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Exciting New
Developments in Buy-Sell Planning
This issue of The
Wealth Counselor examines exciting new developments in
business succession planning - specifically, the use of LLCs
or partnerships to own life insurance for buy-sell planning
purposes. Such a structure obtains the advantages of
cross-purchase and stock redemption buy-sell agreements
without many of the disadvantages of either traditional
structure. This development is significant to all wealth
planning professionals and their business-owner clients.
Background
For many business owners, the business itself is their
primary source of income both during working years and in
retirement. Thus, buy-sell planning is critical for not only
death planning but also disability and retirement planning
during lifetime.
Unfortunately, the two traditional types of buy-sell
agreements ((1) stock redemption (aka entity purchase) and
(2) cross-purchase agreements), have significant limitations
and disadvantages that often prevent business owners from
adequately preparing for many business succession issues.
Stock Redemption (Entity Purchase)
With a Stock Redemption arrangement, the corporation owns
the life insurance and agrees to redeem the shares of a
deceased shareholder at that shareholder's death. The
shareholder in turn agrees that his estate will transfer the
shares back to the corporation for an agreed-upon price.
The advantages of this arrangement are:
- The simplicity of only one life insurance policy per
shareholder;
- The shareholders allocate all premium costs
according to their percentage ownership in the
corporation; and
- This arrangement ensures compliance with the terms
of the buy-sell agreement.
The disadvantages
of stock redemption arrangements are many:
- There is no change to the surviving shareholders'
basis at the owner's death so the surviving shareholders
will incur larger capital gain tax upon a lifetime
disposition;
- The insurance policies are subject to attachment by
the corporation's creditors;
- If the corporation is a C corporation, the death
proceeds may also be subject to the alternative minimum
tax (AMT);
- If corporate-owned buy-sell policies are over-funded
to provide non-qualified retirement benefits to the
owners, the benefits are generally subject to income
tax; and
- Potential taxation on redemption of the stock to the
extent of earnings and profits where the attribution
rules of IRC Sec. 318 apply.
If the corporation
is an S corporation, the results of a stock redemption
arrangement are better, because the AMT and attribution
rules do not apply where the business has always been an S
corporation. Also, the life insurance cash value and death
proceeds give the shareholder some stock basis adjustment,
reducing the amount of capital gain tax that may be
triggered on a sale during life or at death.
Planning Tip: Stock redemption arrangements
require only one policy per shareholder and thus cost
less to implement, but have significant disadvantages as
compared to cross-purchase arrangements.
Cross-Purchase
Under a cross-purchase arrangement, each owner/shareholder
owns a policy on every other owner, and each surviving owner
agrees to buy the deceased owner's interest directly from
the deceased owner's estate.
The advantages of this structure are:
- The survivors use income-tax-free death benefit to
buy stock directly from the decedent's estate, thereby
increasing their average share basis;
- Use of the "wait and see" approach allows surviving
shareholders to keep the insurance proceeds for
themselves to the extent that retained corporate
earnings are available to effectuate a redemption; and
- Policies are protected from the corporation's
creditors.
The disadvantages
of cross-purchase arrangements are:
- The number of policies required to accomplish
funding (each owner must own a policy on each other
owner) quickly becomes unwieldy as the number of
shareholders increases;
- Policies are subject to attachment by the owner's
creditors;
- An owner may fail to pay premiums or refuse to pay
death benefits pursuant to the buy-sell agreement;
- The premium burden is allocated based on the cost of
insurance of each other owner; and
- Application of the transfer-for-value rule (when
surviving owners purchase from the deceased owner's
estate the policies on the other survivors) or need to
buy new policies to cover increased values.
Planning Tip: Cross-purchase arrangements also
have significant disadvantages. For many clients, the
number of policies required for funding and the unequal
cost burden are simply too big of a hurdle for
implementation.
Use of LLCs to Structure and Fund Buy-Sell
Agreements
In a recent Private Letter Ruling, PLR
200747002, the
IRS accepted a strategy that has the advantages of both
cross-purchase and redemption agreements without the
disadvantages of either. With this structure, the
shareholders execute a cross-purchase agreement and form an
LLC, taxed as a partnership, to own the life insurance. The
cross-purchase agreement and LLC operating agreement have
provisions that reference each other.
Special provisions of the LLC include:
- The LLC manager is a corporate trustee, and any
replacement must be a corporate trustee;
- Members cannot vote on life insurance matters;
- The manager must use life insurance proceeds as
required in the buy-sell agreement; and
- The LLC must maintain a capital account for each
member, with special allocations of premiums and
proceeds.
Upon examination of
this structure, the IRS ruled that the life insurance death
proceeds would not be includible in the estate of the
deceased LLC member. Thus, this structure contains the
advantage of the traditional buy-sell structures without the
disadvantages.
Planning Tip: Using an LLC to own life
insurance for buy-sell funding purposes accomplishes the
buy-sell objectives without causing many of the adverse
income tax consequences and without causing estate tax
inclusion.
"LifeCycle" Buy-Sells
This ruling adopts an approach similar to the "LifeCycle"
Buy-Sell Agreement, first written about in "Using a General
Partnership to Structure and Fund Buy-Sell Arrangements," by
James C. Peterson and William S. White, from the January
2000 issue of the Journal of Financial Service
Professionals.
There are some differences, however, between the PLR and
"LifeCycle" structures, in particular:
- The PLR uses term insurance - LifeCycle uses cash
value insurance to also accomplish retirement planning
objectives;
- The PLR limited its ruling to funding a death buyout
- LifeCycle can also be used for non-qualified
retirement benefits; and
- The PLR LLC has a more restrictive operating
agreement - for example, LifeCycle does not require a
corporate trustee as manager (only requires an
independent trustee) and restricts a member against
voting only on policies on that member's life. Counsel
who submitted the PLR believes that these more
restrictive provisions are only necessary for those
seeking a letter ruling.
Planning Tip: Using an LLC or partnership to
own insurance for buy-sell funding purposes eliminates
the tax and other disadvantages of both cross-purchase
and stock redemption agreements. Further, this structure
requires only one policy per owner, making it a more
attractive structure from the business owners'
perspective.
Conclusion
Buy-sell planning is critical for business owners, but many
defer implementation of a business succession agreement
because of either the cost or tax disadvantages, or both, of
the traditional buy-sell structures and common alternative.
Use of an LLC or partnership to own the life insurance for a
buy-sell arrangement eliminates both of these impediments
and thus is much more attractive to business owners.
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