rule may be the route to planning flexibility in many situations that seem to lack a solution.