R.H. from Tacoma, Wash. writes:
I am one of three owners in a small business. We're concerned about the impact of a disability on one of us. What are the possible tax ramifications if we buy disability insurance on the lives of all three business owners to fund a disability buyout? How do we structure the arrangement to benefit from lower capital gains taxes?
Whether the insurance buyers are the owners of the corporation (a cross-purchase agreement) or the corporation is the owner (an entity agreement), the premiums are nondeductible and tax-free to the recipient.
If the corporation does buy out all the disabled shareholder's shares, the redemption is treated as a sale of the redeemed shares (assuming the shareholder isn't considered to indirectly own any company stock under IRS rules after the redemption). With a cross-purchase arrangement, the transaction is considered a straight stock sale.
So the disabled shareholder can benefit from the new 15 percent maximum capital gains rate (assuming the disability occurs before 2009). The taxable amount is the amount received in excess of the shareholder's basis in the company.
But the tax rules are slightly different if the business entity is a partnership, rather than a corporation. A termination resulting from an entity agreement is treated as a liquidation of the partner's interest, which may trigger some ordinary income taxed at regular rates. See your tax pro for the details.
Finally, assuming the disabled business owner realizes gain from the buyout, the gain is included in that person's taxable income in the year received.