Own Your Buy-Sell
Buy-sell and business continuation agreements are important business planning documents. Because every business owner will voluntarily or involuntarily leave their business someday, these agreements are critical in determining both the ownership and decision-making structure of the business after an owner leaves. A smooth transition of business ownership is important for both the remaining owners and the departing owner and his/her family. Owners who do not have a buy-sell plan in place before it is needed may create difficult problems for their families and co-owners.
Just as it is important to have a binding agreement, it is equally important that funds are available to carry out the promises made in the agreement. Even a perfectly drafted buy-sell agreement cannot be carried out unless the buyer(s) have the money to follow through on his/her/their purchase obligation. Ownership transitions will not happen without a concrete plan for financing the agreement. We will offer a new strategy for funding ownership transfers necessitated by an owner’s death.
Most buy-sell agreements include death as one of the triggering events. When this is the case, an owner’s death activates the legal obligations to buy and sell the deceased owner’s interest. Because death is nearly always a triggering event, life insurance policies are often used in the funding of the agreement. Some potential advantages life insurance provides include:
- The policy death benefit is generally payable in full as soon as the policy has been issued and a premium has been paid, even if the insured owner dies shortly thereafter.
- Policy death benefits may be paid relatively quickly after proof of death so the buyer will have some or all of the funds necessary for the purchase.
- Policy death benefits are generally paid to the policy beneficiary income tax free under IRC Section 101.
Different varieties of buy-sell arrangements have been developed over time. The two most common varieties are the entity purchase arrangement (in which the business buys back/redeems a departing owner’s interest) and the cross purchase arrangement (in which the remaining owners purchase their pro rata shares of the departing owner’s interest). Both arrangements have their respective potential advantages and disadvantages.
Nearly all buy-sell agreements that use life insurance as a funding mechanism have one thing in common: The insured business owners do not own the life insurance policies that insure their lives. In an entity purchase arrangement the business typically owns the policies. In a cross purchase arrangement the other owners or another entity (e.g. a trust or a general partnership) own the policies. Life insurance policies can be very valuable assets. The fact that owners do not own their own life insurance policies can result in a number of real problems, including:
The person/entity owning the policy may not pay the premiums or may mismanage the policy so that it is not in force at the insured owner’s death; in these instances no death benefits are paid.
The insured business owner has no ability to make decisions concerning the policy on his/her life.
“Surplus” death benefits (those in excess of the amount needed to purchase a deceased owner’s interest) are retained by the policy owner and cannot be used to meet the deceased owner’s personal financial objectives.
Additional problems may arise when the purchase obligation is triggered before the departing owner’s death. Many buy-sells are activated when a triggering event occurs prior to an insured owner’s death. In lifetime buy-outs, there are not any policy death benefits available to fund the purchase of the departing owner’s interest. In these situations:
If an owner’s health deteriorates, he/she may become uninsurable and be unable to purchase other life insurance coverage.
Even when a departing owner is insurable, the cost of purchasing new coverage could be prohibitive because of age, health or other conditions.
The insured may not have the legal right to acquire ownership of the policy if he/she leaves the business before death.
Even when a departing owner does have the right to acquire ownership of the policy(ies) insuring his/her life, the cost of acquiring those policies could be too high.
Some buy-sell agreements have provisions which give departing owners a limited opportunity to acquire ownership of their policies. For example, when they leave, the agreement may give them the option to purchase their policy from its current owner for its fair market value. Or, the agreement may give the purchaser(s) the option to transfer the policy back to the departing owner and treat the policy’s value as part of their payment.
In some cases these provisions can be helpful. Much of the time, however, they may be ineffective for a number of reasons. For some policies, it can be difficult to establish their fair market value. Some policies include various guaranteed features/components which can be hard to value. It is quite possible that the owners may disagree over a policy’s fair market value. If the insurance company is asked to value it (as it is sometimes asked to do for the filing of 712 form), the remaining owners may not find the value acceptable. Other times the policy may not provide much in the way of long-term value. For example, when term life insurance is used to fund a buy-sell agreement, the policy may terminate at a specified age (e.g. age 70 or age 80) or the premiums may increase substantially after age 65, the approximate age when many owners hope to retire.
Despite potential valuation difficulties and disagreements, a departing owner’s life insurance policy is an asset which could possibly be quite useful in his/her personal retirement planning or wealth transfer planning. Personal ownership of the policy would give the departing owner control of the death benefit; he/she could change the beneficiary designation so the death benefits could be used to meet personal financial objectives.
The “Own Your Own Policy Buy-Sell” strategy is an alternative for structuring the ownership of life insurance policies designed to fund either an entity purchase or a cross purchase buy-sell agreement. This strategy separates the ownership of the life insurance policies from the obligation to purchase created under the agreement.
