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Dealings de Los Muertos: Capitalizing Buy-Sell Agreements

Rustin Diehl• RDiehl@TBGroup.org• 801-938-4035

The Spectrum of Life Insurance

Pure Insurance Pure Investment

Term Permanent Modified Annuities Mutual FundsInsurance Insurance Endowment

Contracts

Tax Free Death Benefit

Potential for Tax Free Withdrawals

of Cash Value

Life Insurance Protection

Investment Component

WholeLife

VariableLife

UniversalLife

§ Non-Taxable Instances of Life Insurance:

§ Generally, life insurance death benefit proceeds received by a beneficiary are not taxable – they are not includable in gross income and do not need to be reported. 26 U.S.C. § 101(a)(1). Further, spouses can receive payouts from life insurance policies free from estate taxes, even if the estate is large enough to be taxed.

§ Permanent life insurance policies build cash value over time, and the gains in the cash value account are not subject to income tax. (IRC Section 7702(g)).

§ Permanent life insurance policies can be surrendered in exchange for a lump sum. No taxes will be owed on this amount as long as the surrender payout is less than what was paid into the policy. (IRC Section 72(e)(5)(C)).

§ Life insurance premiums are nondeductible. (IRC Section 264(a)(1).

§ Mutual insurance companies owned by policyholders may give some money back to

policyholders each year in the form of dividends. These dividends are not taxable as long as the amount is not more than a policyholder has paid in premiums.

Taxation of Life Insurance - Nontaxability

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§ Life Insurance Used in Buy-Sell Agreements:

§ The value of the property shall be determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right). (IRC Section 2703(a)(1).

§ Under the 2017 TCJA, AMT was repealed. Under previous rules causing the taxation of life insurance proceeds, AMT could arise in some circumstances. Under the previous rules, a life insurance policy owned by a corporation on the lives of its stockholders as part of a redemption agreement could become taxable on the buildup of cash value in the policies for Alternative Minimum Tax (AMT) purposes. IRC §§ 55, 56(c)(1), 56(g)(4)(B)(ii). This occurs when there is “income” in the policy (determined under

IRC § 7702(g)). Such income is the amount by which that year’s increase in surrender value plus the cost of that year’s life insurance protection exceeds the premiums paid for that year. IRC § 7702(g)(1)(B). A similar rule applied to disability insurance, as well. IRC § 53 allowed a credit against regular tax in future years for AMT paid; this may make the issue more one of timing.

Taxation of Life Insurance - Buy Sell Agreements

§ Taxable Instances of Life Insurance:

§ Interest received by a beneficiary is taxable and should be reported as interest received. 26 U.S.C. § 101(c) . This could occur in a circumstance where a beneficiary elects to take the payout in installments over time rather than a lump sum, in which case the insurance company would also pay interest on the balance, and that interest would be subject to income tax.

§ If a permanent life insurance policy is surrendered and has built up more value than has been paid in, due to investment returns, income taxes would be owed on the amount of the payout that exceeds what was paid in. (IRC Section 72(e)(5)(C)).

§ A policyholder may borrow tax free against the cash value built up in a permanent life insurance policy. However, that money must be paid back, with interest, though such repayment can occur at death from the death benefit proceeds. If a loan is still outstanding and the policy is surrendered or lapses, taxes will be owed on any loan balance that exceeds what was paid into the policy.

§ Other taxable instances include: 1) Transfers for Value of Life Insurance Policies and 2) Lack of Insurable Interest.

Taxation of Life Insurance – Exceptions to Non Taxability

Section 7702 Defines Life Insurance

• Term Insurance, Permanent Insurance and Modified Endowment Contracts (a “MEC”) all meet the requirements of Section 7702

• Accordingly, death benefit proceeds payable to a MEC are tax free

Section 7702A Defines Requirements for Tax Free Access to Cash Value

• Permanent Insurance meets the requirement of Section 7702A while Modified Endowment Contracts fail the requirements

• Permanent Life Insurance – Withdrawals of cash value are generally tax free

• Modified Endowment Contracts – Follows the WIFO method of withdrawals (i.e., withdrawals are first a withdrawal of taxable income)

Modified Endowment Contracts

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Side by Side Comparison

Premium Financed Buy-Sell Tax Efficiency Comparison

Options: 1. Use Company

Profits

2. Borrow Funds (IRC 6166 or 453)

3. Pay Life Insurance Premiums

4. Financed Life Insurance

Contribution of purchase funds tax freeGrowth of purchase funds tax freeDeath Benefit proceeds tax free

Premium Financed Buy-Sell: Fully Funded Obligation

$10M (and growing) BusinessBusiness needs to buy-out concentrated positions of retiring owners

• Two business partners age 40• Need buy-sell coverage to age 65• Current valuation of business $10M• Would like to see alternatives to term coverage• Do not want to be forced to seek more insurance when business

valuation increases but insurance capacity decreases• Would like to see a supplemental income starting around age 65 for 15

years

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Premium Financed Buy-Sell and Executive Compensation

$50M BusinessBusiness needs to buy-out concentrated positions of retiring owners

• Business posted $2M cash as collateral with a private bank by securing a line of credit on a portion of the business.

• Private bank lends $15 million for payment of insurance premiums to an insurance trust, with the trust as the guarantor of the loan.

• Insurance trusts purchase life insurance on the lives of executives and key employees.

• The original $2M of collateral generates a death benefit of $50M+.• Plus, in 12-14 years, (depending on age) the executives may begin

taking cash distributions of $1M/year as non-qualified compensation.

Premium Financed Estate Tax Payoff

$50M Estate Tax LiabilityA good offense is the best defense.

• Use PF to pay off estate.

10X Bequest55 year-old clientCommitted $5M donation to a specific University over 10 years

• Created a gift that exceeded 10 times the original pledge with a specially designed life insurance policy.

• Policy was financed.• The original $5M pledge was used as collateral, which

maintained the client’s ability to give that same amount to the University.

• Client received a tax deduction on the $5M gift today.• Client continued to manage his own assets.

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Traditional Advisory and Investment Services

Freeze – Lock out Future Appreciation

Burn – Settlor reduces estate further by paying taxes

Squeeze –Valuation Discounts

Earn a Better Return

Financed Insurance

and Modified

Endowment Contracts

www.T B G r o u p . o r g

Dealings de Los Muertos: Capitalizing Buy-Sell Agreements

Rustin Diehl• RDiehl@TBGroup.org• 801-938-4035