The Right Buy-Sell Agreement for Your Client

One of the most important planning issues confronting a business owner is what happens to his or her shares of the business upon death. Insurance-funded business transfer plans can guarantee the shares will be legally transferred to the right successors at the right price. The primary questions revolve around what type of buy-sell agreement and what life insurance owner and beneficiary designations will accomplish this business transfer plan most efficiently.

The most popular types of buy-sell agreements include (1) cross purchase, (2) stock redemption (“entity”), (3) unilateral (“one-way”) and (4) cross endorsement. Summarized in this article is the basic structure of each type of agreement where life insurance is used to guarantee funding of the purchase price on the death of a shareholder.

All buy-sell agreements should be drafted by legal counsel for the respective C corporation, S corporation, or limited liability company (LLC), depending on the specific fact pattern of the case. Optional wait-and-see language can be drafted into any buy-sell agreement, which allows a cross purchase option or stock redemption option to be decided only after a share owner has died. Also, “trusteed” buy-sell plans can be drafted for multiple shareholder situations to reduce the number of insurance policies required and provide for a professional trustee to administer the buy-sell plan.

Cross purchase agreement

• Each share owner agrees to buy the shares of the other owners upon their death for a specified price.

• Each share owner is the owner and beneficiary of insurance on the lives of the other owners and is responsible for premiums on these cross-owned policies.

• The business can pay bonus compensation to each share owner to pay premiums. These bonuses are deductible to the business (IRC Section 162) and taxable as current compensation to each policy owner.

• Upon the death of an owner, the surviving owners receive a 100% increase in the cost basis of the shares purchased.

• The surviving owners use the income tax-free insurance proceeds to purchase the shares from the estate of the deceased. The estate of the deceased distributes this cash to heirs according to the terms of the deceased business owner’s will or trust.

Stock redemption (entity plan) agreement

• The business entity (C corp, S corp, LLC) agrees to buy back (redeem) the shares of each owner upon his or her death for a specified price.

• The business entity is the owner and beneficiary of insurance on the lives of each owner.

• The premiums are a non-deductible expense for the business (IRC Section 264).

• Upon the death of an owner, cost basis increases to the surviving owners depend upon the business type. Surviving owners of a C corp receive a 0% cost basis increase. Surviving owners of a cash basis S corp can receive a 100% cost increase if the “short tax year” S corp procedure of IRC Section 1377(a)(2) is followed. And surviving owners of an LLC will get a proportional cost basis increase equal to their respective share ownership in the LLC with some proportional “wasted basis” being allocated to the deceased LLC owner.

• The business entity uses the income tax-free insurance proceeds to purchase the shares from the estate of the deceased. The estate of the deceased distributes this cash to heirs according to the terms of the deceased business owner’s will or trust.

(Note: Life insurance proceeds paid to a C corp may be subject to the corporate alternative minimum tax in certain situations.)

Unilateral (one-way) agreement

• A younger generation family member or key employee agrees to buy all the shares of the 100% owner upon death.

• The younger generation family member or key employee is the owner and beneficiary of insurance on the life of the 100% owner and is responsible for premiums.

• The business can pay partial or full bonus compensation to the younger generation family member or key employee to pay premiums. These bonuses are deductible to the business (IRC Section 162) and taxable as current compensation to each policy owner.

• Upon the death of the 100% owner, the younger generation family member or key employee receives a 100% increase in the cost basis of the shares purchased.

• The younger generation family member or key employee uses the income tax-free insurance proceeds to purchase the shares from the estate of the 100% owner. The estate of the deceased 100% owner distributes this cash to heirs according to the terms of the deceased 100% owner’s will or trust.

Cross endorsement agreement

• Each share owner enters into an endorsement split dollar-business cross purchase agreement with the other owners.

• Each share owner is the owner of an insurance policy on his or her own life and endorses all or a portion of the death benefit to the other owners via beneficiary designation.

• The business can pay bonus compensation to each share owner to pay premiums. These bonuses are deductible to the business (IRC Section 162) and taxable as current compensation to each policy owner. In addition, each policy owner reports income for the economic benefit rental charge based on the Table 2001 rate per thousand for the amount of insurance endorsed to the other share owners.

• Upon the death of an owner, the surviving owners receive a 100% cost basis increase in the shares purchased.

• As beneficiaries of the policy (endorsement), the surviving owners use the income tax-free insurance proceeds to purchase the shares from the estate of the deceased. The estate of the deceased distributes this cash to heirs according to the terms of the deceased business owner’s will or trust.

In summary, the life insurance-funded buy-sell agreements previously listed perform a variety of important functions:

(1) A buyer for the shares of each share owner is guaranteed.

(2) The sale price is fixed in a legally enforceable agreement.

(3) The funding for the buy-sell obligation is provided by the income tax-free life insurance death benefit.

(4) Cash liquidity equal to the purchase price of the shares is provided to the family of the deceased owner.

(5) Life insurance premiums provide the lowest present-value cost method to accomplish the transfer when compared to alternative financial methods.

(6) Family members of the deceased owner receive cash, and the surviving owner receives the shares in a timely manner — exactly what both parties desire.

(7) Disagreement on the future direction and operation of the business between the surviving share owners and the heirs of the deceased owner is avoided.

by Russell E. Towers, J.D., CLU, ChFC, for April 2012 of Life Insurance Selling Magazine.  Russell  joined Brokers’ Service Marketing Group in 2002 as vice president of business & estate planning.

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