CLU Planning for Business Owners Questions and Answers — Questions and Answers
Question 1: Three equal partners in a C-corporation have a cross-purchase buy-sell agreement funded by life insurance. If one partner dies, which of the following accurately describes the income tax consequences for the two surviving partners?
- The death benefit is received income tax-free, and the surviving partners receive a step-up in basis for the shares they purchase from the deceased partner's estate. (Correct answer)
- The death benefit is taxable as a dividend to the surviving partners, and they do not receive a step-up in basis.
- The death benefit is received income tax-free, but the surviving partners do not receive a step-up in basis in the acquired shares.
- The death benefit is taxable as ordinary income to the corporation, which then distributes the after-tax proceeds to the surviving partners.
Correct answer: The death benefit is received income tax-free, and the surviving partners receive a step-up in basis for the shares they purchase from the deceased partner's estate.
In a cross-purchase buy-sell agreement, the partners own policies on each other. The death benefit proceeds are received income tax-free under IRC Section 101(a). When the surviving partners use these proceeds to buy the deceased partner's shares, the purchase price becomes their new basis in those specific shares. This 'step-up' in basis is a key advantage of the cross-purchase structure, as it reduces potential capital gains if the survivors later sell the acquired shares or the entire business.
Question 2: A closely held corporation wants to provide liquidity to the estate of its majority shareholder upon her death to cover estate taxes and administrative expenses. Which of the following allows the corporation to redeem a portion of the decedent's stock without the distribution being treated as a dividend?
- A Section 162 Executive Bonus Plan
- A Non-qualified Deferred Compensation Plan
- An Entity-Purchase Buy-Sell Agreement
- A Section 303 Stock Redemption (Correct answer)
Correct answer: A Section 303 Stock Redemption
IRC Section 303 allows a corporation to redeem stock from a deceased shareholder's estate to pay for federal and state death taxes, funeral costs, and administrative expenses, treating the transaction as a sale or exchange (capital gain) rather than a dividend. This is a significant exception to normal redemption rules. To qualify, the value of the stock must exceed 35% of the decedent's adjusted gross estate, among other requirements.
Question 3: XYZ Corp. provides a 'double bonus' Section 162 executive bonus plan to its CEO. The plan funds a life insurance policy with an annual premium of $50,000. Which statement is TRUE regarding the tax implications of this arrangement?
- The corporation's deduction is limited to the $50,000 premium, and the CEO pays taxes on that amount.
- The corporation can deduct the bonus paid to the CEO, and the CEO reports the bonus as taxable income. (Correct answer)
- The corporation cannot deduct the bonus, but the CEO receives the benefit tax-free.
- The bonus is deductible by the corporation, and the CEO does not have to report any income because it is used for life insurance.
Correct answer: The corporation can deduct the bonus paid to the CEO, and the CEO reports the bonus as taxable income.
Under a Section 162 plan, the bonus paid to the executive is treated as compensation. Therefore, it is tax-deductible for the corporation (assuming it's reasonable compensation) and is included in the executive's gross income, subject to income and payroll taxes. A 'double bonus' or 'gross-up' bonus means the employer pays an additional amount to cover the executive's tax liability on the bonus, ensuring the net amount is sufficient to pay the full policy premium.
Question 4: A company establishes a split-dollar life insurance plan where the employee is the owner of the policy, and the employer's premium payments are secured by an interest in the policy's cash value and death benefit. This arrangement is best described as which of the following?
- An endorsement method plan
- A key person insurance plan
- A collateral assignment method plan (Correct answer)
- A group carve-out plan
Correct answer: A collateral assignment method plan
In a collateral assignment split-dollar arrangement, the employee (or a trust) owns the policy. The employer's contributions (premiums) are treated like a loan, and the employer secures its interest by taking a collateral assignment on the policy's cash value and death benefit, ensuring repayment of its outlays upon termination of the plan or the insured's death. This contrasts with the endorsement method, where the employer owns the policy.
Question 5: Which of the following is a primary characteristic of a non-qualified deferred compensation (NQDC) plan?
- It must be offered to all full-time employees to satisfy non-discrimination rules.
- Plan assets are held in a separate trust and are protected from the employer's creditors.
- The employer's tax deduction is taken when the compensation is deferred, not when it is paid.
- It can discriminate in favor of highly compensated employees and benefits are subject to the claims of the employer's creditors. (Correct answer)
Correct answer: It can discriminate in favor of highly compensated employees and benefits are subject to the claims of the employer's creditors.
Non-qualified deferred compensation plans are not subject to the strict ERISA participation and non-discrimination rules that govern qualified plans like 401(k)s. This allows employers to offer them exclusively to a select group of management or highly compensated employees. A key feature (and risk for the employee) is that the assets are not formally funded in a protected trust; they remain general assets of the employer and are subject to the claims of its creditors in case of bankruptcy or insolvency.
Question 6: Regarding the tax treatment of a key person life insurance policy owned by and payable to a C-Corporation, which of the following statements is correct?
- The corporation can deduct the premiums paid, and the death benefit is received tax-free.
- The premiums are not deductible, but the death benefit may be subject to the corporate alternative minimum tax (AMT). (Correct answer)
- Both the premiums paid and the death benefit received are fully taxable to the corporation.
- The premiums are not deductible, and the death benefit is always fully exempt from all corporate income taxes.
Correct answer: The premiums are not deductible, but the death benefit may be subject to the corporate alternative minimum tax (AMT).
Under IRC Section 264, a business cannot deduct the premiums on a life insurance policy where it is the direct or indirect beneficiary. While the death benefit is generally received income tax-free under IRC Section 101(a), for a C-Corporation, the proceeds can increase the corporation's adjusted current earnings (ACE), potentially subjecting the death benefit to the corporate alternative minimum tax (AMT).
CLU Planning for Business Owners Questions and Answers
Three equal partners in a C-corporation have a cross-purchase buy-sell agreement funded by life insurance.
If one partner dies, which of the following accurately describes the income tax consequences for the two surviving partners?