As a company grows in value, it may become important for the company to obtain life insurance policies on its shareholders or key executives. In the case of a company that has multiple shareholders, an issue often arises as to whether the life insurance policies should be owned by the company itself, or whether each shareholder should own an insurance policy on the life of each other shareholder. Clients have approached this issue in different ways. This entry summarizes and discusses some of the primary advantages and disadvantages of each approach. The discussion below assumes that the company is an S corporation with more than two shareholders.
Insurance Held at the Shareholder Level. In many cases, life insurance proceeds are intended to provide liquidity in the event of a shareholder death and to protect the company's operating cash flow. There are several primary disadvantages to having each shareholder hold a life insurance policy on each other shareholder.
First, in the event that there are at least three shareholders, continuing policies must be "uncrossed" after the death of the first shareholder. If Shareholder A dies, Shareholders B and C would use their insurance proceeds to purchase Shareholder A's shares. Shareholders B and C must also then purchase Shareholder A's life insurance policies on Shareholder B and Shareholder C. This uncrossing can lead to additional future taxes on receipt of the life insurance proceeds of the uncrossed policies.
Second, there can be a concern that a recipient of a life insurance payment could fail to use the payment for its intended purpose. Third, there could be premium variance among the shareholders, depending on the other shareholders' health variables.
An advantage of having life insurance policies held outside of the company is that shareholders that receive life insurance proceeds and use the proceeds to purchase a deceased shareholder's stock should receive a higher tax basis in the stock than they would have received if the company had received the proceeds and distributed the proceeds among the shareholders to fund the purchase or simply redeemed the deceased shareholder's stock.
There could also be an estate tax advantage, because the company would have a reduced value for estate tax purposes as a result of not holding the life insurance proceeds itself. Finally, if the company goes bankrupt, the value of the policies does not accrue to the benefit of the company's creditors.
Most if not all of the disadvantages of holding life insurance policies at the shareholder level can be eliminated by establishing a life insurance trust outside of the company to hold and administer the policies.
Insurance Held at the Company Level. In some cases, it is simpler to cause the company to hold the life insurance policies and to use the proceeds to redeem a shareholder's stock in the event of a shareholder death. In addition to its simplicity and reduced administrative cost, the company can control the premium payments and insurance proceeds. Premium variability is eliminated by having the company pay all premiums directly.
Several disadvantages include the lower shareholder-level tax basis that is described above. Also, the policies could be subject to the claims of creditors in the event of a company's insolvency.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
