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For Agent Use Only. Not for public distribution
Buy Sell Planning for
QPSC, S Corp, and LLC
Professional Practice Owners
R...
For Agent Use Only. Not for public distribution
 Professional Practices where revenue is generated
by fees and/or commiss...
For Agent Use Only. Not for public distribution
 Verify Fair Market Value (FMV) of professional
practice… 1-2 times gross...
For Agent Use Only. Not for public distribution
 Collect personal financial information to compute a
Life Insurance Needs...
For Agent Use Only. Not for public distribution
 QPSC (IRC Section 448(d)(2)
Professionals) U.S. Form 1120
 Business inc...
For Agent Use Only. Not for public distribution
S Corp and LLC
Pass-Through Taxation
S Corp - Net Profit
Form 1120S
• Pass...
For Agent Use Only. Not for public distribution
 Legal Agreement to Purchase Shares at a Stated Price
 Finance the Oblig...
For Agent Use Only. Not for public distribution
 Business entity (QPSC, S Corp, or LLC) is owner and beneficiary
of insur...
For Agent Use Only. Not for public distribution
 Cost basis Adjustment for surviving owners
 *QPSC ….. 0% basis increase...
For Agent Use Only. Not for public distribution
 “EOLI” rules for “notice and consent” of IRC Section 101(j)
and IRS Noti...
For Agent Use Only. Not for public distribution
 Each share owner is owner and beneficiary of insurance on the life of
th...
For Agent Use Only. Not for public distribution
 Non-owner professional (employee) is owner and
beneficiary of insurance ...
For Agent Use Only. Not for public distribution
 Typically insurance is arranged in cross purchase method
 However, agre...
For Agent Use Only. Not for public distribution
 Useful when owners have maxed-out QRP contributions and
wish to save mor...
For Agent Use Only. Not for public distribution
 At death, survivors receive 100% cost basis increase when shares are
pur...
For Agent Use Only. Not for public distribution
 Often, the TFV Rule of IRC Section 101(a)(2)(B) comes into play to
re-ar...
For Agent Use Only. Not for public distribution
Case Study
• S Corp with four owners (doctors, lawyers, CPAs), each 25%
sh...
For Agent Use Only. Not for public distribution
 Professional Owner Survives to Retirement
 Buy sell agreement typically...
For Agent Use Only. Not for public distribution
 10 year amortized payment = $123,290 annually
 Tax free cost basis ($10...
For Agent Use Only. Not for public distribution
 Future operating cash flow of the S Corp or …
 Significant down payment...
For Agent Use Only. Not for public distribution
 Life Insurance Funded Buy Sell Agreements
Perform Important Functions
1)...
For Agent Use Only. Not for public distribution
Russell E. Towers JD, CLU, ChFC
Vice President, Business & Estate Planning...
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Buy Sell Planning for QPSC, S Corp, and LLC Professional Practice Owners

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Sometimes it’s difficult to decide which type of buy sell agreement to recommend when dealing with QPSC, S Corp, and LLCs. Should it be a stock redemption plan funded with employer owned insurance or a cross purchase plan funded by cross owned insurance?

Get expert insight from Russell E. Towers JD, CLU, ChFC
Vice President, Business & Estate Planning at Brokers' Service Marketing Group ( A brokerage general agency for financial professionals).

