Tax Strategies Using Life Insurance in Business Buy-Sell Agreements

Business owners often implement buy-sell agreements, sometimes using life insurance to facilitate ownership transition after an owner's death. A recent examination of a U.S. Supreme Court ruling reveals a potential income tax planning benefit for certain taxpayers using life insurance-backed transition arrangements. Historically, this decision appeared disadvantageous for taxpayers with taxable estates. However, it may offer a tax advantage for estates valued below the estate tax exemption threshold.

Forvis Mazars notes that this opportunity may not remain available indefinitely. The current planning advantage relies on a historically high federal estate tax exemption, which might change. Early action could secure this potential benefit.

The Supreme Court case, Connelly v. United States, addressed how life insurance proceeds should be evaluated for estate tax when used for ownership redemption. The court ruled that such buy-sell arrangements might not be considered for estate tax purposes, and the proceeds received must be included in the company's fair market value, increasing estate tax exposure but also creating unintended income tax implications.

When life insurance proceeds are factored into a business's valuation, a higher income tax basis is established for the business. This adjustment is significant for estates not subject to federal estate tax, offering potential tax neutrality and increased income tax benefits. A properly structured redemption qualifying as a sale or exchange could generate a capital loss, providing a valuable tax attribute for the estate.

Consider a business worth $6 million with two equal owners and a $3 million company-owned life insurance policy. Upon one owner's death, the company's value for estate tax purposes rises to $9 million, owing to the addition of insurance proceeds. The deceased owner's share, valued at $4.5 million for tax purposes, leads to a capital loss when redeemed for $3 million, assuming a qualifying sale or exchange.

Such strategies are most applicable to businesses using company-owned life insurance for buyouts where estates are exempt from federal estate tax. Business executors should evaluate these opportunities carefully. However, living business owners need to consider broader implications of buy-sell arrangements, including business continuity and cash flow, alongside tax considerations.

Further, the practical use of any capital loss depends on capital gain activity, as it typically offsets such gains. Estates or beneficiaries with capital gains may benefit, while those without substantial gains may find limited advantage. Estates facing federal estate tax or redemptions that don’t qualify as sales may not benefit from this strategy. Forvis Mazars advises a thorough assessment of buy-sell structures, potential estate tax impacts, and how any capital losses might be utilized.

Forvis Mazars Private Client services, potentially including investment advisory or accounting services, offer tailored solutions for closely held and family-owned businesses, integrating estate, tax, and succession planning. It's important to note that this information is not intended as investment advice, and consulting financial or tax professionals before making significant financial decisions is strongly recommended. The provided information reflects the situation at the time of its presentation and may change.