buy sell agreements funded with life insurance

Copyright 2014 Daniel G. Alcorn

Daniel G. Alcorn

Buy-Sell Agreements FundedWith Life Insurance


1. Why Should You Consider a Buy-Sell Agreement?2. Why Fund With Life Insurance?3. Cross Purchase Buy-Sell4. Entity Purchase Buy-Sell5. Unilateral Buy-Out6. Wait and See Buy-Sell7. General Tax Considerations8. Tax Consequences to Seller9. Basis for Surviving Owners10. Selecting a Buy-Sell Structure11. Valuing a Business


1. Why Should You Consider aBuy-Sell Agreement?

Buy-sell planning helps preserve control and value of a business at the death, disability, or retirement of an owner.

These agreements provide that the estate of a deceased owner will be paid a fair value for his/her interest, and that the surviving owners will maintain control and ownership of the business.

Life insurance on the owners can be a source of money to fund these arrangements.


2. Why Fund With Life Insurance?

Assure that funding is available to purchase the business interest at the business owner’s death.

Provide funds to purchase the business interest for the cost of premiums paid on the policy.

Avoid negative impact on working capital and credit position of the business.

Simple and effective funding method when compared to other methods, such as a taxable sinking fund or paying “out-of-pocket” for the business interest.


3. Cross Purchase Buy-Sell

Owners (A and B) enter into an agreement that surviving owner will purchase the business interest of a deceased owner.

Each owner buys a life insurance policy on the other owner and names self as beneficiary (i.e., A is owner and beneficiary of policy on B’s life.)


Cross Purchase - How Does It Work?

1. Owners enter into an agreement that surviving owner will purchase the business interest of a deceased owner.

2. Each owner buys a life insurance policy on the other owner and names self as beneficiary.

Client

Business

Loan

Life Insurance Company

Buy-Sell Agreement

Owner A

Loan

Owner B


Cross Purchase - How Does It Work?

3. Owner A receives the death benefit from Life Insurance Company.

4. Owner A Buys the business interest from the estate of owner B.

5. Result: Owner A owns 100% of business.

Client

Business

Loan

Life Insurance Company

Business InterestOwner A

Loan

Estate of Owner B$

$


Cross Purchase Advantages Purchasers obtain an increased basis in the acquired

business interest which means potential tax savings at a later lifetime sale.

Funding is not subject to the claims of business creditors.

Funding can be assisted by the business through additional compensation.

If the business has a higher tax bracket than the individuals there is greater tax leverage by having the individuals pay the premiums.

Allows owners to designate percentage of ownership acquired.


Cross Purchase Disadvantages

Plan may be difficult to administer if there are multiple owners

There is less tax leverage if the business has a lower tax bracket than the individuals

Insured plans require multiple policies on each owner. No. of policies needed = No. of Owners x (No. of Owners - 1)

Perceived inequity if large differences in premiums due to age/health


4. Entity Purchase Buy-Sell

Business and owners (A and B) enter into an agreement that the business will purchase the interest of a deceased owner

Business buys life insurance policies on each owner and names business as beneficiary


Entity Purchase - How Does It Work?

1. Business and owners enter into an agreement that the business will purchase the interest of a deceased owner.

2. Business buys life insurance policies on each owner and names business as beneficiary.

Client

Business

Loan

Life Insurance Company Owner A

Loan

Buy-Sell Agreement

Owner B


Entity Purchase - How Does It Work?

3. Business receives the death benefit.

4. Business buys the business interest from the estate of owner B.

5. Result: Owner A owns 100% of business.

Client

Business

Loan

Life Insurance Company Owner A

Loan

$

Business Interest$

Estate of Owner B


Entity Purchase Advantages

Funding is provided by the business rather than by the individual owners

Requires only one insurance policy on each owner

There is greater tax leverage if business has a lower tax bracket than the individuals

Discrepancies in premiums due to age/health are less of a perceived problem


Entity Purchase Disadvantages

Possible problem with the corporate accumulated earnings tax

Stock attribution rules could cause payment from the business to the estate to be taxable as a dividend

