One of the most difficult and perplexing issues facing business owners is how to transfer a business to successive owners. This gets especially more complicated when the transfer involves more than two business owners. Assuming that the owners (called shareholders) have a competently written Buy / Sell Agreement, the question becomes how to structure the funding mechanism. That is, what entity owns the life insurance policies that cover each shareholder and how do you make this the most tax-efficient for everyone involved?
The easiest – and least tax-efficient – is for the Company to be the owner and beneficiary for all the life insurance policies. This way, when an insured dies, the life insurance proceeds get paid directly to the Company, which then retires the deceased’s shares and pays the heirs the fair market value of those shares, which is presumably the amount of the death benefit of the life insurance paid. By extension, the remaining owners’ shares appreciate by the value of the deceased shares. The trouble with this arrangement is that the tax basis for these shares remains the same. This means that, when the remaining owners sell their shares in the business, they pay capital gains on everything over-and-above their original tax basis – including on the appreciation from the newly acquired shares.
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