Funding purchase of stock from deceased shareholder's estate or heirs with insurance.

Facts: The Hawk Corporation, which has a value of $2 million, has only voting common stock outstanding. The corporation is owned equally by Jane, Peter, Mark and Lynn, who are all siblings. Jane and Peter are the original shareholders of the corporation. All shareholders participate in Hawk's daily management and operations. * The shareholders have agreed that a buy-sell agreement should be executed that requires, on the death of one of the shareholders, that either the other shareholders or the corporation purchase the deceased shareholder's stock. Because Hawk's value has substantially increased over the past few years and it has historically experienced cashflow problems, the shareholders are concerned that neither they nor Hawk will have the cash to fund this required purchase. The shareholders want to keep the cost as low as possible became of the cashflow problems and are not concerned the arrangement might benefit one of them more than another. Issue: How can the shareholders ensure funds will be available to purchase a deceased shareholder's stock?

Analysis

Buy-sell agreements can benefit both surviving shareholders and a deceased shareholder's estate, by guaranteeing that stock in a closely held corporation will have buyers and will not be sold to outsiders. The assurance derived from the agreement is meaningless, however, if funds for the purchase are not available. Often, as with the Hawk Corporation, the value of a closely held corporation has increased so much that the remaining shareholders may not be able to fund the purchase of a deceased shareholder's stock. Similarly, the cashflow requirements of a closely held corporation could result in a lack of funds available for the corporation's redemption of the stock or for distribution (as wages or otherwise), to the shareholders to fund their purchase of the stock. One common method of dealing with such funding problems is to purchase insurance on the lives of each of the shareholders.

Assume that the shareholders adopt a cross-purchase form of buy-sell agreement rather than a redemption format. Because the individual shareholders are required by the buy-sell agreement to purchase a decedent's stock, the insurance should be owned and the premiums paid for by the shareholders. The surviving shareholders should be the beneficiaries. Inconsistencies between policy ownership, premium payments, beneficiary designations and the buy-sell agreement can cause problems. (For example, if the corporation pays the premiums for insurance owned by the shareholders, the premiums might be considered compensation or constructive dividends to the shareholders.) Such problems can be avoided if the buy-sell agreement corresponds to the provisions and ownership of the insurance, and the premiums are paid accordingly.

Generally, when shareholders agree to purchase a deceased shareholder's stock, either a cross-insurance arrangement or a joint-life (first-to-die) policy is used. As mentioned previously, an important factor to remember with either of these arrangements is that the premiums should be paid by the shareholders.

In a cross-insurance arrangement, each shareholder purchases an insurance policy on the life of each of the other shareholders based on their interests in the corporation. In Hawk's case, each shareholder would own three policies, resulting in a total of 12 policies being purchased for the arrangement. Each policy would be in the amount of $166,667 (one-third of $500,000 (a one-quarter interest in the corporation)). Obviously, such a plan becomes less feasible as the number of shareholders increases.

When considering a cross-insurance arrangement, a tax adviser should let the shareholders know that this method will produce disproportionate results between the remaining shareholders and the decedent's estate. For example, if Jane dies, at her death all of the shareholders (including Jane) would have paid the same amount of insurance premiums. The three remaining shareholders would each collect the proceeds of their policies on Jane's life and buy one-third of Jane's stock from her estate. Each then has an ownership interest of $666,667 in Hawk (value of their original one-quarter interest of $500,000, plus the $166,667 of shares purchased from Jane's estate). Even though Jane paid the same amount of insurance premiums, her estate would not enjoy the same increase in assets; it would have $500,000 (the payments from the other shareholders for her original one-quarter ownership interest).

Alternatively, a joint-life policy plan might be used. Under a joint-life policy plan, one insurance policy on the shareholders' joint lives is purchased. The policy's face value is usually the percentage of the corporation's value that each of the surviving shareholders will have if one of the shareholders dies. In other words, the amount of the policy would equal 100% of the corporation's value if there are two equal shareholders, 50% if there are three equal shareholders, etc. Each shareholder pays a proportionate share of the premiums for the policy. Proceeds of the policy are payable to both the surviving shareholders and the estate.

Under this arrangement, if Jane dies, the amount collected under the policy would be $666,667, which equals a surviving shareholder's ownership of one-third of Hawk's $2 million value. The $666,667 in proceeds would be payable 25% to Jane's estate and 25% to each of the surviving shareholders, to be used in purchasing her stock. Consequently, the remaining shareholders would own stock worth $666,667 (one-third of $2 million) and Jane's estate would have cash of $666,667 ($500,000 from the surviving shareholders and $166,667 from the insurance policy). Thus, the estate's and the surviving shareholders' assets would increase equally.

The premiums on a joint-life policy are more expensive than the individual single-life policies used in cross-insurance arrangements (but typically should be less costly than the sum of the premiums of the individual policies). Also, the proceeds payable directly to an estate or to named beneficiaries (if the decedent at his death possessed any of the incidents of ownership in the policies) are included in the estate for estate tax purposes. If the policy is owned by someone other than the decedent, the proceeds would be excluded from the estate.

The cost of using insurance to fund the purchase of a decedent's stock would be reduced by using a joint-life policy with a value equal only to the value of the stock being purchased, rather than the larger value discussed previously. Again, this method would result in the same problem discussed previously (an inequality of assets stemming from the differences in corporate ownership between the remaining shareholders and the decedent's estate). The shareholders should weigh the benefit of lower insurance costs against an equality of asset ownership.

Disproportionate ownership of stock will make use of insurance proceeds to fund stock purchases even more complicated. The shareholder with a smaller interest would have to pay higher premiums than the other shareholder, because it would take more cash to buy that shareholder's larger interest. A similar problem would exist if there is a large difference in the ages of the shareholders. In some cases, these problems could lead the tax adviser to recommend the use of a redemption form of buy-sell agreement rather than a cross-purchase format.

Conclusion

The tax adviser should recommend insurance be purchased on the shareholders' lives to fund the purchase of stock from a deceased shareholder's estate.

Editor's note: This case study has been adopted from PPC Tax Planning Guide--Closely Held Corporations, 13th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Linda Ketter-Craig and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex. 2000.

Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington, VA