Funding is subject to the claims of business creditors No new cost basis for surviving owners if business is a C

corporation Does not allow owners to designate percentage of

ownership acquired — may result in unintended shift of control

There is less tax leverage if business has a higher tax bracket than the individuals

Corporate cash values and death benefit may be subject to alternative minimum tax


5. Unilateral Buy-Out

A sole proprietor and key person enter into a buy-sell agreement

Key person buys a life insurance policy insuring the sole proprietor

At the death of sole proprietor, key person receives the death benefit and buys business from sole proprietor’s estate


6. Wait and See Buy-Sell The business has option to buy all or a portion of a

deceased owner’s interest

The surviving owners have option to buy any of the ownership interest not purchased by the business. Any interest not purchased by the remaining owners must then be purchased by the business

Insurance policies to fund the wait and see plan can be maintained by either the owners or the business. Normally the funding is maintained by the owners. If the business decides to purchase the decedent’s interest, the surviving owners lend or contribute the funds to the business


7. General Tax Considerations Premium payments are not deductible Proceeds paid on death are generally received free of

income tax The value of the business interest for estate tax

purposes will generally be measured by the value specified in the buy-sell agreement, although the IRS is not bound by values specified in agreements between family members

Termination of funded cross purchase buy-sell plan may trigger taxable income if policies with gain are exchanged

Unless an exception is available, the transfer for value rule could cause the death benefit to be income taxable if a policy is transferred to a shareholder who is not the insured


8. Tax Consequences to Seller On the sale of a business interest by a deceased owner’s

estate, the estate generally recognizes no gain because its basis is “stepped up” to fair market value at death

A portion of the payment to the estate may be taxed as ordinary income if the business is a partnership with accounts receivable, appreciated inventory, or goodwill

Stock attribution rules may cause the payment to the estate from a family owned corporation to be taxed as a dividend


9. Basis of Surviving Owners In a cross purchase buy-sell, a purchasing owner’s basis in

the business interest is increased by the purchase price

In an entity buy-sell, the basis of the surviving owners might be increased when the death benefit is paid, depending on the type of entity:◦ C Corporation: Stock basis of remaining shareholders is

not increased

◦ S Corporation: Each owner’s basis is increased proportionately by insurance proceeds received by the entity. A §1377 election may be made in a cash basis S corporation to allocate all basis increase to surviving owners

◦ Partnership: Life insurance proceeds received by the partnership increase each partner’s basis proportionately unless special allocations are made

◦ LLC: Generally same as partnership


10. Selecting a Buy-Sell Structure Who should be the purchaser? How many owners exist? How old are the owners? What percentage of ownership does each owner have? What is the type of business entity? Are the owners related? Are the owners insurable? What is the net worth of each owner? What are the tax brackets of the owners and business entity? Do non-active spouses have any interest in the business? Do other family members have an interest in the business? Who should pay for premiums on insurance policies? What is the likelihood the business will be sold during the

owner’s lifetimes? Will the surviving owners purchase the business interest pro-

rata? Will there be a shift in control upon an owner’s departure? Are there significant business or personal creditors? Is the business a corporation subject to alternative minimum

tax? Should the agreement cover death, disability and retirement? What is the value of the business?


11. Valuing a Business

Valuation of a business is a critical part of a buy-sell plan and may be based on any of the following methods:◦ Appraisal

◦ Owner’s Agreement

◦ Adjusted Book Value

◦ Capitalization of Income

The agreement and funding arrangement should be reviewed periodically to determine if the valuation and funding are current


Daniel G. AlcornNiskayuna, New York 12309Office: 518-346-2115 Email: [email protected] Twitter: @DGANewYork Blog: www.dgalcorn.wordpress.com

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Disclosure

sThis material was created to provide helpful information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Daniel G. Alcorn does not offer tax or legal advice.

Any guarantees offered by life insurance products are subject to the claims-paying ability of the issuing insurance company. Riders may be available for an additional cost. There are considerable issues that need to be considered before replacing life insurance such as, but not limited to; commissions, fees, expenses, surrender charges, premiums, and new contestability period. There may also be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans. Please discuss your situation with your financial advisor.