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AMT imposed on life insurance proceeds in a buy-sell agreement.

Many taxpayers have redemption agreements under which the corporation agrees to purchase the stock of a deceased stockholder. In some of these cases, the purchase price is funded with life insurance. If the corporation is a C corporation rather than an S corporation, the collection of life insurance proceeds may trigger an alternative minimum tax (AMT) that could be as much as 15% of the proceeds received.

One technique to avoid the imposition of AMT has been to adopt a cross-purchase agreement, under which each stockholder agrees to maintain life insurance on the other stockholders and then use the proceeds to purchase the stock on a stockholder's death. The technique has always worked if there were only two stockholders. However, with three or more stockholders, a cross-purchase technique did not work after the first stockholder died because of a rule known as the transfer for value rule. If one stockholder were to die, and if the insurance policies owned by that deceased stockholder insuring the surviving stockholders were transferred to the surviving stockholders to fund their eventual buyout, that transfer was deemed to be a transfer for value, and the proceeds when received were taxable as ordinary income.

In a series of letter rulings, the IRS has authorized an approach that appears to solve both the problems of transfer for value and the AMT. The stockholders should form a partnership, whose sole purpose would be to own the life insurance policies on all the stockholders. if stockholder A in a three-stockholder corporation were to die, for example, the partnership would collect the life insurance proceeds on A and credit them to the capital accounts of stockholders B and C. The receipt of life insurance proceeds by a partnership is a tax-free event that does not trigger any AMT. The surviving stockholders (B and C) would then withdraw the proceeds from the partnership and contribute the life insurance proceeds to the capital of the corporation. That contribution would give the surviving stockholders basis in their shares. The corporation would receive the life insurance proceeds as a capital contribution with no tax consequence and use those funds to redeem the stock of the first stockholder (A) who died.

This technique avoids the transfer for value rule, since the partnership continues to own the insurance policies on surviving stockholders B and C with no adverse income tax consequences. The same sequence of events would occur when B or C dies. In addition, it gives the surviving stockholders a step-up in basis by virtue of their collecting life insurance proceeds and then contributing those proceeds to the corporation's capital.

In Letter Ruling 9309021, the Service sanctioned the use of a partnership solely for the purpose of owning these life insurance policies without any requirement that the partnership have any other business purpose (such as owning real estate or equipment).

This technique should be evaluated by practitioners for all their clients who fund buy-sell agreements with life insurance. From Harris Markhoff, Esq., Partner, Danziger & Markhoff, White Plains, N. Y.
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Author:Markhoff, Harris
Publication:The Tax Adviser
Date:Sep 1, 1993
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