In spite of the potential advantages of personal life insurance ownership to fund buy-sell agreements, this alternative is not widely used. There are at least three main reasons:
- Someone else (either another owner, entity or the business itself) has the legal obligation to purchase their interest. Because potential purchasers need to make sure they have sufficient funds to satisfy their purchase obligations under the agreement, it can make sense for them to own and control the policies.
- The entity purchase and cross purchase methods are well known and provide business owners and their tax and legal advisors with workable and predictable results.
- The transfer for value rule of IRC Section 101. One of the biggest advantages of using life insurance in buy-sell funding is that policy death benefits are generally federal income tax free to the policy beneficiary when the insured owner dies. This valuable income tax benefit may be lost if the business owners own their own policies because they may violate the “transfer for value rule.” A transfer for value occurs when the owner of a life insurance policy transfers an interest in the policy to someone else and receives something of value in return. Under IRC Section 101 a transfer for value isn’t limited to just cash or tangible assets; “value” can also include a legally enforceable promise which could potentially benefit the transferor (such as a promise to purchase the owner’s interest). The result of violating the transfer for value rule is that the policy death benefit less the combined total of the consideration paid and total premiums paid after the transfer become taxable income to the policy beneficiaries.
Here’s an example to illustrate the point.
A and B are each 50% owners of a business. Each purchases a $1,000,000 life insurance policy on his/her own life and names the other owner as the policy beneficiary. Under normal circumstances neither A nor B would name each other as policy beneficiaries. Reciprocal promises to name each other as beneficiaries can be implied from their respective actions (or from the terms of the agreement). These reciprocal promises are the “value” that triggers the transfer for value rule. Thus, if A dies, part or all of the $1,000,000 death benefit B receives as the beneficiary of A’s policy may be taxable income to B.
Fortunately, it is possible to avoid the harsh income tax consequences of the transfer for value rule. In IRC Section 101(a)(2) Congress created a number of exceptions to the rule; if one of those exceptions applies, then it is possible the policy beneficiary may still receive the life insurance death benefits free of federal income taxes. An exception likely to apply to many buy-sell arrangements is the “partnership exception.” This exception shields transfers for value from federal income taxes if the transfer is to a partner of the insured or to a partnership in which the insured is a partner. There are some fine points to this exception which should be kept in mind, including:
- The partnership must actually be operated as a partnership and not merely exist in form only.
- Members of a limited liability company (LLC) that has elected to be taxed as a partnership are considered to be “partners” for purposes of the transfer for value rule. (Private Letter Ruling (PLR) 9625013).
- A transfer for value from a corporation to a partnership in which an insured shareholder is a partner comes within the exception (PLR 9042023).
- Transfers to shareholders who are partners, even though in an unrelated partnership, fall within the exception (PLR 9347016, PLR 9045004).
- The transfer of policies insuring shareholders / partners from a corporation to a partnership established specifically to receive and manage the policies comes within the exception (PLR 9309021).
The IRS has ruled that it will not issue rulings concerning whether or not the exception applies to a transfer of a policy to an unincorporated organization where substantially all of the organization’s assets consist or will consist of life insurance policies on the lives of its members (Rev. Proc. 20063, 2006-1 IRB 122). Thus, it may advisable for the partnership to have other assets in addition to life insurance policies on the lives of the partners in the partnership.
The ability to use the partnership exception to avoid the transfer for value creates an opportunity for a new type for life insurance-funded buy-sell arrangement—the “Own Your Own Policy (OYOP) Buy-Sell.” In this approach each owner owns his/her own policy and names other owners (or the business in an entity purchase agreement) as beneficiaries of part of the death benefit so they have the ability to meet their purchase obligations. If these owners are in a partner/partnership relationship, the transfer for value rule should be avoided.
Assuming there is valid partnership in place or the business is organized and taxed as an LLC, LLP or a partnership, these steps may be taken:
- The owners enter into a cross purchase arrangement; each owner agrees to purchase his/her pro rata share of the interest of the other shareholders when they die.
- Each owner purchases and pays the premiums on a policy on his/her own life with a face amount at least as large as the value of his/her interest in the business; an option B death benefit approach (death benefit payable is the face amount plus premiums paid) may be appropriate because the insured’s estate will then recover premiums paid into the policy.
- Each owner names the other owners as partial beneficiaries of the policy death benefit according to their pro rata shares of the business; the necessary forms are filed with the insurance company.
- At an insured owner’s death, the death benefits are paid out according to the policy beneficiary designation; each surviving owner uses his/her share of the death benefit to purchase part of the deceased owner’s share of the business from his/her estate under the terms of the agreement.
