Choosing a structure for a buy/sell arrangement can be difficult. The difficulty is knowing what type of buy/sell structure will produce the best results when the triggering event is unknown and will likely take place many years in the future.
A buy/sell format that may seem to be a good choice for a business today may not make sense 5, 10 or 20 years down the road. Change is a regular occurrence in business, and it is likely that situations will change after a buy/sell agreement is finalized but before a triggering event occurs.
Possible Changes Include:
Industry shifts
Economics of a business
Owners’ health
Makeup of owners’ families
Tax laws
Local business climate
Business technology
Owners’ finances
Owners’ personal objectives
Insurance companies and products
So that business owners can respond to unexpected future changes, including some provisions in the buy/sell agreement that give it flexibility is probably wise. By their nature, most entity purchase and cross-purchase agreements are fixed and may not be able to accommodate many changes.
What are some ways flexibility can be incorporated into a buy/sell agreement? This article will discuss two potential strategies: (1) creating flexibility in the identity of the buyer(s) and (2) creating flexibility in the ownership of life insurance policies purchased to fund the agreement.
Creating Flexibility
Among The Purchasers
One of the most important tasks of a buy/sell agreement is to create a binding obligation to purchase the departing owner’s interest. Meeting this objective, however, doesn’t mean there can’t be some flexibility in the identity of the purchaser or that there can’t be several purchasers. The objective of the agreement is to make sure the departing owner’s entire interest is purchased and that ownership remains within a specific group of individuals.
Using preliminary purchase options is a strategy with the potential to add ownership flexibility while still assuring that the entire interest for sale will be purchased and that ownership will remain within the group. A buy/sell arrangement that uses purchase options before a mandatory purchase is often called a “wait-and-see buy/sell.”
The Wait-and-See Buy/Sell. This arrangement allows the owners to wait until the first death or another triggering event to decide whether the business, the remaining owners, or a combination of the two will purchase the interest for sale. This flexibility is useful because it allows the remaining owners to postpone deciding what the future ownership makeup will be until a triggering event actually occurs. Wait-and-see arrangements allow the purchasers to be the entity, the remaining owners—or both.
How It Works. In a typical wait-and-see arrangement, the business has the first option to purchase all or part of the interest for sale at the price or formula set in the agreement. If the business does not fully exercise the option and purchase the entire available interest within a specified time, the surviving owners are next in line to purchase the interest remaining for sale. Each remaining owner may have the option to purchase his pro rata share of the remaining interest. If the remaining owners do not fully purchase the remaining interest, then the business entity is required to purchase the remainder.
A wait-and-see arrangement adds flexibility because if a cross-purchase plan is more advantageous than an entity purchase at the time of the triggering event, the business does not have to exercise its first option to purchase. The remaining owners will then exercise their individual options. On the other hand, if the owners believe an entity purchase plan is more advantageous, they can elect that the business purchase the entire interest available for sale.
Life insurance policies funding a wait-and-see arrangement are usually owned by the individual owners just as in the cross-purchase funding format. If one owner dies, and the remaining owners decide to complete the purchase in a cross-purchase format, they will receive the death benefits and may use them to fund the purchase of their shares of the interest. If they decide to use the entity purchase format instead, they will receive the policy death benefits and then they can lend these death benefits to the business entity. When the loan is paid up, it is likely that only the interest paid on the loan will be considered taxable income to the owners.
The Own-Your-Own Policy Buy/Sell
Nearly all buy/sell agreements that use life insurance have one thing in common: The insured business partners do not own the life insurance policies that insure their own lives. In an entity purchase arrangement the business owns the policies. In a cross-purchase arrangement the other owners or another entity (e.g., a trust or a general partnership) own the policies.
The fact that owners don’t own their own policies has the potential to create a variety of problems, including:
• An owner is precluded from making decisions about the policy insuring his life.
• If an owner leaves the business before death, he may not be able to acquire ownership of his policy or use the death benefits for personal financial objectives.
• If an owner’s health deteriorates, he may become uninsurable and unable to purchase other life insurance coverage; thus, he may need the buy/sell coverage for his family.
• Even if a departing owner is insurable, the cost of purchasing new coverage could be prohibitive because of age, health or other conditions.
Many buy/sells are triggered when an owner retires, becomes disabled or voluntarily leaves for other reasons. In those cases the policy death benefit can’t be used to purchase the departing owner’s interest because the insured owner hasn’t died. Nevertheless, the departing owner’s policy is a potentially valuable asset which could be quite useful in his wealth transfer and personal financial planning. When policies are individually owned, each partner controls his death benefit after leaving the business and can change the beneficiary designation to meet his personal objectives.
Potential Advantages. There are a number of potential advantages when partners own their individual buy/sell life insurance policies, including:
• One Policy Per Owner—There is no need for multiple policies on each owner.
