One of the critical needs of a small business is to
protect against the untimely death of an owner. This is
important because the family of the owner may face a
large tax bill, and may not have the liquidity to pay the
tax. To make matters worse, it may not be desirable
for the deceased owner’s family to have a hand in
running the business.
Traditionally, this problem can be solved with a well
designed buy-sell arrangement. Although there are
a variety of ways to structure such an arrangement,
the two most common approaches are the stock
redemption and the cross purchase plans. These
plans are often funded with life insurance. Insurance
can provide both the liquidity needed by the family to
meet its tax obligations, and the ready cash for the
surviving owners to purchase the interest of the
In a stock redemption plan, the corporation agrees to
purchase or retire the stock of a deceased
stockholder. Typically, the corporation purchases life
insurance on each stockholder to fund the
arrangement. In a cross purchase plan, the owners
agree to buy the stock of a deceased partner. To fund
a cross purchase arrangement, each owner buys life
insurance on each of the co- owners. In both cases,
life insurance guarantees that funds will be available if
and when they are needed.
A frequent obstacle to funding a buy-sell arrangement
is a lack of sufficient cash to pay for the required
insurance. For example, in a 34% tax bracket it takes
$15,150 in pre-tax earnings to support a $10,000 life
insurance premium. So, it’s not surprising that many
owners ask if there is a way to deduct the cost of the
insurance premium. Can this be done?
In fact, there is a way...by purchasing life insurance
through a profit-sharing plan sponsored by the
business. When properly structured, the funding of a
cross purchase plan in this manner has all the
advantages of a traditional buy-sell arrangement, with
the added benefit of income tax leverage to reduce
the owners’ out-of-pocket costs.
A little background...
The Internal Revenue Service (IRS) defines a
qualified profit-sharing plan as a plan of deferred
compensation. This definition creates flexibility that
is not available with a qualified pension plan.
Amounts allocated to the profit-sharing account of a
participant may be used to provide incidental life
insurance protection for himself, or anyone in whom
the participant has an insurable interest [Treasury
Reg. 1.401-1(b)(1) (ii)]. The IRS has agreed in private
letter rulings that this regulation supports the
purchase of life insurance on the life of a coshareholder,
to fund a cross purchase arrangement.
(See PLRs 8108110 and 8426090.)
Generally, in designing such an arrangement the
following conditions should be met:
The plan must be a tax-qualified profit-sharing
The plan should allow each individual
participant to direct a portion of his or her
account toward the purchase of life insurance.
The plan should provide that participants may
purchase life insurance on themselves, or on
the life of any individual in whom they have an
The purchase of insurance must meet the socalled
“incidental death benefit” limitations.
Taxable insurance costs (“PS-58 costs”) must
be reported by the participant whose account
is supporting the cost of the life insurance.
If the participant is married, the spouse of the
participant should consent in writing to the use
of the profit-sharing funds in this manner.
At death, the amount at risk under the policy
may be distributed immediately to the
surviving shareholder. This amount is
received free of income tax, and may be used
to satisfy the buy-sell agreement. The cash
value portion of the policy should remain in
the profit-sharing plan.
The funding of a cross purchase arrangement through
a profit-sharing plan in this manner may work best for
small, closely-held businesses with two or three
owners. But, it can work in larger businesses as well,
and this approach may provide a cost-effective means
of purchasing life insurance. This is an important
consideration for any business that may not otherwise
have the ability to fund the buy-sell plan.
Synovus is here when you are ready to talk with someone to help with your estate planning needs. Call us at 1-888-SYNOVUS (1-888-796-6887.)
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