- If an owner retires or otherwise leaves the business before death, the remaining owners may use the cash values in the policies they own on themselves and/or other personal assets to purchase their respective shares of the departing owner’s interest.
- Both the departing and remaining owners file the forms needed to change the beneficiary designations on all the life insurance policies.
If the business is organized as a C corporation or Subchapter S corporation and the parties wish to establish an entity purchase or stock redemption buy-sell format, the life insurance policies may still be owned by the insured owners. Although the partnership exception may not be available to shield the death benefit from the transfer for value rule, a different exception to this rule may apply—the corporation exception. This exception can be used when the transfer for value is to a corporation in which the insured is a shareholder or director. See IRC Section 101(a)(2)(b).
The shareholders could potentially use the Own Your Own Policy strategy to implement a corporate entity purchase/stock redemption plan with these steps:
- The owners and the corporation enter into a stock redemption buy-sell agreement; the corporation agrees to purchase the interests of shareholders when they leave or die.
- Each owner purchases and pays the premiums on a policy on his/her own life with a face amount at least as large as the value of his/her interest in the business.
- Each owner names the corporation as one of the policy beneficiaries as required in the agreement; the agreement may establish standards for the owners regarding paying premiums and administering the life insurance policies.
- Assignment forms or beneficiary forms are filed with the insurance company.
At an insured owner’s death, the death benefits are paid to the corporation per the beneficiary designation; the corporation uses these death benefits to redeem the deceased owner’s stock.
- If an owner retires or otherwise leaves the business before death, the corporation will use other assets to redeem the departing owner’s stock; the beneficiary forms are changed.
Upon close examination, there may be a number of potential advantages when business owners own their own buy-sell life insurance policies. They include:
- Personal Ownership and Control—Each owner makes the decisions concerning his/her own policy (however, if the agreement sets standards for the policies, each owner would have to satisfy those standards / requirements).
- One Policy Per Owner—There is no need for multiple policies on each owner.
- Ability to Include Personal Death Benefit Coverage—An owner may want more death benefits than the amount needed under the agreement; he/she may decide to increase the death benefits to accomplish personal protection and wealth transfer planning objectives in addition to the buy-sell funding objective.
- Each Owner Pays His/Her Own Way—Each owner is responsible for his/her own premiums; younger or healthier owners are not forced to pay premiums on older or less healthy owners.
- Choose Own Policy and Set Own Premium Level—Within the terms of the agreement, each owner may decide what type of policy to purchase and how much premium to pay; they may choose to pay in more than the minimum in order to increase cash values potentially available to fund the purchase of another owner’s interest or to create supplemental retirement income for themselves.
- Business Dollars for Premiums Potentially Available—The business may assist with paying premiums; time-tested premium funding techniques like IRC Section 162 bonus plans, split dollar, and split dollar loans may potentially be used.
- The Policies Are Portable—Every owner who leaves the business before death takes the policy with him/her; there is no need to attempt to acquire the policy from another owner or from the business.
- Wealth Transfer Planning—After an owner leaves, he/she may reposition the policy to meet personal needs without going back through the underwriting process to purchase new coverage; problems with increased premiums and decreased insurability can potentially be avoided.
Some possible disadvantages to an OYOP Buy-Sell arrangement include:
- A procedure for monitoring the policies should be implemented and enforced. The buy-sell agreement could require each owner to present a quarterly, semi-annual or annual report of the status of their life insurance policy. The business could hire a life insurance expert to review the policy information and make an annual report.
- The policy beneficiary designations should be confirmed with the insurance company and reviewed regularly.
- If applicable, economic benefit calculations would need to be performed annually and any taxable gifts should be reported to the IRS; to the extent economic benefit gifts do not qualify for the gift tax annual exclusion, a portion of an owner’s lifetime gift tax exemption would be used.
- Taxable gifts that reduce an owner’s lifetime gift tax exemption may also reduce the amount of the estate tax unified credit available at the owner’s death; as a result, the amount of property an owner may be able to transfer federal estate tax free at death may be reduced.
For many years advisors to business owners have avoided having owners personally own the life insurance policies that fund their buy-sell arrangements. This may no longer need to be the case. The Own Your Own Policy Buy-Sell is a strategy which has the potential to provide many business owners with the ability to own and control their life insurance policies while still maintaining policy death benefits to fund buy-sell obligations triggered by death. Because the OYOP strategy has the potential to combine buy-sell funding with personal life insurance needs, it gives them the opportunity to combine all their life insurance needs in a single policy. It also gives business owners who leave their businesses during their lifetimes more opportunity to customize, structure and manage their policies to provide ongoing benefits after they leave the business.