• Personal Ownership and Control—Each partner owns and makes the decisions concerning his policy (although each owner must manage the policy to satisfy any standards or requirements set in the buy/sell agreement).
• Personal Death Benefit Coverage—If an owner wants more death benefits than the amount needed under the buy/sell agreement, he may wish to combine the coverage required under the buy/sell agreement with the coverage for his personal protection and wealth transfer planning.
• Personal Responsibility—Each owner is responsible for his own premiums. Younger or healthier owners aren’t forced to pay premiums on older or less healthy owners.
• Personal Premium Level—Owners decide how much premium to pay; they may choose to pay more than the minimum in order to increase cash values potentially available for supplemental retirement income.
• Policy Is Portable—Every owner who leaves the business before death takes the policy with him; there is no need to attempt to reacquire the policy from another owner or from the business.
• Personal and Wealth Transfer Planning—After an owner leaves, he has the option to reposition the death benefits to meet personal needs without going back through underwriting to purchase new coverage; thus, problems with increased premiums and decreased insurability can potentially be avoided.
Two Reasons Personal Ownership Is Rarely Used. In spite of the potential advantages, personal ownership of death benefits to fund buy/sell agreements is a strategy that is seldom used. This is true for two primary reasons:
1. Someone else (either another owner, entity or the business itself) has the legal obligation to purchase the interest. Because potential purchasers need to make sure they have sufficient funds to satisfy their purchase obligations under the agreement, it may not make sense for them to own and control the policies.
2. The transfer for value rule of IRC Section 101. One of the advantages of using life insurance as part of the buy/sell funding is that policy death benefits are generally federal income tax-free to the policy beneficiary when the insured owner dies. This valuable income tax benefit may be lost if the business owners own their own policies because they may violate the “transfer for value rule.”
A transfer for value occurs when the owner of a life insurance policy transfers an interest in the policy to someone else and receives something of value in return. Under IRC Section 101 “value” isn’t limited to just cash or tangible assets; “value” can also include an enforceable promise which could potentially benefit the recipient (such as a promise to purchase the owner’s interest).
Violating the transfer for value rule results in taxable income to the policy beneficiaries to the extent of the difference between the policy death benefit and the total of the consideration paid plus all premiums paid after the transfer.
Here’s an example to illustrate the point. A and B are each 50 percent owners of a business. Each purchases a $1 million life insurance policy on his own life and names the other as a beneficiary (normally neither A nor B would name each other as a policy beneficiary). Reciprocal promises to name each other as beneficiaries can be implied from their respective actions (or from the terms of the agreement). These reciprocal promises are the “value” that triggers the transfer for value rule. Thus, if Partner A dies, part or all of the $1 million death benefit Partner B receives as the beneficiary of A’s policy may be taxable income to B.
The Partnership Exception. Fortunately, it is possible to avoid the harsh income tax consequences of the transfer for value rule. In IRC Section 101(a)(2) Congress created a number of exceptions to the rule; if one of those exceptions applies, then it is possible the policy beneficiary may still receive the life insurance death benefits free of federal income taxes.
The exception most likely to apply to buy/sell arrangements is the partnership exception. This exception shields transfers for value from federal income taxes if the transfer is to a partner of the insured or to a partnership in which the insured is a partner.
The ability to use the partnership exception to avoid the transfer for value rule may create an opportunity for a new type of life insurance funded buy/sell arrangements:the Own Your Own Policy Buy/Sell. In this approach each owner owns his policy and assigns or endorses part of the death benefit to the other owners so they will have the funds to meet their purchase obligations under the agreement. If these owners are in a partner/partnership relationship, income taxation of the death benefits under the transfer for value rule should be avoided.
• How the Own Your Own Policy Buy/Sell Works. Assuming there is valid partnership in place or the business is organized as a limited liability company (LLC), limited liability partnership (LLP), or a general partnership, these steps may be taken:
1. The owners enter into a cross-purchase arrangement; each owner agrees to purchase his pro rata share of the other’s death.
2. Each owner purchases and pays the policy premiums on his own life with a face amount at least as large as the value of his interest in the business. An option B death benefit approach—where the death benefit payable is the face amount plus premiums paid—may be appropriate because the insured’s estate will recover premiums paid into the policy.
3. Each owner assigns or endorses part of his policy’s death benefit to the other owners according to their pro rata shares of the business; the necessary forms are filed with the insurance company.
4. At an insured owner’s death, the benefits are paid according to the assignment/endorsement and the policy beneficiary designation; each surviving owner uses his share of the death benefit to purchase part of the deceased’s share of the business from his estate, as required by the agreement.
5. If an owner retires or otherwise leaves the business before death, the remaining owners may use the cash values in their policies and/or other personal assets to purchase their respective shares of the departing owner’s interest.
