2018 Florida Best Buy Sell Life Insurance Agreement
Using life insurance to fund a buy-sell agreement is a very common strategy for business owners.
What is a Buy-Sell Agreement?
A buy-sell agreement is a contract requiring the sale of a business or investment interest upon the occurrence of a specified event.
This event may be the death of one of the owners or their disability, retirement, divorce, bankruptcy, termination of employment or withdrawal, seizure by creditors, or a proposed transfer of an ownership interest by gift or sale. In a buy-sell agreement, one or more parties may obligate themselves to buy or may have the option to buy the business or investment interests from the party obligated to sell.
A buy-sell agreement is recommended for many closely-held businesses, professional groups, or jointly owned investments, such as real estate.
Buy-sell agreements may:
- Provide for the orderly transfer of business or investment interests on the death, retirement or disability of an owner. The agreement also could add voluntary or involuntary separation from the business, a desire to sell during lifetime, bankruptcy of the owner, divorce, and seizure by the owner’s creditors.
- Permit the remaining owner(s) to retain control, eliminating conflicts with new owners who might object to compensation arrangements, employee benefits, dividends, development or disposition of jointly owned investments, etc., and to allow them to control admission of new owners.
- Effect the transfer of the business to the right family members, such as children active in the business rather than the surviving spouse or children who are not active in the business.
- Create a market at a fair price for the interests of owners who are or become inactive.
Types of Buy-Sell Agreements
There are four (4) basic types of buy-sell agreements:
- Entity Redemption Agreement. This is an agreement where the business enterprise agrees to buy (redeem) the business interest from the selling party.
- Cross-Purchase Agreement. This is an agreement solely among owners who agree to buy each other’s interest.
- “Wait-and-See” Agreement. This is an agreement when the business and its owners agree jointly or in the alternative to buy the seller’s interest.
- Unilateral Agreement. This is an agreement when the sole owner is selling the entire business to one or more key employees, family members or other interested parties.
There are variations on each, such as “option” buy-sell agreements. The right to buy or sell may be given to one or both parties (put or call rights).
The price paid under a buy-sell agreement could be all cash, could be on an installment basis, or might be cash up to the amount of life insurance received to fund the agreement and on an installment basis for the rest.
Life Insurance Funding Cross-Purchase Agreement
A buy-sell agreement obligates one party to purchase a deceased business owner’s interest at a certain price, and another party-the deceased owner’s estate or heirs-is obligated to sell the interest at that price.
Under a cross-purchase type of buy-sell agreement, each business owner individually agrees to buy a portion of a deceased owner’s interest. Under another type, the entity buy-sell agreement, the business entity itself, not the individual owners, agrees to buy the interest.
A buy-sell agreement gives business owners certainty about who will purchase a deceased owner’s interest, what the price will be, when the sale will take place, and where the funds will come from. To fund a cross-purchase buyout, each owner purchases a life insurance policy covering the life of every other owner. The total amount of insurance approximates the purchase price for the insured’s share of the business.
- Each co-owner is the owner and beneficiary of policies on the other owners’ lives, not on their own lives. The policy proceeds are used to purchase the business or investment interest.
- Premiums paid are not deductible.
- Death benefit proceeds pass tax-free to the surviving owners.
- A survivor’s tax basis in his business interest increases to the extent of the interest which is purchased.
- In structuring cross-purchase agreements, survivorship clauses are recommended which limit the parties obligations if multiple deaths occur in a short time period.
Use of LLCs to Structure and Fund Buy-Sell Agreements
In a recent Private Letter Ruling, PLR 200747002, the IRS accepted a strategy that has the advantages of both cross-purchase and redemption agreements without the disadvantages of either. With this structure, the members sign a cross-purchase agreement and form an LLC, taxed as a partnership, to own the life insurance. The cross-purchase agreement and LLC operating agreement have provisions that reference each other.
Special provisions of the LLC include:
- The LLC manager is a corporate trustee, and any replacement must be a corporate trustee;
- Members cannot vote on life insurance matters;
- The manager must use life insurance proceeds as required in the buy-sell agreement; and
- The LLC must maintain a capital account for each member, with special allocations of premiums and proceeds.
Upon examination of this structure, the IRS ruled that the life insurance death proceeds would not be includible in the estate of the deceased LLC member. Thus, this structure contains the advantage of the traditional buy-sell structures without the disadvantages.
Using an LLC to own life insurance for buy-sell funding purposes accomplishes the buy-sell objectives without causing many of the adverse income tax consequences and without causing estate tax inclusion.
For any questions regarding buy-sell agreements and life insurance quote call us today
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