Founding Attorney
When creating a buy-sell agreement, it’s important to consider the many tax considerations involved. Working with an experienced attorney can help you navigate the tax-related challenges of implementing a buy-sell agreement.
A buy-sell agreement is an important tool for business owners creating a business succession plan. If multiple partners or owners are involved and one passes away, retires, or otherwise leaves the company, problems can arise without a buy-sell agreement.
The Tax Implications of Funding a Buy-Sell Agreement with Life Insurance
It’s common for business owners to purchase life insurance policies for their co-owners. If one of their co-owners passes away, the policy proceeds can fund the buy-sell agreement. Proceeds from life insurance policies are usually excluded from the beneficiary’s taxable income, whether the beneficiary is an individual, a shareholder, or a corporation. However, an exception is the “transfer for value” rule. Insurance proceeds will be considered taxable income if an existing policy was acquired for value by someone:
- Other than the insured or
- A partner of the insured
- A person other than the insured or 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 officer
Working with an attorney can help you ensure your buy-sell agreement is structured and funded in a way that avoids the “transfer-for-value” rule impacting the sale. Otherwise, the after-tax insurance proceeds will be reduced significantly. For example, you may be able to structure your buy-sell agreement as a cross-purchase agreement or mitigate the risk by creating a hybrid agreement naming the corporation as a party to the transaction.
Internal Revenue Code (IRC) Section 2703
Section 2703 of the Internal Revenue Code (IRC) establishes specific valuation guidelines for buy-sell agreements. These regulations ensure that the agreement’s terms comply with tax regulations and provide a fair market value for the assets involved. Specifically, the appraiser or tax assessor must disregard the agreement when valuing an asset for the purchase of a buy-sell agreement.
In other words, the appraiser or tax assessor cannot consider the agreement’s terms when determining the asset’s value or interest. This regulation is intended to prevent individuals from artificially using buy-sell agreements to depress the asset’s value.
Exceptions to the IRC Valuation Guidelines for Buy-Sell Agreements
There is an exception to Section 2703 of the Internal Revenue Code (IRC). It will not apply when the buy-sell agreement meets the following criteria:
- The agreement is a bona fide business arrangement
- The agreement is not being used as a way to transfer property between family members for less than the full and adequate consideration or value of the assets, and
- The terms of the agreement are comparable to a similar “arm’s length transaction”
When these three factors are met, the provisions of IRC 2703 do not apply, and the appraiser and tax assessor can consider the agreement’s terms when determining the value of the interest.
Contact a Business Succession Attorney in New York and New Jersey
When drafting a buy-sell agreement, considering the tax implications is essential. The business succession attorneys at Merlino & Gonzalez are prepared to help you navigate the buy-sell agreement process smoothly with careful planning to address potential tax issues. Don’t hesitate to contact us to schedule a consultation and learn more. We represent clients in Staten Island, New York, and New Brunswick, New Jersey.