The Ins and Outs
The Company You Keep®
Establishing a buy-sell agreement is
one of the most important steps you $ $
can take to help ensure the continua-
tion of your business. A buy-sell
Policy on Policy on
agreement can cover a buy-out due B’s Life A’s Life
to retirement, death, or disability, and
helps “peg” the value of your busi- Owner A Owner B
ness for estate tax purposes, so long is the owner and beneficiary is the owner and beneficiary
as the value of the business repre- of a policy on Owner B of a policy on Owner A
sents a fair market value in an arms
length standard of valuation required Agreement
by Section 2703 of the Internal
Problems solved if either owner dies…
There are a number of buy-sell plans
to choose from: the cross purchase,
entity, and trustee plans are among Surviving Deceased Owner’s
New York Life $ Owner
$ Heirs or Estate
the most popular.
Deceased Business Interests
Cross Purchase Plan
The cross purchase plan is one of the
easiest to administer and can be ideal If you use life insurance as a funding when a large discrepancy in the age
for businesses with three or fewer vehicle, the number of policies or percentage ownership of share-
owners. In this plan, the business needed to fund the plan will increase holders exists. In an entity plan, the
owners enter into an agreement with as the number of shareholders shareholders enter into an agreement
one another. The surviving owners increases. The formula is: Total with the business. The business
purchase the deceased or Number of Policies Needed = purchases the deceased or withdraw-
withdrawing owner’s interest. Number of Shareholders x (Number ing owner’s interest. Family and estate
of Shareholders - 1). attribution rules must be considered.
For example, you and your partner
(or co-shareholder) each have an A business with four shareholders Using the previous example, the
investment basis of $50,000. The requires 12 individual policies to fund surviving owner’s original cost basis
business value now is $200,000. Upon the plan. With five shareholders, the of $50,000 will not increase to
your partner’s death, you purchase plan would need 20 individual $150,000 at the death of an equal
the deceased’s share of the business policies. In our example, you need shareholder because the business, in
for $100,000. Your new basis is now two policies; one where you are the essence, buys back the deceased’s
$150,000. If you sell the business applicant, owner, and beneficiary on
years down the road, in this case for your partner’s life—and vice versa. 1
Section 2703 of the Internal Revenue Code applies
to buy-sell agreements entered into after October 8,
$200,000, you realize a gain of only 1990, or substantially modified after this date, and
$50,000. This step-up in basis would Entity Plan applies only to closely held businesses.
result in a lower capital gains tax and,
essentially, reduce your income taxes. The entity plan can be ideal for busi-
nesses with three or more owners, or
interest. If the business is later sold
for $200,000, the owner would realize
a gain of $150,000.2
As opposed to the cross purchase
plan, where 12 policies were required Agreement $ B’s Life
for four shareholders, the entity plan
only requires four policies in total. Policy on
The business is purchasing the poli- A’s Life
cies, not the individual shareholders.
Owner A Owner B
(or Escrow Agent Plan)
Problems solved if Owner A or B Dies…
Although the trustee plan may be
more cumbersome to set up, it may Deceased Owner’s
provide business owners with the Corporation $ Heirs or Estate
best of both worlds. With this plan, Owners A or B
shareholders have a buy-sell plan Deceased Business
utilizing a trustee or escrow agent. Interests
Each shareholder endorses his/her
stock certificates in blank and delivers
them to the trustee. At the death of the other owners’ lives. The surviving G Insurance proceeds subject to
an owner, the trustee purchases the owners use the life insurance creditors of the business owners.
deceased’s interest. The trustee, proceeds to purchase the deceased
according to the terms of the agree- owner’s interest.
ment, sees that the business issues Entity Plan and Life Insurance
new shares to each surviving owner The business applies for, owns, and
in exchange for the shares that Advantages: pays the life insurance premiums on
belonged to the deceased or with- G Surviving owners receive basis each shareholder’s life. The business
drawing owner. And the trustee, as credit to the amount paid for the uses the life insurance proceeds to
the life insurance policy beneficiary, deceased business owner’s purchase the deceased’s business
sees that the deceased’s estate interest. interest. (Please note that the entity
receives the proceeds. plan is similar to a stock redemption
G Business (C corporation) avoids
possible exposure to the alternative plan.)
How Does Insurance Fit into minimum tax.
