Succession Planning and Key Person Life Insurance: The Tax Implications

If a corporation purchases life insurance on the life of a key person to indemnify it against loss on account of the key person’s death, are proceeds includable in the insured’s estate?

If, at an insured’s death, a policy was owned by and payable to a corporation and the insured possessed no “incidents of ownership” in the policy, the proceeds are not includable in the insured’s gross estate. If the insured possessed at death any incidents of ownership in the policy, the proceeds are includable in the gross estate even though the corporation has been named owner and beneficiary.

Death proceeds of life insurance owned by and payable to a corporation are considered, along with the other non-operating assets, as a relevant factor in valuing a corporation’s stock for estate tax purposes. Consequently, where an insured is a stockholder, the value of proceeds will be reflected in valuing stock includable in the insured’s gross estate. It is not correct to value the stock first, without considering the insurance proceeds, and then simply add the amount of proceeds to that value. Factoring life insurance proceeds into the valuation of stock may or may not result in an increase in value equal to the full value of the insurance proceeds, depending on the valuation method. 

For example, it may be possible to obtain some reduction in the value of stock to reflect loss to the business of the key person’s services. The executor must offer proof to establish that the insured’s death actually did cause a loss as a loss does not result per se from the death of the owner and manager of a corporation.

It has been held that no decrease in value for loss of an insured’s services will be allowed if the stock is personal holding company stock where the assets consist almost entirely of stocks and bonds; a corporation must be an operating business requiring management, with going value and good will.

If an insured is a controlling stockholder, that is, one who owns stock amounting to more than 50% of the total combined voting power of the corporation, then to the extent proceeds are payable other than to or for the benefit of the corporation, any incidents of ownership in the insurance held by the corporation as to the proceeds will be attributed to the insured and thereby will cause the proceeds to be includable in the insured’s gross estate.

In a revenue ruling, X corporation owned insurance on the life of its controlling stockholder, D. The corporation assigned all of its incidents of ownership in the policy to A. D died within three years of the assignment, and proceeds of the policy were paid to A. The IRS held that the proceeds were includable in D’s estate under IRC Section 2035 by reason of attribution to D of the incidents of ownership held by the corporation. The ruling failed to identify the policy’s beneficiary before the assignment.

The IRS also held that proceeds were includable in an insured’s estate under IRC Section 2035 where a corporation transferred a policy insuring the controlling shareholder to a third person within three years of the insured’s death even though the insured disposed of the insured’s stock after the transfer of the policy and prior to the insured’s death.

Proceeds also were includable in an insured’s estate where a corporation retained ownership of a policy and an insured transferred enough stock so as to cease being a controlling shareholder within three years of death.

How is a closely held business interest valued for federal estate tax purposes where there is a purchase agreement?

The value of a closely held business interest is to be determined without regard to any purchase agreement exercisable at less than fair market value, determined without regard to the purchase agreement, unless the purchase agreement:

(1) is a bona fide business arrangement;