A Life Insurance-Funded Redemption Agreement Gone Bad

Summary

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Podcast Summary: "A Life Insurance-Funded Redemption Agreement Gone Bad"

ACTEC Trust & Estate Talk
Date: October 22, 2024
Host: Margaret Van Houten (ACTEC Fellow)
Guest: Steve Gorin (ACTEC Fellow)

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Episode Overview

This episode examines the risks associated with redemption agreements in family businesses funded by life insurance, following the Supreme Court’s recent decision in Connally v. United States. Guest expert Steve Gorin explains why redemption agreements can expose estates to unexpected tax liabilities and discusses safer alternatives, specifically cross-purchase agreements and the use of a life insurance LLC.

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Key Discussion Points and Insights

1. Background: Connally v. United States

• [00:39] Margaret Van Houten introduces the Supreme Court’s ruling, where over $1 million in estate tax became due because a buy-sell agreement funded by life insurance failed to avoid inclusion of those proceeds in the company’s value.

2. The Dangers of Life Insurance-Funded Redemption Agreements

• [01:18] Steve Gorin describes the facts of Connally:
  • Life insurance proceeds were paid to the corporation.
  • The corporation used those proceeds to redeem (buy back) the deceased shareholder’s stock at a fixed price.
  • The agreement violated IRC Section 2703, which resulted in the buy-sell being disregarded for valuation purposes.
• Key Risk: The life insurance proceeds were counted as part of the company’s assets, increasing the estate tax bill.
• “So the question is, is the life insurance that the business receives included in the business's value? 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.” (Steve Gorin, 02:25)

3. The Role of IRC Section 2703

• Section 2703 allows the IRS to disregard buy-sell agreements unless they are comparable to what unrelated parties would use.
• Even a perfectly executed agreement risks IRS challenge:
  • “No matter how well you document it, the IRS could say, I don't agree that that was comparable... you have a potential litigation risk.” (Steve Gorin, 04:03)
• Reference to the Huffman case, where the taxpayer failed to prove comparability, leading to a loss.

4. The Safer Alternative: Cross Purchase Agreements

• [05:07] In a cross purchase, other shareholders, not the company, own life insurance on each other and use proceeds to buy out the deceased's shares.
• Advantages:
  • Life insurance is not a corporate asset, so it avoids IRS inclusion in valuation.
  • Endorsed by the Supreme Court:
    • “You could have avoided this problem using the cross purchase. You wouldn't have had the life insurance counted as an asset.” (Steve Gorin, 05:35)

5. Practical Challenges with Cross Purchase Agreements

• Complexity increases with multiple shareholders:
  • Changing ownership (shareholders leaving or joining) complicates policy ownership and beneficiary structure.
  • Sales of policy can trigger tax issues, including the transfer-for-value rule, which may make proceeds taxable.
  • “If you violate that rule, then the death benefit is subject to income tax. Normally life insurance death benefit is not...” (Steve Gorin, 06:10)

6. Innovation: The Life Insurance LLC Solution

• Creating an LLC to hold policies on owners’ lives:
  • LLC is owned by the shareholders.
  • LLC centralizes life insurance holdings and provides flexibility for ownership changes.
  • Reduces tax risks when owners exit or new ones join.
  • Advisable to appoint an independent manager and contractually bind the LLC to administer the buy-sell properly.
  • “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...” (Steve Gorin, 07:23)

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Notable Quotes and Memorable Moments

• “There’s a big risk here when you have life insurance payable to a company that is redeeming the deceased shareholder… it would be much safer not to have that life insurance go into the company for the redemption.”
  — Steve Gorin, [03:15]

• “No matter how good you are, you have a potential litigation risk.”
  — Steve Gorin, [04:04]

• “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.”
  — Steve Gorin, [08:11]

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Timestamps for Important Segments

• 00:39 — Overview of Supreme Court’s Connally decision
• 01:18–05:05 — Analysis of risks in insurance-funded redemptions and IRS scrutiny under Section 2703
• 05:07 — Introduction of cross purchase agreements as a safer alternative
• 06:08 — Potential pitfalls of cross purchase agreements (policy transfers, taxes)
• 07:11 — The life insurance LLC structure as a practical solution
• 08:11 — Summary advice: adopt cross purchase with LLC structure

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Summary Takeaways

• Redemption agreements funded by life insurance, especially in family businesses, are exposed to significant estate tax risks post-Connally decision.
• Cross purchase agreements, preferably facilitated through a life insurance LLC, can help avoid these risks, but require careful structuring to dodge tax traps.
• Consult experienced counsel and consider the life insurance LLC model for flexibility, ease of transition, and tax efficiency in business succession planning.

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Transcript

[A]

A life insurance funded redemption agreement gone bad that is the subject of today's ACTEC Trust and Estate Talk.

[B]

Welcome to ACTEC Trust and Estate Talk from the American College of Trust and Estate Council, a professional society of peer elected trust and estate lawyers in the United States and around the globe. This series offers professionals best practice advice, insights and commentary on subjects that affect our profession and clients. And now our ACTEC Fellow host with today's topic.

[A]

This is Margaret Van Houten, ACTEC Fellow from West Des Moines, Iowa. The U.S. supreme Court issued a ruling in Connally v. United States in June of this year. The Supreme Court held that more than $1 million 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.

[C]

Thank you, Margaret. It's a pleasure to be here and to talk about this important case. So 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, you know, a fixed price. And that price was a bargain. It actually isn't quite as simple as that. There was a lot of flaws in the way the case kind of went. There's a kind of, a lot of people may dismiss this as a bad facts case, that they didn't really follow the agreement quite correctly and the agreement violated Internal revenue code section 2703. So the ramifications of violating 2703 is you ignore the buy sell agreement and then you, you need to value the company based on the true value. And so the question is, is the life insurance that the business receives included in the business's value? 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. And in another case called blount, which is 11th Circuit opinion, it kind of indirectly overruled that. And 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. And 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 alternative, 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. And the answer is, well, theoretically yes. But I did another podcast called Huffman Case Endangers Buy Sell Agreements, in which I explained that anytime you have a buy sell agreement that's governed by code section 2703, which is basically when you have one or more family members who have a majority 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 meet 2703 and we get to disregard it. And no matter how well you document it, the IRS could say, I don't agree that that was comparable because that's a case of proving the evidence. And Huffman was lost because the taxpayer was not 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 so when you have a redemption agreement, you're handing this risk to the irs. Go and argue with me about comparability. Now. Anytime you have a buy sell, you are going to have that 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. So 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. But of course, the Supreme Court also recognizes that there was some potential drawbacks to a cross purchase as well. So I'm going to mention for a minute some of those drawbacks. So suppose you have owners A, B and C, and then you're going to have a policy on A and B. I'm sorry, I'm sorry, you have a life insurance policy on A. We're going to keep it simple. Just one. 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 a 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 then 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 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 valuable One way to centralize all of this is to have a life insurance LLC that holds the policies. So 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 to make sure that B and C don't do anything wrong with it. You make A's beneficiaries B a third party contractual beneficiary to the LLC operating agreement just for purposes of making sure that the use in the buy sell doesn't get jeopardized. And 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. So 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. So I hope this has been helpful and look forward to future contact with you.

[A]

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

[B]

Thank you for listening to this episode of ACTEC Trust and Estate Talk, the podcast series about wealth planning matters from the American College of Trust and Estate Council. To find an ACTEC lawyer near you, visit actec.org Please subscribe to this series and leave us a rating or a review.

[C]

It.