Buy-Sell Agreements FundedWith Life Insurance Jay C. Lewis, CLU
Why Should You Consider a Buy-Sell Agreement? Why Fund With Life Insurance? Cross Purchase Buy-Sell Entity Purchase Buy-Sell Unilateral Buy-Out Wait and See Buy-Sell Escrowed Buy-Sell Disability Buy-Out General Tax Considerations Tax Consequences to Seller Basis for Surviving Owners Selecting a Buy-Sell Structure Valuing a Business
Why Should You Consider aBuy-Sell Agreement?Buy-sell planning helps preserve control and value of a business atthe death, disability, or retirement of an owner.These agreements provide that the estate of a deceased owner willbe paid a fair value for his/her interest, and that the surviving ownerswill maintain control and ownership of the business. Life insurance onthe owners can be a source of money to fund these arrangements.
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
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? Business Loan Owner A Buy-Sell Owner B Client Agreement Loan Life Insurance Company1. 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.
Cross Purchase - How Does It Work? Business Loan Business Interest Estate of Owner A Client $ Owner B Loan $ Life Insurance Company3. 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.
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
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? Loan Buy-Sell Owner B Business Agreement Loan Life Insurance Company Owner A Client1. 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.
Entity Purchase - How Does It Work? Loan Business Interest Estate of Business $ Owner B Loan $ Life Insurance Company Owner A Client3. 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.
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
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
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
Escrowed Buy-Sell A cross purchase buy-sell plan which requires only one policy per owner An escrow agent holds the business interests and insurance policies of each owner Premiums are paid by the owners Sometimes referred to as the Trusteed Buy-Sell plan
Disability Buy-Out Provisions are included in any type of buy-sell agreement for purchase of business interest from owner who becomes disabled Disability buyout insurance is purchased to fund buyout
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
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
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
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?
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
Questions?Jay C. Lewis, CLU® IPS Advisors, Inc. 8080 N. Central Expwy., Suite 1500 Dallas, TX 75206 Office: 214-292-4117 Email: firstname.lastname@example.org Twitter: @Ins_Counselor Blog: www.jayclewis.wordpress.com
DisclosuresThis material was created to provide accurate and reliable information on the subjects covered but should not be regarded asa complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The servicesof an appropriate professional should be sought regarding your individual situation. Neither NFP nor its subsidiaries oraffiliates 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 lifeinsurance such as, but not limited to; commissions, fees, expenses, surrender charges, premiums, and new contestabilityperiod. There may also be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax onoutstanding policy loans. Please discuss your situation with your financial advisor.Securities and Investment Advisory Services may be offered through NFP Securities, Inc., Member FINRA/SIPC.NFP Securities, Inc. is a subsidiary of NFP (National Financial Partners Corp.).