6. The owners complete all paperwork necessary to release the assignment/endorsement they hold against the departing owner’s policy and the departing owner releases his assignments/endorsements against their policies.
• Incentive to Use Cash Value Insurance. Many business owners consider the need for buy/sell life insurance to be temporary. That’s because they often expect to sell their interests when they retire (usually between ages 60 and 70). As a result, they often use term life insurance to fund their obligation to purchase upon another owner’s death.
The Own Your Own Policy Buy/Sell structure creates incentives to use cash value insurance for the buy/sell funding. Because the policy death benefit can meet other personal and wealth transfer objectives after an owner leaves a business, his policy will need to be in force for the balance of his life. Cash value insurance may also be attractive because of its potential to provide some degree of supplemental retirement income. The fact that a policy has a variety of potential uses after an owner leaves a business increases the odds of selling cash value policies.
Managing the Policy. A business owner may be able to combine both his business and personal life insurance planning in one personally owned policy. The total death benefit could include components for buy/sell funding, spousal support, mortgage and personal debt repayment and estate liquidity. Of course, the personal portion of the death benefit would be included in his taxable estate. If this is a problem, then it may be possible for him to establish an irrevocable life insurance trust (ILIT), which would own the policy. The portion of the death benefit needed to fund a buy/sell arrangement could be handled by naming the other owners as beneficiaries of the ILIT to the extent of ownership in the business. The ILIT could be drafted so that their status as beneficiaries would end if they die before the owner or if the owner leaves the business prior to death.
An insured is responsible for paying policy premiums. He can use personal funds or enter into a premium sharing arrangement with the business or an outside entity. If it makes financial sense, the business may be able to supply some of the premium dollars through a 162 bonus plan, an economic benefit split dollar arrangement, or a split dollar loan. It is also possible that some assets from the business could be distributed to the owners as dividends or (depending on the business’ tax structure) return of basis.
Savvy business owners will want to make sure the death benefits they need from another owner’s policy will be paid to them so they can meet their purchase obligations upon another owner’s death. Thus, their status as beneficiaries, entitled to receive a portion of the death benefit, must be secured through a written assignment, an endorsement of death benefits, or an irrevocable beneficiary designation. They should consult with their tax and legal advisors to determine which option is best suited to their needs.
• Potential Tax Consequences of the OYOP Buy/Sell. The year-to-year income tax treatment of an OYOP buy/sell arrangement is not known with certainty. The transfer for value issue should arise only when an insured owner dies, not while he is alive. It does not create year-to-year income tax consequences during an insured’s lifetime. Also, it is possible to “cure” a transfer for value before the insured’s death by transferring the policy back to the insured.
Are there any year-to-year tax consequences when a policy owner names a business partner as a temporary beneficiary of all or part of the death benefit of his policy in return for a business partner doing the same for him? The answer to this question is not known with certainty.
• Potential Disadvantages. Possible disadvantages of an OYOP buy/sell arrangement include:
1. A procedure for monitoring the policies should be implemented and performed annually.
2. The death benefit assignments/endorsements should be filed with the insurance company.
3. Economic benefit calculations will need to be performed annually if the split dollar rules apply.
4. Taxable gifts could either use up a portion of the business owner’s $13,000 per donee gift tax annual exemption or part of the $1 million lifetime gift tax exemption and may also reduce the amount of the estate tax unified credit available at death. As a result the amount of property an owner may be able to transfer federal estate tax-free at death may be reduced.
• Widespread Potential for Use. The OYOP buy/sell concept could potentially be used by a large number of businesses. That’s because many existing businesses are organized as LLCs, LLPs and general partnerships. The LLC form of business is a legal structure that is often adopted by new businesses. Owners of C corporations and Subchapter S corporations sometimes have assets that are used in the business but are owned outside the corporation in a partnership.
If there is no existing partnership in place, C corporation and Subchapter S corporation owners may choose to create one by contributing personal assets and/or taking distributions from the corporation and contributing the after-tax portion of some of those distributions into a new partnership.
Flexibility in business succession planning and funding can be very important to the future of a business, its owners and their families. A buy/sell arrangement which can’t adjust to changing business and personal circumstances may fail to accomplish what it was designed to achieve. The wait-and-see format provides potential options for how a business is owned after an owner leaves. The own your own policy approach is a funding strategy which may increase flexibility for the life insurance policies funding the agreement.
Consider presenting these ideas to the business owners you encounter and the attorneys and CPAs who advise them.
These materials are not intended to and cannot be used to avoid tax penalties. This information is general in nature and not comprehensive, the applicable laws change frequently, and the strategies suggested may not be suitable for everyone. Each taxpayer should seek advice from an independent tax advisor.
