What Is An Insured Controlled Cross Purchase (ICCP)?

The Insured Controlled Cross Purchase (ICCP) strategy is a variation of a buy-sell agreement used to facilitate the transfer of ownership in a business when an owner or partner dies, retires, or becomes incapacitated. The strategy uses life insurance policies owned by the business owners themselves (rather than the business entity) and incorporates certain controls to mitigate tax and basis issues. The ICCP is designed to address the challenges highlighted by recent court rulings, such as the Connelly case, which have implications for the tax treatment of life insurance proceeds used in buy-sell arrangements.

How the ICCP Strategy Works

The ICCP strategy involves setting up life insurance policies in which each business owner (partner) personally owns a policy on the lives of the other owners. Here’s a step-by-step breakdown of how it functions:

1. Each Partner Owns Life Insurance on the Others: In a business with multiple partners, each partner purchases a life insurance policy on the lives of the other partners. For instance, if there are three partners (A, B, and C), Partner A owns a policy on B and C, Partner B owns a policy on A and C, and Partner C owns a policy on A and B.
2. Insurance Policy Premiums: Each partner pays the premiums on the policies they own. The policy’s face value is typically equivalent to the estimated value of each partner’s ownership share in the business.
3. Triggering Events and Buyout Funding: Upon the death of a partner, the life insurance policy owned by the surviving partners pays out. The surviving partners use the insurance proceeds to buy out the deceased partner’s ownership interest from their estate or heirs.
4. Ownership Redistribution: After using the life insurance proceeds to purchase the deceased partner’s share, the surviving partners redistribute the ownership interests according to the terms of the buy-sell agreement.

Benefits of the ICCP Strategy

The ICCP approach has several benefits, especially when addressing issues raised by the Connelly court ruling:

• Basis Step-Up for Surviving Partners: In a traditional stock redemption plan, the business entity itself receives the life insurance proceeds and buys back the deceased owner’s shares. This can lead to challenges with the basis step-up, as seen in Connelly, where the life insurance proceeds do not directly increase the remaining owners’ basis in their shares. However, in an ICCP strategy, the surviving partners personally receive the life insurance proceeds and use them directly to purchase the deceased partner’s shares. This purchase transaction allows the surviving partners to receive a step-up in basis for the newly acquired shares, potentially reducing their future capital gains tax liability when they sell their ownership stake.
• Avoiding Corporate AMT: Since the business does not own the life insurance policies, the proceeds do not flow through the company. This can help the business avoid certain tax complications, such as being subject to the corporate alternative minimum tax (AMT) on life insurance proceeds, a concern for C corporations in particular.
• Control Over Premium Payments and Proceeds: The ICCP structure gives individual partners more control over their policies and the proceeds. Each partner owns the policies and can therefore make decisions about the policies’ management, such as adjusting coverage or deciding on the use of proceeds in alignment with the terms of the buy-sell agreement.

How the ICCP Strategy Addresses the Connelly Ruling

The Connelly court ruling had a significant impact on how businesses view stock redemption agreements funded by life insurance. The ruling clarified that life insurance proceeds used in a stock redemption scenario do not allow for a basis increase in the shares of the remaining shareholders. This means that, when a business receives the insurance payout to buy back shares, the surviving owners might end up with a higher taxable gain upon selling their shares in the future, as their basis in the company remains unchanged.

The ICCP strategy addresses this issue in the following ways:

1. Direct Ownership of Policies by Shareholders: By having the life insurance policies owned by individual shareholders rather than the business entity, the ICCP structure avoids the basis complications seen in the stock redemption scenario. When a shareholder dies, the surviving shareholders receive the proceeds directly and use those funds to purchase the deceased shareholder’s interest. This transaction allows for a basis adjustment in the acquired shares.
2. Direct Purchase, Not Redemption: The key to the ICCP strategy’s advantage is that the surviving shareholders purchase the shares directly from the deceased owner’s estate rather than the business entity repurchasing them. This direct purchase creates a bona fide transaction that allows the surviving partners to increase their basis in the shares they acquire, which aligns with IRS rules for basis adjustments in cross-purchase arrangements.
3. Minimizing Future Capital Gains: By allowing a step-up in basis through direct ownership and purchase, the ICCP strategy helps the surviving owners minimize potential capital gains taxes when they later sell their shares. This makes the ICCP strategy particularly appealing for businesses looking to manage their long-term tax exposure.

Example: ICCP Strategy in Action

Scenario: A business has three partners—Alice, Bob, and Carol. Each partner owns a $1 million life insurance policy on the lives of the other two partners. Upon Alice’s death, Bob and Carol each receive $500,000 from the life insurance policies they own on Alice’s life.

• Buyout Process: Bob and Carol use the life insurance proceeds to purchase Alice’s ownership interest from her estate.
• Ownership Adjustment: Bob and Carol’s ownership stakes increase proportionally based on their buyout of Alice’s shares.
• Step-Up in Basis: Because Bob and Carol directly used the life insurance proceeds to purchase Alice’s shares, they receive a step-up in basis on the shares they acquired. This means that if Bob or Carol eventually sell their shares, they may owe less in capital gains taxes due to their increased basis.

This approach contrasts with a stock redemption plan where the business might buy back Alice’s shares, and Bob and Carol would not receive a basis adjustment, potentially leading to higher capital gains taxes later.

Pros and Cons of the ICCP Strategy

Pros:

• Tax Efficiency: The direct purchase by the surviving partners provides a basis step-up, which can be more favorable in terms of capital gains taxes.
• Control: Each partner has more control over the life insurance policies they own and can manage how the proceeds are used in a buyout.
• Flexibility: The ICCP approach can be customized to fit the needs of businesses with multiple owners, allowing each partner to set their own insurance coverage levels.

Cons:

• Administrative Complexity: With multiple owners, each needing to own policies on the other partners, the ICCP strategy can become administratively complex, especially with more than two or three owners.
• Premium Costs: Each partner must pay premiums for policies on multiple other partners, which can become expensive if the business has many owners or if the partners have significant age or health disparities.
• Coordination Needed: The success of the ICCP strategy depends on proper coordination and legal drafting of the buy-sell agreement to ensure that the proceeds are used as intended.

The Insured Controlled Cross Purchase (ICCP) strategy offers a way to manage business succession using life insurance while addressing tax challenges highlighted by the Connelly court ruling. By ensuring that life insurance policies are owned by individual partners and using the proceeds directly for cross-purchase transactions, this strategy helps surviving partners achieve a step-up in basis for their acquired shares. This can result in significant tax savings over time, making it an attractive option for business owners who want to manage their tax exposure and ensure a smooth transition of ownership. However, the strategy requires careful planning, coordination, and an understanding of the partnership’s unique needs to maximize its benefits.

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Michiel Laubscher & Laubscher Wealth Management LLC is not an investment advisor and is not licensed to sell securities. None of the information provided is intended as investment, tax, accounting, or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other offerings. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information contained herein is at your own risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Michiel Laubscher & Laubscher Wealth Management LLC does not promise or guarantee any income or specific result from using the information contained herein and is not liable for any loss or damage caused by your reliance on the information contained herein. Always seek the advice of professionals, as appropriate, regarding the evaluation of any specific information, opinion, or other content.