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)

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.

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)

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]

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

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.