Each Plan? Advantages:
G Corporate creditors cannot reach
No matter what you choose, be sure the insurance proceeds. G Premium dollars may be cheaper if
to fund your buy-sell agreement G Corporation can pay premiums if the business is in a lower tax
properly. For many, permanent life treated as additional compensation bracket than the owners.
insurance has been a smart choice. to shareholders/employees (under G Permits the pooling of premium
Insurance is a cost-effective way to a Section 162 Bonus Plan) or under obligations.
ensure that the funds are available a Split Dollar Arrangement.
when needed most. Insurance
G No question arises as to “unreason-
proceeds allow you to purchase the able compensation,” as it could
deceased owner’s share of the busi- Disadvantages: when salaries are increased to pay
ness. Proceeds are available G Plan becomes more difficult to the premiums for life insurance
immediately when death occurs. administer as the number of used to fund a cross purchase plan.
Cross Purchase Plan and Disadvantages:
G May cost more to the shareholders
if the corporation is in a lower tax G State law often restricts redemp-
Each owner applies for, owns, and bracket. tions unless they are from surplus.
pays the life insurance premiums on
The corporate alternative minimum tax (AMT) is a second tax system that applies to quot;Cquot; corporations.
It is designed to make certain that all corporations pay a tax in their profitable years. Small corporations
(quot;Cquot; corporations with less than $7.5 million of average gross receipts in the last three years) are not subject
to the Corporate AMT.
(Life insurance proceeds provide Advantages: family held) business. First, the agree-
instant surplus.) G Ensures that the purchase will be ment must be a bona fide business
G Surviving owner’s basis in the stock carried out. arrangement. Second, the agreement
of a C corporation remains the must not be merely a device to trans-
G Surviving owners in a cross fer the business interest to family
same, even though the overall purchase plan receive an increase
value of one’s ownership may members for less than full and ade-
in their basis for their newly quate consideration. And third, the
increase. Survivor’s basis is acquired interest.
increased in an S corporation, terms of the agreement must be com-
partnerships or LLC. G Shareholders or corporation may parable to those found in similar
periodically contribute funds to the arrangements entered into by persons
G Corporate creditors can reach the trust so the trustee can pay the in an arm’s length transaction.
cash value of permanent life premiums on the lives of the share-
insurance and policy proceeds. Business valuation is a complex and
holders. specialized task for which the busi-
G Potential accumulated earnings tax G Can avoid multiple required poli- ness owner should consider the serv-
problems may exist. cies in cross purchase agreement. ices of a professional business
G Potential alternative minimum tax appraiser. Accreditation that many of
considerations in a C corporation.3 these professionals may have earned
Disadvantage: would include Certified Public
G Voting power may be altered in an G Higher initial start-up costs may be Accountant (CPA), Certified Valuation
undesirable way. Consider a incurred due to expenses associat- Analyst (CVA), or Accredited in
business where the father owns ed with drafting the buy-sell agree- Business Valuation (ABV).
30%, his son 30%, and an unrelated ment. Your advisors should note
key employee owns 40%. If the that transfer-for-value issues may
business redeems the father’s stock “The Company You Keep®”
arise where there are three or more
at death, the unrelated key stockholders. You can feel secure knowing that
employee now owns a majority of New York Life and its subsidiaries
the outstanding stock and have the products and services to
effectively controls the business. What Value to Use meet your funding needs. Contact
G Constructive ownership (i.e., attri- The value of the business is the heart your New York Life agent today
bution) may result in significant of the buy-sell agreement. It is the and find out why New York Life
adverse income tax consequences. value that the deceased owner’s heirs is “The Company You Keep®.”
will receive, and the surviving
Trustee Plan (or Escrow Agent Plan) owner(s) will pay for the interest. New York Life does not offer tax,
and Life Insurance There is, however, another interested legal, or financial planning advice.
party—the IRS. To this end, the IRS This discussion is intended to be gen-
The trustee is the beneficiary of a has issued some guidance. Rev. Rul. eral and does not cover all possible
life insurance contract on each 59-60 says fair market value is based scenarios or tax consequences. The
shareholder. on the history and nature of the busi- consequences may differ significantly
The trustee collects the proceeds on ness, economic outlook, book value, depending upon the type of business
the decedent’s life and delivers them earning capacity, dividend paying entity involved. Consult your tax,
to his or her estate. The trustee holds capacity, goodwill, and recent sales of legal, or financial advisor before
all shares endorsed in blank, and stock and similar publicly traded making any decisions.
delivers the deceased’s share to the company stock. More recently IRC
other shareholders (cross purchase) §2703 provides the following guid-
or to the corporation (redemption or ance to a fair market value arrange- 3
Life insurance proceeds and inside buildups of
available cash values are included in adjusted cur-
entity plan purchase). ment in a closely held (especially rent earnings for purposes of the corporate alter-
native minimum tax.
New York Life Insurance Company
New York Life Insurance and Annuity
Corporation (A Delaware Corporation)
51 Madison Avenue
New York, NY 10010
The Company You Keep®