Policy Purchased by S Corporation

<div class="Section1">Normally, no taxable gain will result to a deceased&rsquo;s estate if stock is sold to surviving individual shareholders at its full market value under a standard buy-sell agreement. At the stockholder&rsquo;s death, the stockholder&rsquo;s estate receives a new tax basis in the stockholder&rsquo;s stock equal to its fair market value at the time of death or an alternate valuation date.<a href="#_ftn1" name="_ftnref1">¹</a> Because the sale price under a properly designed buy-sell agreement usually is accepted as the fair market value of the stock, the basis and sale price normally will be the same ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="322">322</a>). Consequently, there should be no capital gain. Since individuals, rather than the corporation, purchase the stock, the payment cannot be regarded as a dividend ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="300">300</a>). However, if the parties to the buy-sell agreement are related, additional caution should be taken to determine that the sale price under the buy-sell agreement is reasonable.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 1014.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Under the 2017 tax reform legislation, the exceptions to the transfer for value rule do not apply if the policy was transferred in a transaction that qualifies as a reportable policy sale. <em>See</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a> for details.<br /> <br /> There is danger that proceeds may be considered taxable income from a wagering contract instead of tax-exempt life insurance proceeds.<a href="#_ftn1" name="_ftnref1">¹</a> If there is an insurable interest when a policy is taken out, the contract will not be considered a wagering contract, even if an insurable interest is not present at death.<a href="#_ftn2" name="_ftnref2">²</a> Insurable interest is determined by the laws of the various states. Consequently, if there is an insurable interest under applicable state law, death proceeds should qualify as life insurance proceeds under IRC Section 101(a).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Atlantic Oil Co. v. Patterson</em>, 331 F.2d 516 (5th Cir. 1964).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Ducros v. Commissioner</em>, 272 F.2d 49 (6th Cir. 1959).<br /> <br /> </div></div><br />

<div class="Section1">Yes, if the cash surrender value is greater than the employee or stockholder&rsquo;s net premium cost. The gain is ordinary income, not capital gain.<a href="#_ftn1" name="_ftnref1">¹</a> Normally, there is no deductible loss where a policy is sold for adequate consideration ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="62">62</a>). If the policy sold is subject to a nonrecourse loan, the amount realized on the sale includes the amount of the loan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="280">280</a>).<a href="#_ftn2" name="_ftnref2">²</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Gallun v. Commissioner</em>, 327 F.2d 809 (7th Cir. 1964).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect; 1.1001-2(a).<br /> <br /> </div></div><br />

<div class="Section1">Each stockholder’s pro rata share of any gain received by an S corporation, such as gain on endowment maturity or from sale or surrender of a life insurance policy, will be included in a stockholder’s gross income and will increase the basis in the stock.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC §§ 1366(a)(1), 1367(a)(1)(A).<br /> <br /> </div>

<div class="Section1"><br /> <br /> No.<br /> <br /> The employer does not receive the proceeds as life insurance payable by reason of the insured’s death but as a restitution of embezzled funds. Consequently, the income tax exclusion under IRC Section 101(a) does not apply. If the employer has claimed a loss deduction, the employer must report the proceeds as a recovery of a previously deducted embezzlement loss.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     <em>Tennessee Foundry &amp; Mach. Co. v. Commissioner</em>, 399 F.2d 156 (6th Cir. 1968).<br /> <br /> </div>

<div class="Section1"><br /> <br /> No.<br /> <br /> A surviving stockholder will not be treated as having received a constructive dividend merely because the percentage of interest in a corporation is increased by a redemption.<a href="#_ftn1" name="_ftnref1">¹</a> A redemption may result in a constructive dividend to a survivor if the survivor had an obligation to purchase the stock, for example, under a cross-purchase agreement, and redemption by the corporation satisfies that personal obligation.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> A survivor does not realize taxable income from a redemption unless his or her obligation to purchase stock was primary and unconditional. Thus, there is no constructive dividend if a survivor has assigned his or her obligation to the corporation before conditions for performance of the contract arose, if the buyout contract contained a provision permitting the stockholder to call on the corporation to buy the stock, or if the survivor could have elected not to buy the stock.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     <em>Holsey v. Commissioner</em>, 258 F.2d 865 (3d Cir. 1958); Rev. Rul. 58-614, 1958-2 CB 920; Rev. Rul. 59-286, 1959-2 CB 103.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     <em>Smith v. Commissioner</em>, 70 TC 651 (1978).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>Pulliam v. Commissioner</em>, TC Memo 1984-470; Rev. Rul. 69-608, 1969-2 CB 42.<br /> <br /> </div>

