Life Insurance Proceeds and the Business
Life Insurance Proceeds Can Cause Balloon Effect in Value of the Business
Generally, when a business is the beneficiary of a life insurance policy, the value of the death benefit proceeds received becomes property of the business and increases the value of the business. The difference between the amount of the death benefit received and the cash value carried on the books of the business is the increase in the value of the business. This is sometimes referred to as ballooning. The value of the shares of each surviving shareholder increases proportionately.
Balloon Effect May Lead to Inequities in Certain Circumstances
Under certain circumstances, the ballooning results in inequity in the treatment of the deceased and the surviving shareholders. Such an inequity could occur under an entity purchase buy-sell agreement that is funded with life insurance. Under such an agreement, when an insured owner dies, the business receives the policy proceeds—these are used to buy the deceased owner’s interest from the family or estate. If the purchase price established under the buy-sell agreement doesn’t include the value of the life insurance proceeds, the family of the deceased won’t benefit from the increase in the value of the business that results from the receipt of the death benefit. In addition, the family may not benefit from the built-up cash values of the policies owned on the lives of the other shareholders.
Example: Ron, Rob, and Lisa are equal shareholders in a business valued at $300,000 and are bound under an entity purchase buy-sell agreement fully funded using life insurance (the company owns a policy on each shareholder). Ron dies. The business owns a $100,000 policy on Ron’s life and collects the proceeds as beneficiary, increasing the value of the business to $400,000. The $100,000 proceeds are transferred to Ron’s estate in exchange for his stock. Rob and Lisa now each hold a 50 percent interest in the company, which is valued at $300,000 (plus the cash values on the existing policies on their own lives). Ron’s estate doesn’t receive any benefit from the increase in the value of the business as a result of the receipt of the proceeds of the insurance policy on Ron’s life or the cash values in the policies on the lives of Rob and Lisa.
Tip: A practical solution might be for the sale price in an entity purchase agreement to reflect the cash values of all policies funding the buy-sell agreement. The deceased shareholder would then receive a benefit (through the sale price) from cash value accumulations in the policies.
Proceeds Paid to C Corporation may Trigger Alternative Minimum Tax (AMT)
The death proceeds of a life insurance policy are typically received income tax free. An exception to this treatment is when proceeds are received by a corporation. Death benefits received by a C corporation may be subject to the alternative minimum tax (AMT). In addition, any buildup in cash surrender value of the policies may also subject a C corporation to, or increase existing exposure to, the AMT. The corporate AMT is not a problem when the policy is held by and the proceeds are received by an S corporation, a partnership, or the co-shareholders or partners of the insured (assuming that such co-shareholders or partners are individuals).
Cost Basis of Surviving Shareholder’s Stock Not Increased by Proceeds
The value of the business (thus the proportional share for each shareholder) increases when the business receives the death benefit proceeds. However, if the business is structured as a C corporation, then the cost basis of the survivor’s stock is not increased by the value of the proceeds. This could result in additional income tax gain if the survivor sells the stock during his or her lifetime. When the stock is held until death, the stock generally receives a step-up in basis to the fair market value (FMV).
Example: Ron, Rob, and Lisa are equal shareholders in a business. The shares were originally purchased for $50,000 for a total initial value of $150,000. The shares are now valued at $300,000 ($100,000 each). Ron dies. The company owns a $100,000 policy on Ron’s life, and collects the proceeds as beneficiary, increasing the value of the business to $400,000. Under the terms of an existing buy-sell agreement, the business pays Ron’s estate $100,000 for his share of the business. Ron’s estate receives a step-up in basis for the shares, bringing the basis of the shares to the FMV of the stock. As a result, the estate does not recognize any gain when it sells Ron’s share of the business. The $100,000 is included in the value of Ron’s estate. Rob and Lisa now each hold a 50 percent interest in the company, which is valued at $300,000 and do not receive a step-up in basis. Each has a basis in their shares of $50,000. Lisa decides to sell her shares at the FMV of $150,000 and is subject to capital gains tax on the gain of $100,000 ($150,000 sale price less $50,000 cost basis).
Death of Insured Key Employee and the Valuation of Stock
Death Benefit Proceeds Treated as Company Assets
Life insurance proceeds paid to a corporation under a key employee life insurance policy are usually treated as assets of the company. When the insured key employee is also a shareholder, the value of the business assets are taken into consideration in valuing the stock held by the owner or key employee’s estate for death tax purposes. The full value of the proceeds is included in establishing the value of the corporation’s stock. Since the cash values are legally carried on the corporation’s books, the proceeds from the life insurance increase the value of the business by the amount they exceed the cash values. In essence, life insurance proceeds payable to the corporation may increase the net worth of the corporation and the value of the insured owner/key employee’s stock in the corporation.
Loss of Key Person May Reduce Value of Stock
One factor to consider in valuing the business after the death of a key employee or owner is the loss of services for the business. The loss of services can affect the profitability of the business through diminished sales, production capability, or service delivery, which in turn may be shown to reduce the value of the business. In such a case, the loss to the business may be used to offset the increase in value resulting from the receipt of the insurance proceeds. To use this offset, the business must prove it suffered a loss by the death of the insured key employee. Loss must be established clearly at the time of death of the insured person. If the business does not prove that it suffered a loss, the full death benefit (less the cash value) must be included in the corporate assets for the purpose of calculating the value of the stock.
Tip: One way to establish the value of an insured key employee or owner is to include a statement in the minutes of the board of directors meeting in which the key person insurance is authorized. The statement should include language that recognizes the key person’s value to the firm, the potential losses resulting from the person’s death, and that the insurance is intended to partially offset such a loss to the business. Although not conclusive, such an inclusion will provide evidence of the intent of the directors and may have considerable bearing on the valuation issue at the death of the insured.
For answers to specific questions regarding your situation, please consult your insurance agent, and your tax advisor. If you have questions, contact the experts at Henssler Financial:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Disclosures: The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