Published in: Economy & Finance
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Buy Sell Planning for QPSC, S Corp, and LLC Professional Practice Owners

  1. 1. For Agent Use Only. Not for public distribution Buy Sell Planning for QPSC, S Corp, and LLC Professional Practice Owners Russell E. Towers JD, CLU, ChFC Vice President - Business & Estate Planning
  2. 2. For Agent Use Only. Not for public distribution  Professional Practices where revenue is generated by fees and/or commissions where capital is not a material income producing factor:  Medical and dental practices  Law firms  Accounting firms  Architectural firms  Fee based financial planning firms  Independent insurance firms … life insurance, property and casualty etc.  Investment management firms Professional Practices
  3. 3. For Agent Use Only. Not for public distribution  Verify Fair Market Value (FMV) of professional practice… 1-2 times gross annual revenue is typical. More established firms will be at the higher end of range  FMV appraisal from CPA firm with expertise in professional practice valuation (ABV designation)  Basic Considerations: (a) QPSC, S Corp, LLC… (b) Appraised Fair Market Value… (c) Percentage Ownership of Each Owner... (d) Type of Buy Sell Agreement Business Financial Information
  4. 4. For Agent Use Only. Not for public distribution  Collect personal financial information to compute a Life Insurance Needs Analysis for each professional business owner  Determine total income protection, mortgage repayment, college costs, final expenses, etc.  If business value is LESS than total insurance need, then sell two policies Personal Financial Information (1) Policy #1 as entity or cross purchase buy sell. • Death proceeds are used to purchase shares from estate of deceased business owner. Cash is distributed from the estate to spouse and family (2) Policy #2 is owned personally with spouse beneficiary • Or Irrevocable Trust for the benefit of spouse and family depending on facts of case
  5. 5. For Agent Use Only. Not for public distribution  QPSC (IRC Section 448(d)(2) Professionals) U.S. Form 1120  Business income minus deductible business expenses = net profit  QPSC tax rate = flat 35% Does not have marginal brackets ranging from 15% to 35% like regular C Corp Qualified Personal Service Corp (QPSC) Taxation
  6. 6. For Agent Use Only. Not for public distribution S Corp and LLC Pass-Through Taxation S Corp - Net Profit Form 1120S • Pass-Through of Net Profit (K-1) to Personal Tax Return of S Corp Owners (Schedule E of Form 1040) • Accumulated Adjustment Account (AAA) reconciliation (previously taxed profit) LLC - Net Profit Form 1065 • Pass-Through of Net Profit (K-1) to Personal Tax Return of LLC Owners (Schedule E of Form 1040) • Capital Account reconciliation (previously taxed profit)
  7. 7. For Agent Use Only. Not for public distribution  Legal Agreement to Purchase Shares at a Stated Price  Finance the Obligation at the Lowest Cost  Life Insurance Premiums transfers the financial risk to an Insurance carrier  Term, no-lapse UL, indexed UL, whole life  Stock Redemption - Entity Plan  Cross Purchase Plan  Unilateral “One-Way” Purchase Plan  “Wait and See” Optional Plan  Cross Endorsement Buy Sell Plan Business Continuation Planning
  8. 8. For Agent Use Only. Not for public distribution  Business entity (QPSC, S Corp, or LLC) is owner and beneficiary of insurance. EOLI “Notice and Consent” rules apply.  Entity is responsible to purchase shares from estate of deceased.  Entity pays non-deductible insurance premiums which will be part of K-1 “pass-through” profit for S Corp and LLC owners  A “trusteed entity plan” may be used to provide additional certainty that the plan will be executed properly  (See IRC Section 1377(a)(2) for special S Corp redemption “short tax year election” rules). Stock Redemption / Entity Plan
  9. 9. For Agent Use Only. Not for public distribution  Cost basis Adjustment for surviving owners  *QPSC ….. 0% basis increase for survivors  *S Corp ….. potential 100% basis increase for survivors equal to purchase price under IRC Section 1377(a)(2) procedure. Cash basis taxpayer. (1) Short term note payable (2) Short tax year election (3) Collect insurance proceeds and allocate basis to survivors (4) Pay off note to estate of deceased  * LLC ….. Partial basis increase and partial “wasted basis” for share of deceased (i.e. 25% owner = 25% “wasted basis” …. 75% basis increase for survivors) Stock Redemption / Entity Plan