<div class="Section1"><br /> <br /> No. An estate typically realizes no capital gain as a result of a redemption. Where a redemption is a capital transaction ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="300">300</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="303">303</a>), an estate has no tax liability unless the price paid by the corporation exceeds the new tax basis of the stock redeemed.<br /> <br /> When a stockholder dies, his or her stock receives a new basis equal to its fair market value at date of death or at an alternate valuation date.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> As sale price under a proper stock redemption agreement generally is accepted as the fair market value of shares ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="322">322</a>), the sale price should equal the estate&rsquo;s basis and no gain or loss should be realized by an estate.<br /> <br /> For decedents dying in 2010, modified carryover basis rules in IRC Section 1022 may apply, so stock may not receive a full basis step-up.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 1014(a)(1), 1014(a)(2).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> If an S corporation has no accumulated earnings and profits from when it was a C corporation or as a result of a corporate acquisition, then a redemption of stock will be treated as a capital transaction. That is, it will be tax-free to the extent of the shareholder&rsquo;s basis and any excess will be treated as capital gain.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> If an S corporation has accumulated earnings and profits, however, then part of the payment by the corporation could be treated as a dividend.<a href="#_ftn2" name="_ftnref2">²</a> The exceptions to dividend treatment under IRC Sections 302(a) and 303(a) are available to S corporations ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="300">300</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="303">303</a>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 1368(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 1368(c).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A partnership can agree to make payments to a retiring partner or to the estate or beneficiary of a deceased partner, other than payments in liquidation of that partner’s partnership interest. The payments either may be periodic guaranteed amounts or a share of future profits. In either case, the payments will be taxed as ordinary income to the payee.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> Payments of a guaranteed amount will be deductible by a partnership.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Similarly, payments representing a share of profits will reduce the remaining or surviving partners’ share of distributable taxable income.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> This tax treatment applies only to payments made by a partnership as an entity and not to payments made by individual remaining or surviving partners. A partnership, even a two person partnership, will not be considered as having terminated so long as these payments are being made because partners’ interests have not been liquidated.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Rev. Rul. 71-507, 1971-2 CB 331.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.736-1(a)(4).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 736(a).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     Treas. Reg. § 1.736-1(a)(6).<br /> <br /> </div>

<div class="Section1"><br /> <br /> Under a liquidation agreement, partners may elect to treat amounts paid for goodwill as either the purchase price for a capital asset or as ordinary income. For partners retiring or dying on or after January 5, 1993, or for payments made under a written contract that was binding as of January 4, 1993, an additional requirement applies to the election to treat goodwill as ordinary income. This treatment may be elected only if capital is not a material income-producing factor in a partnership and a retiring or deceased partner was a general partner.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> Where an agreement provides that part of the purchase price is for goodwill, the amount allocable to goodwill also will be treated as having been paid for a deceased’s interest in partnership property. Regulations state that payment for goodwill, to be treated as a capital transaction, must be reasonable. However, the value placed on goodwill by partners in an arm’s length agreement, whether specific in amount or determined by formula, generally will be regarded as the correct value.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the material income-producing factor/general partner requirements mentioned above are met and the agreement makes no provision for goodwill, or stipulates that payment for goodwill is to be treated as income, the amount paid for goodwill is taxable as ordinary income to the estate or other recipient. If treated as ordinary income, it is deductible by the partnership.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Election to treat payment for goodwill as a capital investment or ordinary income may be made either in the original articles of partnership or in a subsequent business purchase agreement.<a href="#_ftn4" name="_ftnref4">⁴</a> The IRS has ruled that determination as to whether a professional practice has saleable goodwill will be made on the basis of all the facts in a particular case and not on the basis of whether a business is dependent solely on the personal characteristics of the owner.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 736(b)(3).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.736-1(b)(3).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 736(b)(2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     <em>Jackson Investment Co. v. Commissioner</em>, 346 F.2d 187, 15 AFTR 2d 1125 (9th Cir. 1965).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     Rev. Rul. 64-235, 1964-2 CB 18, as modified by Rev. Rul. 70-45, 1970-1 CB 17.<br /> <br /> </div>