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Buy Sell Agreements Funded with Life Insurance

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A Buy Sell Agreement is a critical component of your business continuation plan. Visit: http://dgalcorn.wordpress.com/2013/06/04/buy-sell-business-continuation-plans-part-1-of-5/

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Buy Sell Agreements Funded with Life Insurance

  1. 1. Copyright 2014 Daniel G. Alcorn Daniel G. Alcorn Buy-Sell Agreements Funded With Life Insurance
  2. 2. Copyright 2014 Daniel G. Alcorn 1. Why Should You Consider a Buy-Sell Agreement? 2. Why Fund With Life Insurance? 3. Cross Purchase Buy-Sell 4. Entity Purchase Buy-Sell 5. Unilateral Buy-Out 6. Wait and See Buy-Sell 7. General Tax Considerations 8. Tax Consequences to Seller 9. Basis for Surviving Owners 10. Selecting a Buy-Sell Structure 11. Valuing a Business
  3. 3. Copyright 2014 Daniel G. Alcorn 1. Why Should You Consider a Buy-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.
  4. 4. Copyright 2014 Daniel G. Alcorn 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.
  5. 5. Copyright 2014 Daniel G. Alcorn 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.)
  6. 6. Copyright 2014 Daniel G. Alcorn 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
  7. 7. Copyright 2014 Daniel G. Alcorn 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 Interest Owner A Loan Estate of Owner B$ $
  8. 8. Copyright 2014 Daniel G. Alcorn 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.
  9. 9. Copyright 2014 Daniel G. Alcorn 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
  10. 10. Copyright 2014 Daniel G. Alcorn 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
  11. 11. Copyright 2014 Daniel G. Alcorn 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
  12. 12. Copyright 2014 Daniel G. Alcorn 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
  13. 13. Copyright 2014 Daniel G. Alcorn 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
  14. 14. Copyright 2014 Daniel G. Alcorn 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
  15. 15. Copyright 2014 Daniel G. Alcorn 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
  16. 16. Copyright 2014 Daniel G. Alcorn 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
  17. 17. Copyright 2014 Daniel G. Alcorn 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
  18. 18. Copyright 2014 Daniel G. Alcorn 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
  19. 19. Copyright 2014 Daniel G. Alcorn 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
  20. 20. Copyright 2014 Daniel G. Alcorn 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?
  21. 21. Copyright 2014 Daniel G. Alcorn 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
  22. 22. Copyright 2014 Daniel G. Alcorn Daniel G. Alcorn Niskayuna, New York 12309 Office: 518-346-2115 Email: dgalcorn@live.com Twitter: @DGANewYork Blog: www.dgalcorn.wordpress.com Questions?
  23. 23. Copyright 2014 Daniel G. Alcorn Disclosures This 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.

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