Do you have life insurance for your business and/or owned by your business? If so, the death benefit is supposed to be tax free, right? It might be. It might not be. Or worse, it could be taxed twice.
Let me tell you a story about Joe. He owned a very successful business with his partner Mike. Like most partners they loved working with each other, but shuddered at the thought that something would happen to one of them and the surviving partner would be left working with “the wife.” So like most business owners in their position, they went to their CPA who referred them to an attorney to write up a buy/sell agreement. This agreement stated that if one of them were to die or become disabled to the extent they could no longer work, the other partner would have the right to buy him out. This wasn’t that attorney’s first rodeo. He gave them some great advice. He put additional clauses in the document addressing what the purchase price would be and tax issues they could face. He even told them they needed to get life insurance and disability buy-out insurance to mitigate the surviving partner’s liability to buy out the family of the disabled or deceased partner. Furthermore, it would help protect the spouse of the deceased partner. Mike knew a guy - a college friend who sold insurance. They bought everything the attorney told them to and were set. Well, maybe not so much.
Joe died last year, ten years almost to the date they set all of this up. The life insurance proceeds were paid to the business and Mike bought Joe’s shares with the money along with a note he took from the bank to meet the valuation that was done. There was only one problem. The life insurance proceeds were taxable to the business. They weren’t supposed to be, but they were.
And, did I say one problem? Joe’s wife also had one problem. The amount she received for purchase was also taxable.
Confused? Let me lay this out for you: Mike bought Joe’s shares for $2,800,000. He received $1,500,000 in life insurance benefits. He paid $697,500 in taxes on these proceeds. He had to take a note from the bank for $1,997,500 to pay Joe’s wife.
Joe’s wife paid $658,070 in taxes from selling her stock.
The good news is Joe’s wife was out of Mike’s hair. The bad news—Mike owes a lot of money to the bank and Joe’s wife will have to learn to live on less than what they had planned on.
The worst part of all of this is that it could have, and should have been avoided. Life insurance is supposed to be tax-free and should be. The key is working with someone that knows what they are doing.
Perhaps we should dedicate the rest of this year to “cleaning up messes.” The truth is, a story like Joe’s could very easily be cleaned up with Tax Reform. They key is in knowing whether or not your story is similar to Joe’s. Remember - the good news is that you got up this morning. The bad news is that you have fewer days to do that. Don’t leave your spouse and partner with a tax nightmare. Let us help you review this today!