W   E   S   T
FINANCIAL SERVICES
buy sell plan

 

Buy-Sell Funding With Life Insurance

WHAT IS BUY-SELL PLANNING?

At the heart of a good business succession strategy is the planning that provides for the efficient passing of the business should the owner or one of the owners, die, become disabled, or wish to, or have to, leave the business for another reason. Buy-Sell Planning is one component of business planning and should be viewed within the context of long term business and succession planning. A Buy-Sell Agreement is the centerpiece of any Buy-Sell Planning.

WHAT IS A BUY-SELL AGREEMENT?

A Buy-Sell Agreement is a legally binding document that spells out what will happen to a business when a specific triggering event occurs, such as the death or disability of a business owner or shareholder. Other events typically covered in a Buy-Sell Agreement include the resignation, retirement or termination of a shareholder or owner.

WHAT ARE THE BENEFITS OF A BUY-SELL AGREEMENT?

The major benefit of a Buy-Sell Agreement is that it allows for the continuation of the business by providing for an agreed upon transition of the business. In addition to providing a ready market for the business, a Buy-Sell Agreement can provide that the price for both buyer and seller is a fair one. The agreed upon price can, in many instances, set the value of the business for estate planning purposes.

WHAT IS MEANT BY A "FUNDED" BUY-SELL AGREEMENT?

While the Buy-Sell Agreement can provide the legal framework for the sale and transition of a business, it does not provide the cash needed to fund it. One of the most popular methods of funding a Buy-Sell Agreement is permanent life insurance. Based on current federal tax law, permanent life insurance has several tax advantages. The death benefit will be received tax-free, in most instances, and the cash value in the Buy-Sell Agreement policy grows tax-deferred. The cash value provides a pool of money that can be accessed with tax efficiency to fund a buy-out. Other methods of funding a Buy-Sell Agreement include: term insurance, borrowed funds, a sinking fund, or an installment purchase.

HOW ARE BUY-SELL AGREEMENTS FUNDED WITH LIFE INSURANCE STRUCTURED?

The majority of Buy-Sell Agreements funded with life insurance are either Entity or Cross Purchase Agreements. Other methods include Trusteed Cross Purchase and Wait and See Agreements.

Entity Agreement (Stock Redemption Plan in a corporate setting) - In this Buy-Sell Agreement the business enters into an agreement with the owners to purchase the business interests of the owner at a triggering event. To provide the cash to purchase those interests at death, the business buys life insurance on each owner in an amount equal to the value of their business interest. The business is the applicant, owner, and beneficiary of the policy. The business pays all premiums on the policy and the policy becomes a business asset. Any cash value in the Buy-Sell Agreement policy is shown on the balance sheet and is subject to business creditors. An Entity Agreement is relatively easy to administer since the premium payments come from one source and the number of policies needed is minimized. At death the life insurance proceeds are paid to the business. The business uses those funds to purchase the deceased owner's business interests from the estate of the deceased. A major disadvantage of this type of Buy-Sell Agreement is that the remaining owners may receive no step up in basis or only a partial step up in basis on the shares purchased from the deceased owner's estate.

Cross Purchase Agreement - In this type of agreement the business owners each agree to purchase the business interests of any owner at a triggering event. In order to fund the Buy-Sell Agreement in case of death, each business owner buys a life insurance policy on each other owner for the amount needed to fund his or her obligation. The business owner is the applicant, owner, beneficiary and premium payor on policies for all of the other owners. At death, each surviving owner receives the death benefit proceeds directly from the insurance carrier and uses those funds to purchase from the estate of the deceased a pro-rata share of the business. A major disadvantage of this method is the number of policies needed to fund the Buy-Sell Agreement when there are more than two owners. If there are two owners, only two policies are needed. However, for more than two owners the number of policies needed is equal to the equation "Y x (Y minus 1)," where Y is equal to the number of owners. For example, if there were four owners, there would have to be 12 policies (4 x (4 minus 1) = 12).

Trusteed Cross Purchase Agreement - This type of Buy-Sell Agreement minimizes the number of policies needed to fund the agreement in case of death. First, a trust is established with an independent trustee. Thereafter, the business interests of all owners are placed in the trust and life insurance is applied for, owned and paid for by the trust. Under this approach, only one policy is needed per owner. Since the independent trustee is named as beneficiary, the trustee will collect the death benefit and pay the deceased owner's estate for the deceased owner's portion of the business. The trustee then apportions the business interests into each owners account within the trust on a pro rata basis. Although this seems like a very attractive method for handling a Buy-Sell Agreement, it is not without its drawbacks. The primary issue that must be addressed is for entities that have more than two owners and are not taxed as a partnership. Under this entity structure, "transfer for value" rules under IRC Sec. 101(a)(2) must be reviewed. Specifically, when an owner sells his business interests to the trust, either at death or retirement, he is also selling his indirect interest in the policies on the other owners. This could be deemed a "transfer for value" and could cause the death benefit to be taxable as ordinary income. If this is a concern, one solution might be the use of a partnership to hold the life insurance policies. Whatever the approach, the client's Attorney will have to determine the best approach based upon all facts and circumstances. An additional concern is the inclusion of life insurance in the estate of the deceased owner. As the trust is revocable, this is a real concern. Careful drafting of the trust document and the Buy-Sell Agreement may eliminate these risks.

