By Boyce F. Lowery, CLU, ChFC
Last month we discussed the three most important elements of a solid buy-sell agreement. We looked at the importance of the owners being in agreement on the methodology used for company valuation, both now and in the future. Taking into consideration all possible contingencies when establishing the triggering events for the agreement was the next key element. Finally, we discussed funding options.
Today we are going to discuss how to structure a successful buy-sell agreement. If a partner retires, who buys out that partner? It could be either one or more of the other partners in the business or the firm itself. If you fund the agreement with life insurance, who is the owner of those policies and who are the beneficiaries? In simple terms, you have three main options for structuring a buy-sell agreement regarding parties to the agreement.
Traditional Cross-Purchase
In the traditional cross-purchase agreement, each partner has an agreement with other partners to personally buy them out when a triggering event occurs. With this approach, each partner will typically buy a life insurance policy on each of the other partners to provide them with the funds to purchase the deceased partner’s ownership from their family should death occur.
This structure gets more complicated as the number of owners increase. In a business with six owners, each one has to own and maintain five life insurance policies, one for each of their partners. This would mean a total of 30 policies – a very cumbersome situation at best. Also, the more fluid the company ownership is, with new owners coming in and existing owners leaving, the more complicated this structure gets.
The advantage of a Cross-Purchase arrangement is that the buyers get an increase in their tax basis for the purchase of the ownership interest of the departing partner. The downsides of a Cross-Purchase arrangement certainly includes complexity where there are 3 or more owner-partners.
Entity Purchase
A way of structuring buy-sell agreements that can solve some of the complexities of the traditional cross-purchase plan is the entity purchase. Instead of each owner personally buying out a departing owner, the business itself buys them out. There is only one life insurance policy needed for each owner’s life and the business is the owner of the policy.
While this structure can simplify things, it also brings in a new level of complexity. When a business owns a life insurance policy, it must take care to comply with the requirements found in Section 101(j) of the Internal Revenue Code. Failure to do so can potentially bring in income taxes being due for the life insurance death benefit proceeds. Additionally, when owners vary in age, health, and ownership percentage, there can be inequities in the premium amount for each owner.
Insurance LLC
Both traditional cross-purchase agreements and entity purchase plans have advantages and disadvantages, so business owners have long yearned for a hybrid option that combines the benefits of each while limiting their drawbacks. There is an option that may do just that; the insurance LLC. Unless a business itself is already structured as a true partnership or an LLC taxed as a partnership, this approach may be the best option. Even if the business is an LLC taxed as a partnership or an outright partnership, having a separate LLC own life insurance policies can provide asset protection from the creditors of the operating entity.
In this structure, the business owners would create an LLC that is taxed as a partnership. It is separate from the primary business and is created for the administration of the insurance policies funding the buy-sell agreement. The LLC itself is the entity that purchases life insurance on each owner, and there are various ways this can be funded. If an owner perishes, the life insurance proceeds can be used by the remaining partners individually to buy out the family of the deceased. If an owner departs the business for a reason other than death, the life insurance policy can be transferred as a part of the payment for their ownership if crafted in the agreement. The insurance policies might also be structured in a way to provide additional income tax free cash flow to a retiring partner.
To be sure, there are many benefits to utilizing an insurance LLC. This approach avoids potential tax issues down the road for the transfer of policies out of the partnership while preserving the tax benefits of a cross-purchase agreement without the disadvantages. It brings greater simplicity and flexibility to the entire process. As previously mentioned, an insurance LLC also protects the insurance policies from the creditors of the business or of the individual owners. The surviving owners receive a step-up in basis on the purchased interests of a departing owner, which can help reduce tax burdens for the surviving owners if the business is later sold. Finally, proceeds can be excluded from the deceased owner’s taxable estate with proper planning.
Work with an Experienced Professional
Buy-sell agreements and everything that goes into them can be complex, and there can be major consequences if things are not done properly. There are important tax and legal issues at stake. Because of this, it is vital that you work with seasoned professionals who have vast experience with buy-sell planning when structuring your agreement. We have worked in tandem with many attorneys on countless Buy-Sell Agreements to think through the issues for buy-sell planning.
Have you had your buy-sell agreement and underlying funding reviewed for any pitfalls? If you don’t have a buy-sell agreement at all or if you aren’t certain the agreement you have is up to standard, don’t procrastinate. This is too important of an issue to leave hanging. We can help. Call us today at 888-827-0146 for your free and confidential consultation.
About Boyce
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.