  10. 10. For Agent Use Only. Not for public distribution  “EOLI” rules for “notice and consent” of IRC Section 101(j) and IRS Notice 2009-48. Also note PLR 201217017 when a stock redemption buy sell agreement and EOLI is involved.  Written notice to insured in a timely manner prior to issuance of policy  IRS Form 8925 filed with business tax return  If no timely compliance with “notice and consent” and death occurs, then any death benefit in excess of cost basis is taxable income Employer Owned Life Insurance
  11. 11. For Agent Use Only. Not for public distribution  Each share owner is owner and beneficiary of insurance on the life of the other share owner(s)  Surviving owner(s) are responsible to purchase shares from estate of deceased. 100% cost basis increase equal to purchase price  Entity may pay taxable bonus comp to owners to pay insurance premiums  Taxable K-1 profit distributions from S Corp or LLC may also fund premiums  A “trusteed cross purchase plan” may be used where 3 or more owners are involved. Reduce the number of policies. Trustee will manage the beneficial interests that each shareholder has in the premiums, cash values, and death benefits on the lives of the other shareholders (i.e. 3 owners = 6 policies … 4 owners = 12 policies) Cross Purchase Plan
  12. 12. For Agent Use Only. Not for public distribution  Non-owner professional (employee) is owner and beneficiary of insurance on life of 100% share owner.  Non-owner professional(s) are responsible to purchase shares from estate of deceased 100% share owner. 100% cost basis increase equal to purchase price  Entity may pay taxable bonus comp to non-owner professional (employee) to pay premiums.  A “trusteed unilateral plan” may be used when there are 2 or more non-owner (employee) professional buyers Unilateral “One Way” Buy Sell Plan
  13. 13. For Agent Use Only. Not for public distribution  Typically insurance is arranged in cross purchase method  However, agreement gives option to determine method of purchase (stock redemption v. cross purchase) at death of share owner. (i.e. 60-90 day options).  If stock redemption is chosen, surviving owners collect death proceeds and either: A) loans cash to company (liability on books) or B) makes a capital contribution (paid-in capital) of cash to company …. to execute the redemption  Either surviving share owner or business entity will be responsible to purchase shares from estate of deceased depending on which option is chosen “Wait and See” Optional Plan
  14. 14. For Agent Use Only. Not for public distribution  Useful when owners have maxed-out QRP contributions and wish to save more for themselves AND cover a buy sell obligation with the same insurance policy. Use a cash accumulation type of policy - Indexed UL ,Whole Life  Each owner enters into an endorsement - cross purchase business agreement  Each owns their own policy and endorses the death benefit to the other owners via the beneficiary designation (irrevocable?). Problem if owner/insured surrenders policy?  Business can pay taxable bonus comp to each owner to pay premiums. In addition, each policy owner reports income for “economic benefit rental charge” based on Table 2001 rates Cross Endorsement Buy Sell Plan
  15. 15. For Agent Use Only. Not for public distribution  At death, survivors receive 100% cost basis increase when shares are purchased from estate of deceased  Death proceeds are included in gross estate of deceased but should be offset by an equal estate tax deduction for the liability associated with the buy sell agreement  Each policy owner has access to tax free withdrawals and loans from policy cash value as a non-qualified retirement supplement  Note: Possible Transfer for Value issues with QPSC and S Corp because the mutual promises of buy sell agreement could be viewed as contractual “consideration” between co-shareholders. So, if TFV is an issue, use this concept for LLCs. LLCs fall under the partner/partnership exception to TFV rule. LLC could even be a business entity separate and apart from the QPSC or S Corp Cross Endorsement Buy Sell Plan