Wait and See Agreement - If a decision cannot be made as to whether an Entity or Cross Purchase Agreement is more advantageous, a Wait and See Agreement can be drawn up. This allows the business owners to wait until a triggering event to decide on the course of action. In most situations an agreement is drawn up that gives the business the first option to purchase the stock at a triggering event. If the business does not purchase the stock, the business owners then have the option to purchase. If they do not exercise that option, the business would be required to purchase the stock. The Wait and See Agreement provides greater flexibility since the method of purchase is left to be decided until the time of the triggering event.


IF THE LIFE INSURANCE FUNDING THE BUY-SELL AGREEMENT IS OWNED BY THE BUSINESS, CAN THERE BE AN ISSUE WITH THE ALTERNATIVE MINIMUM TAX (AMT)?

Yes, there can be an issue with AMT if the business is a C Corporation, though according to current tax law, this would only apply to those C Corporations with annual gross receipts of over $5 million. In those instances, both the cash buildup and death benefit greater than cost basis could be subject to the corporate alternative minimum tax of up to 15%. You should consult with your tax advisor, if this could affect you.

ARE THERE ANY OTHER INSURANCE PRODUCTS BESIDES LIFE INSURANCE THAT ARE USED TO FUND A BUY-SELL AGREEMENT?

Yes, disability insurance is used to fund a Buy-Sell Agreement should an owner not be able to work because of an injury or medical condition. The need for this type of coverage is vital as the chances for disability are much greater than death prior to retirement.

IS THE VALUATION OF THE COMPANY AN IMPORTANT COMPONENT OF BUY-SELL AGREEMENT PLANNING?

Absolutely. One of the most important aspects of Buy-Sell Agreement Planning is determining a fair price for the business. Everyone should agree with that purchase price and the agreement should come before the triggering event. It allows the sales process to occur during a crisis without a conflict and also allows all parties to plan ahead with confidence.

CAN I SET THE PRICE OF THE BUSINESS FOR ESTATE TAX PURPOSES WITH A VALUATION?

The IRS will value the business interest at the "fair market value." According to Treasury Reg. Sec. 20.2031-3, that amount is defined as "the price at which property would change hands between a willing buyer and a willing seller ... with both parties having reasonable knowledge of the relevant facts." Although the IRS will not be bound by any Agreement, in order for the business value to be "pegged" for tax purposes:

  • The price must be either fixed or easily determinable by a formula

  • The agreement must not be a device to simply pass business interests for less than fair value; it must be a true business agreement

  • The obligation to sell must be binding during lifetime

HOW IS THE BUSINESS VALUE DETERMINED?

It is wise to seek professional advice when valuing a business. There are a number of different ways to value a business, and the subtleties of valuing a business are outside the scope of this Q&A. Each particular situation is different; however, in general a business can be valued by:

  • Market Approach - The business is compared to a publicly traded business and then the value is adjusted accordingly. Finding a publicly traded company that can compare with a privately held company can be a problem with this approach.

  • Income Approach - The valuation is determined either by looking at the history of earnings or cash flow for the company and dividing by a capitalization rate for that industry (Capitalized Returns), or projecting future earnings for the company and applying a discount to determine the present value of that income stream (Discounted Future Returns Method).

  • Asset Approach - The valuation is based on the underlying assets of the company and their value. In general the valuation is based on the value of the assets minus the liabilities, with an adjustment for the type of business.

  • Owner's Estimate - The simplest method, it is the price that the owner agrees is a fair price for the business.

WHO ARE THE PROFESSIONALS THAT SHOULD ASSIST IN DEVELOPING A FUNDED BUY-SELL AGREEMENT?

At least three professionals should be part of the Buy-Sell Agreement Funding process.

  • First, a competent Attorney fluent in Buy-Sell Agreements as well as estate planning issues is needed.

  • Second, an Accountant familiar with the company and the business marketplace of the company is needed.

  • Third, a Financial Advisor well versed in the use of life and disability insurance to fund the Buy-Sell Agreements is needed.

This is vital. Without the insurance, the surviving owners may not have the means necessary to fund the Buy-Sell Agreement. All three should be made well aware of the goals and expectations of all of the owners, their families and heirs.

 

Want more information? Email Us With your Question

For use with non-registered products only. The annuity and insurance products described may be issued by various companies and may not be available in all states. All comments about such products are subject to the terms and conditions of the annuity and/or insurance contract issued by the carrier. These materials are provided for educational purposes only. West Financial Services makes no representation regarding the suitability of this concept or the product(s) for an individual nor is West Financial Services providing tax or legal advice. You should consult your own tax, legal or other professional advisor before purchasing these products. To ensure compliance with requirements imposed by the IRS, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.