By Kevin P. Nicholson and Andrew Rinn, JD
Buy-sell agreements are vital to the continuation of multiowner businesses. The traditional techniques possess inherent risks that must be disclosed to the client. In general, there are two types: entity purchase plans and cross-purchase arrangements.
Entity purchase plans are insurance policy efficient in that only one policy is needed per owner. The business is the premium payer and beneficiary, and policy cash values are listed as assets on the corporate balance sheet. However, these types of plans often fail to allocate a full income tax basis increase to survivors and there may be adverse tax consequences upon subsequent transfer under the transfer for value rule.1
Cross purchase arrangements are basis efficient: surviving owners receive an income tax basis step-up equal to the purchase price of the deceased owner’s stock. The owners of the business are the owners and beneficiaries of life insurance on their co-owners. The drawback here is that younger and healthier owners subsidize premiums on older and less healthy owners. In addition, these arrangements quickly become unwieldy if there are many owners of the business.2
Trusteed arrangements resolve the conflicts between the above techniques. Under this arrangement, the owners use a third party (often an irrevocable life insurance trust) to act as premium payer, owner, and beneficiary of the life insurance policies on each owner and to carry out the buy-sell agreement. Unfortunately, death benefits may also be subject to the transfer for value rule. These traditional strategies offer certain benefits, but they are often outweighed by disadvantages. The challenge is to provide a strategy that meets a business owner’s need to become financially independent of their business and to ensure a smooth business continuation in the event of death or early departure. The Buy-Sell LLC may be just such a strategy.
The Buy-Sell LLC
Buy-Sell LLCs preserve the best traits of traditional techniques while offering a new way forward for business owners seeking a more tailored strategy. The structure is straightforward. First, a limited liability company (LLC), organized as a partnership for tax purposes, is formed. For this discussion, assume the corporation and the Buy-Sell LLC are separate entities. Each shareholder of the corporation is a member of the LLC and owns an equal percentage. However, an existing, stand-alone LLC taxed as a general partnership can facilitate the entire transaction. The LLC acts as owner, premium payer, and beneficiary of one policy for each owner. The owners fund the LLC from personal funds or through a tax-deductible IRC 162 bonus from the primary operating entity.3 In either case, transfers to the LLC are characterized as capital contributions. Each owner will contribute amounts sufficient to pay the life insurance premiums on the policy that insures his or her life. These contributions increase the member’s ownership interest and serve to shield from taxation a subsequent policy distribution from the LLC to the insured.
Upon the death of an owner, the membership agreement will specify that the LLC, as beneficiary of the life policy, will pay the deceased owner’s estate an amount equal to the deceased ownership interest.4 The deceased owner’s estate will then transfer ownership shares to the surviving owners. Most of the proceeds will be available for the survivors to effectuate a buy-out of the operating business. Consider these three facets of Buy-Sell LLCs:
- Allocation of premium burden – In traditional cross-purchase agreements premiums that some owners pay often subsidize the higher premiums of other owners. This problem is somewhat mitigated in entity arrangements where the corporation pays all premiums. Nonetheless, advisers should be cognizant of a more meaningful way to allocate the premiums. Buy-Sell LLCs offer a way. Capital contribution to the LLC to pay premiums will increase the respective basis of each owner. A Buy- Sell LLC allows the membership agreement to control the allocation of premium dollars, even if the allocation is disproportionate to the capital contributions of the owners. However, the agreement may provide accounting flexibility among separate items of business income, gain, deductions, and credits.
- Tax-advantaged distribution at retirement – A significant advantage of the Buy-Sell LLC, and often the primary motivation behind its popularity with professional advisers, is the tax efficiency of the life insurance rollout. A distribution of a policy from a traditional arrangement involving a corporate operating entity would trigger immediate taxation of gain to the corporation and subject the receiving shareholders to income taxation of the fair market value of the policy.6 But when appreciated property is distributed from a partnership through a Buy-Sell LLC rollout, the gain is not recognized by either the business or the recipient. Rather, a life insurance distribution due to retirement or withdrawal is simply treated as an exchange for the member’s interest in the LLC.7 In fact, the entire rollout is unrecognized to the extent of the recipient’s basis in the LLC.8 Upon obtaining ownership of the policy, the retiring owner can then use it to supplement retirement income through loans and withdrawals.9 This is a major benefit of using permanent cash value life insurance to fund a business succession agreement. The death proceeds effectuate a buy-out and, if unused, the same policy may be leveraged for the owner’s retirements needs. Since transfers are exempt from the transfer for value rule, the distribution to the retiring owner will preserve the death proceeds from income taxation.
