Free Chartered Life Underwriter (CLU) Planning for Business Owners Questions and Answers — Questions and Answers
Question 1: A closely-held C corporation has a significant portion of its value tied to the ownership interest of its 70-year-old founder. The founder's estate anticipates a large estate tax liability upon his death. Which of the following allows the corporation to redeem a portion of the decedent's stock to pay for funeral expenses, estate administration costs, and death taxes, with the redemption being treated as a capital transaction rather than a dividend?
- A Section 1244 stock sale
- An IRC Section 303 stock redemption (Correct answer)
- A Reverse Section 303 stock redemption
- A private annuity arrangement
Correct answer: An IRC Section 303 stock redemption
IRC Section 303 provides that a distribution of property to a shareholder by a corporation in redemption of stock, the value of which is included in determining the value of the gross estate of a decedent, shall be treated as a distribution in full payment in exchange for the stock so redeemed. This allows the redemption to receive capital gains treatment, which is highly favorable since the stock receives a step-up in basis at death, often resulting in little to no capital gains tax. The amount of the redemption is limited to the sum of estate taxes, funeral costs, and administrative expenses.
Question 2: Three partners own a growing consulting firm and have a buy-sell agreement in place. They are considering two primary funding structures: a cross-purchase plan and an entity-purchase (stock redemption) plan. What is the primary income tax advantage for the surviving partners if they use a life-insurance-funded cross-purchase agreement versus an entity-purchase agreement?
- The corporation can deduct the life insurance premium payments.
- The death benefit proceeds are received by the corporation tax-free.
- The surviving partners receive an increased cost basis in the business interest they acquire. (Correct answer)
- The administrative burden is lower with a cross-purchase plan.
Correct answer: The surviving partners receive an increased cost basis in the business interest they acquire.
In a cross-purchase agreement, the surviving owners purchase the deceased owner's interest directly. The amount they pay for this interest becomes their new cost basis in those shares. This "step-up" in basis is a significant advantage because it reduces the potential capital gains tax if the surviving owners later sell their interests. In an entity-purchase plan, the business redeems the shares, and the surviving owners' basis in their own shares does not change.
Question 3: A corporation is establishing a non-qualified deferred compensation (NQDC) plan for its key executives to provide supplemental retirement income. To ensure the executives are not subject to immediate income tax on the deferred amounts under the doctrine of constructive receipt, the plan must include which of the following features?
- The plan must be formally funded with an irrevocable trust.
- The executives' rights to the deferred amounts are subject to a substantial risk of forfeiture. (Correct answer)
- The plan's assets must be segregated from the company's general assets.
- The benefits must be fully vested and nonforfeitable from the date of deferral.
Correct answer: The executives' rights to the deferred amounts are subject to a substantial risk of forfeiture.
For a non-qualified deferred compensation plan, taxation is deferred as long as the employee does not have constructive receipt of the funds. A key element in avoiding constructive receipt is that the employee's rights to the compensation are not yet vested. This is typically achieved by making the rights subject to a "substantial risk of forfeiture," which often means the employee must continue to perform substantial services for a specified period to receive the benefits.
Question 4: A financial planner is advising a family-owned manufacturing company on its succession plan. The owners want to determine the company's value for a potential buy-sell agreement. They use a valuation method that analyzes historical earnings, adjusts them for non-recurring items, and applies a capitalization rate to determine the present value of anticipated future profits. What is this valuation method called?
- Adjusted Book Value Method
- Liquidation Value Method
- Market Comparables Approach
- Capitalization of Future Maintainable Earnings Method (Correct answer)
Correct answer: Capitalization of Future Maintainable Earnings Method
The Capitalization of Future Maintainable Earnings (or Capitalization of Earnings) method is an income-based approach that values a business based on its expected future profits. It involves calculating the business's sustainable, normalized earnings and then dividing that figure by a capitalization rate that reflects the risk and expected rate of return.
Question 5: An S-Corporation is the owner and beneficiary of a key person life insurance policy on its president. Which of the following statements correctly describes the income tax treatment of the policy's premiums and death benefit?
- Premiums are tax-deductible, and the death benefit is taxable income.
- Premiums are tax-deductible, and the death benefit is tax-free.
- Premiums are not tax-deductible, and the death benefit is taxable income.
- Premiums are not tax-deductible, and the death benefit is generally received income tax-free. (Correct answer)
Correct answer: Premiums are not tax-deductible, and the death benefit is generally received income tax-free.
Under IRC Section 264(a)(1), a business cannot deduct premiums on a life insurance policy if the business is directly or indirectly a beneficiary. Conversely, under IRC Section 101(a), the death benefit proceeds from a life insurance policy are generally received by the beneficiary free of federal income tax. For an S-Corporation, while the premiums reduce shareholder basis, the tax-free death benefit increases shareholder basis.
Question 6: A business has five owners who wish to establish a life insurance-funded cross-purchase buy-sell agreement. Which of the following is a significant administrative disadvantage of this arrangement compared to an entity-purchase plan?
- The surviving owners do not receive a step-up in basis.
- The policy cash values are considered a corporate asset.
- The number of policies required can become unwieldy. (Correct answer)
- The death benefit may be subject to the corporate alternative minimum tax (AMT).
Correct answer: The number of policies required can become unwieldy.
In a cross-purchase agreement, each owner must purchase a life insurance policy on every other owner. The number of policies required is calculated as n(n-1), where 'n' is the number of owners. With five owners, this would require 5(5-1) = 20 separate policies, creating a significant administrative burden. In contrast, an entity-purchase plan would only require five policies—one for each owner, owned by the business.
Free Chartered Life Underwriter (CLU) Planning for Business Owners Questions and Answers
A closely-held C corporation has a significant portion of its value tied to the ownership interest of its 70-year-old founder.
The founder's estate anticipates a large estate tax liability upon his death.
Which of the following allows the corporation to redeem a portion of the decedent's stock to pay for funeral expenses, estate administration costs, and death taxes, with the redemption being treated as a capital transaction rather than a dividend?