Client says to me, “can you make my premium payments for Life Insurance in a Buy-Sell tax deductible, lower my premium payments, and make it income tax-free for at least a portion of the Life Insurance to me and partners? Sound too good to be true? Actually such a beast does exist. However I, among many others, advise against such a plan. What my client was referring to is a section of the IRS (Section 79) that does permit such an approach. It is called Group Life Insurance.
To begin, the employer can deduct the premiums paid on behalf of an employee if that amount is considered reasonable compensation, which is usually the case. Because it is Group Life Insurance as opposed to Individual, premiums can be lower. Lastly, the first $50,000 of covered is provided tax-free to each participant. One caution is that the plan must be nondiscriminatory. In other words, must cover all employees. Here is one problem. So why couldn’t the partners do part of their Buy-Sell funding with Group Life Insurance?
This approach will not be available for sole proprietors, partners in a partnership, members of a Limited Liability Company or partners who have greater than 2% interest in an S corporation. So this eliminates a good number of businesses. In addition, the taxes above the $50,000 threshold generally become more expensive as one grows older.
Although the premium payments for the Group Life Insurance are tax-deductible, when used to fund a formal written Buy-Sell agreement, the IRS has maintained it is not permissible. This was written in an earlier private letter ruling. In addition, there is a tax trap that should be avoided. If the stockholders in a corporation named each other as a beneficiary, a “Transfer-for-value” could occur. This was referred to in an earlier entry but let me clarify this idea. It means that a valuable consideration would be exchanged for naming a partner as the beneficiary. In plain English, the IRS would say the policy proceeds would be completely taxable as ordinary income, the higher taxable amount. Furthermore, it could be included in the partner’s estate and his business interest for federal and New York State estate taxes. These are red flags that signal extreme caution and are not worth the worry.
Another consideration is the lack of flexibility in a Group Life Insurance program. There is no cash value accumulation. This would prohibit partners from establishing a sinking fund that at some point could effectively buy-out each partner’s interest. This is an attractive point because this cash build-up is tax-free. In summary, due to the long term high costs, tax and legal problems, I think it would be a great disservice to clients to fund their Buy-Sell plans.