- Death of an owner – The Buy-Sell LLC continues to be a dynamic planning tool even upon the death of an owner. A common disadvantage of many entity agreements is the lack of basis step-up at death. Even S corporation entity agreements only allow a limited basis step-up under the pro rata rules governing such entities.10 A noteworthy advantage of this strategy is that it permits the surviving partners to fully allocate the tax-exempt proceeds among themselves. This allows them to obtain a full basis increase without “wasting” a basis increase on a deceased owner who otherwise obtains a basis increase under existing tax provisions.11
Avoiding Tax Traps
The bane of many contemporary entity arrangements is the partial or full inclusion of death proceeds in the insured’s estate through attribution rules. In short, the ownership of the death proceeds would be included in an insured’s estate in proportion to their respective ownership in the entity. However, IRS’s Private Letter Ruling 200214028 addressed this in stating that a member/partner does not possess an incident of ownership in a policy, provided the death benefit proceeds are payable to or for the benefit of the LLC.13 Consequently, since there is no incident of ownership, the death proceeds are excluded from the decedent’s estate under IRC 2042(2).
Another consideration is whether or not the Buy-Sell LLC passes the “business purpose” rule. This rule states a partnership is valid only if it has a legitimate business purpose.14 Although the IRS has indicated it will not issue an advance ruling on this issue, there is guidance to support a partnership venture whereby a general partnership was formed to purchase and own life insurance to facilitate a cross purchase agreement with the owners’ primary corporation.15 Though there appears to be support for an entity with a sole asset of life insurance, the lack of a higher level of legal clarity makes it advisable to err on the side of safety and form a structure with an otherwise valid business purpose. Fortunately, many business owners already use these LLCs for unquestioned business purposes, such as lease-back arrangements and real estate ventures.
Six Attributes of the Buy-Sell LLC
A Buy-Sell LLC avoids the seemingly unavoidable tradeoffs between traditional buy-sell techniques while accentuating their best attributes. The attributes of the Buy-Sell LLC can be summarized as follows:
- Premium equity
- LLC tax basis maximization
- Policy minimization
- Tax advantaged policy rollout
- Policy flexibility
- Avoidance of unnecessary tax inclusion
A technique with this many advantages cannot be ignored by today’s advisers seeking to place the best interest of the client first, especially for those business owner clients seeking to become independent of their business.
1 IRC 101(a)(2). If a policy is transferred for valuable consideration, the death proceeds will be taxable as ordinary income, except to the extent of the consideration received and net premiums.
2 The cross-purchase formula is n(n-1), where n is the number of owners. Thus, three owners would require the purchase of six policies: 3(3-1)=6. This compares with three policies for an entity-purchase arrangement.
3 IRC 264(a)(1). The LLC and the member may not deduct the premiums for life insurance to fund this arrangement although a bonus under IRC 162 (so long as its deemed reasonable) is deductible.
4 Including his or her share of the value of the life insurance policies on the survivors. This will avoid a potential taxable transfer for value as a transfer to an LLC taxed as a partnership in which the insured is a member is a specified exception under this rule.
5 Reg. Section 1.704-1(b)(2).
6 Michael Geeraerts and Bryan Davis, “Transfers of Business-Owned Life Insurance Can Trigger a Tax Hit,” Accounting Today, 10-9-15. If the transfer is to a nonshareholder employee, it is treated as compensation and the employee will have to include the policy’s fair market value in his or her gross income.
7 IRC 731(a). A distribution of property rather than money generally results in no gain or loss recognition or the distribute partners.
8 If the value of the life insurance is not equal to the share of the owner’s interest in the LLC, withdrawals or additions from other business assets can also be made prior to distribution.
9 Loans and withdrawals will decrease the cash value and the death benefit. Tax-free distributions assume the life insurance policy is properly structured so that it is not a modified endowment contract (MEC). Should the policy lapse or be surrendered prior to the death of the insured, there may be tax consequences.
10 Under IRC 1377(a)(2)(Short Year Election) there is guidance allowing an S corporation using cash-basis accounting to make a short-year election and allocate death proceeds solely among the surviving owners.
11 IRC 1014 - Taxpayers are permitted a basis step-up to fair market value at time of death for items of capital property.
12 Wayne M. Zell, “Buy-Sell Agreements re: Business Succession,” The National Law Review, Oct. 13, 2014.
13 Private Letter Ruling 200214028. Keep in mind a private letter ruling is binding authority solely for the requesting party, though such rulings often give the taxpayer a sense of the IRS’s general view on tax matters.
14 Treas. Reg. Section 301.7701-1(a)(2). An important factor in distinguishing a mere tenancy in common, or co-ownership, is the active pursuit of business.
15 Private Letter Ruling 9309021.
Kevin P. Nicholson is cofounder of Walsh and Nicholson Financial Group in Wayne, Pa. He can be reached at email@example.com.
Andrew Rinn, JD, is vice president, advanced markets and competition and case design, for Ameritas in the Lincoln, Neb., area. He can be reached at Andrew.Rinn@ameritas.com.
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