Life insurance often is integral to estate and business plans. Generally, beneficiaries receive the proceeds income-tax free. Yet when corporations and insurance mix, the proceeds can create income and other types of tax liability. No planning is complete without considering these tax issues. Here are five traps that you can avoid with proper planning:

Trap1: Proceeds Trigger AMT

When the beneficiary is a C corporation, as is often the case when a buy-sell agreement calls for a stock redemption on the death of a shareholder, proceeds from insurance policies owned by and payable to the corporation may affect the corporate alternative minimum tax (AMT) calculation, to the extent those proceeds exceed the corporation’s basis in the insurance policy. The Taxpayer Relief Act of 1997 has made this trap a little easier to escape by repealing AMT for small corporations. The Act defines small corporations as those that had average gross receipts of $5 million or less for the three years ending Dec. 31, 1997.

Trap2: Proceeds Become Taxable Due To Transfer-for-Value Rule

If a redemption agreement has caused an AMT problem, you may consider switching to a cross-purchase agreement by having the shareholders buy the policies from the corporation. Although this may solve the AMT problem, it may trigger the transfer-for-value rule: If a policy owner transfers a policy to the beneficiary in exchange for valuable consideration, the death benefit is tax-free only to the extent of the beneficiary’s basis in the policy. Any proceeds the beneficiary receives in excess of basis are taxable to the beneficiary as ordinary income. The transfer-for-value rule does not apply when a policy owner transfers the insurance to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or an officer. Thus, if the shareholders are also partners in an ancillary partnership, the partnership can buy the policies without triggering the transfer-for-value rule.

Trap3: Proceeds Become Includable in Taxable Estate

If a corporation owns a policy insuring a shareholder’s life and the proceeds are payable to someone other than the corporation, the incidents of ownership in the policy may be attributable to the insured and, therefore, be includable in his or her gross estate. This rule will apply if the insured is a controlling shareholder (a shareholder who owns more than 50% of a corporation’s voting stock at the time of his or her death). Of course, considering the effect on the estate plan of any buy-sell or stock purchase agreements a shareholder may have in place is important. A shareholder who owns less than 50% of a corporation’s stock today may later become a controlling shareholder as a result of the death of a parent, spouse or business partner. This will result in the shareholder acquiring incidents of ownership due to the attribution rules and, thus, undesirable estate tax consequences.

Trap4: Proceeds Cause Value of Stock in Taxable Estate To Increase

When the corporation owns a policy insuring the life of a controlling shareholder and the insurance proceeds are payable to or for the benefit of the corporation, the proceeds will not be includable in the shareholder’s gross estate. However, the value of the stock in the shareholder’s estate will, in all likelihood, increase when the corporation receives the proceeds.

Trap5: Proceeds CreateTaxable Dividends

Generally, a corporate-owned policy on a noncontrolling shareholder’s life will not result in income tax consequences for the insured. If the named beneficiary of the policy is also a shareholder, however, both the insured (to the extent of premiums paid) and the beneficiary (to the extent of proceeds received) will be deemed to have received a benefit from the corporation that may be taxed as a dividend.

Don’t Be Among the Unwary

While life insurance is a valuable tool, the unwary may be caught in one of these or other tax traps. If you would like help avoiding these traps, please contact us.

Case Study: Transfer-for-Value Rule