  16. 16. For Agent Use Only. Not for public distribution  Often, the TFV Rule of IRC Section 101(a)(2)(B) comes into play to re-arrange “title” to existing policies. To preserve income tax free death proceeds, the transfer of ownership must meet one of the following “exceptions”:  Transfer to the insured. Also, a transfer to a “grantor trust” is considered to be a transfer to the insured. The TFV rule is an income tax rule, not an estate tax rule  Transfer to a corporation where insured is an officer or shareholder. However, transfer to co-shareholder of insured is NOT an exception. This applies to QPSC and S Corp  Transfer to a partner of the insured  Transfer to a partnership where the insured is a partner  Note: For purposes of the TFV rule, LLCs are considered to be partnerships and LLC members are considered to be partners Transfer for Value (TFV)
  17. 17. For Agent Use Only. Not for public distribution Case Study • S Corp with four owners (doctors, lawyers, CPAs), each 25% shareholders, and firm has estimated FMV of $4 million ($1 million each). A Life Insurance Needs Analysis reveals a total insurance family protection need of $2.5 million for your client who is one of the 25% S Corp owners Situation • $1 million insurance on life of each 25% shareholder, with owner and beneficiary the S Corp, to fund a stock redemption buy sell agreement with “short tax year” election language … PLUS $1.5 million of personally owned insurance with spouse as beneficiary =$2.5 million total need covered with two policies Solution • (1) term insurance • (2) no-lapse UL • (3) indexed UL • (4) whole life Product Choices
  18. 18. For Agent Use Only. Not for public distribution  Professional Owner Survives to Retirement  Buy sell agreement typically requires an installment sale purchase of the retiring professional owner’s shares over a period of time with interest at the AFR rate in effect (IRC Section 1274(d)).  Either the business entity or the remaining owners personally must pay the retiring owner over 10-15-20 years from the operating revenue of the firm, accumulated sinking fund... or from other personal or borrowed funds.  Retiring owner reports income under the Installment Sale rules of IRC Section 453 each year (1) ordinary income on interest (2) capital gain on shares and (3) tax free recovery of cost basis of shares... spread over 10-15-20 years of payment Lifetime Sale of Business Shares
  19. 19. For Agent Use Only. Not for public distribution  10 year amortized payment = $123,290 annually  Tax free cost basis ($100,000 /10 = $10,000 annually)  Capital gain ($900,000 / 10 = $90,000 annually)  Ordinary income ($23,290 annually) Case Study • One of the owners of a professional S Corp has reached age 70 and is retiring under the installment sale terms of the stock redemption buy sell agreement. His interest is valued at $1 million. What does the S Corp have to pay if the retiring owner’s shares are purchased with an amortized 10 year installment note at 4% interest? Situation • Assuming amortized (equal) installment payments over 10 years at 4%, and a cost basis of $100,000, here is the retiring seller’s payment breakdown each year for 10 years Calculation
  20. 20. For Agent Use Only. Not for public distribution  Future operating cash flow of the S Corp or …  Significant down payment plus installment sale for the remainder. This down payment could come from the cash value of a cash accumulation type of life insurance policy owned by the S Corp (i.e. indexed UL or whole life)  This policy does “triple duty” … (1) it protects against an early death which would trigger a purchase of the shares from the estate of the deceased owner (2) it accumulates cash value for a down payment toward a lifetime installment purchase from a retiring S Corp owner (3) it can provide tax free death benefit “cost recovery” for the firm after the firm has used its operating cash flow for a lifetime buy out Case Study • How will the S Corp pay the $123,290 annually for 10 years to purchase (redeem) the shares of the retiring 70 year old share owner? Question
  21. 21. For Agent Use Only. Not for public distribution  Life Insurance Funded Buy Sell Agreements Perform Important Functions 1) A buyer for each owner’s shares is guaranteed 2) The sale price is fixed in a legally enforceable agreement 3) The funding for the legal obligation is provided by tax free life insurance 4) Cash liquidity equal to the purchase price is provided to the family of the deceased 5) Life insurance premium is the lowest present value cost to accomplish the intended transfer of shares Buy Sell Summary
  22. 22. For Agent Use Only. Not for public distribution Russell E. Towers JD, CLU, ChFC Vice President, Business & Estate Planning 500 South Main Street Providence, RI 02903 888.523.1162 Option 3 russ@bsmg.net End

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