Business Succession Planning and Life Insurance

Lee Slavutin, MD, CPC, CLU
Tax Hotline, April 1999

When a private business is owned by two or more persons-especially when they are not from the same family-the most important document needed to assure the smooth continuation of the business is an owners' buy-sell agreement. This is an agreement that will control the future disposition of the business's shares.
Here's how to structure one to protect your business...

Goals
A buy-sell agreement protects the business and its owners by assuring that if one dies or leaves, the remaining owners will retain full ownership and control of the business.

The agreement also fixes the financial return that an owner will receive when he/she retires or leaves the business-or that his family will receive should he die unexpectedly.

Important: A buy-sell agreement performs an important task by heading off potentially costly disputes and damaging lawsuits that could arise if these issues aren't resolved in advance.

Basics
A buy-sell agreement should provide for the "buyout" of an owner- interest in the company upon death, disability, personal bankruptcy, or retirement.
It will...

Fix a price for each owner's interest in the company, or provide a formula for doing so at a later date.
Create a mechanism to pay the price.
Prevent the sale of any owner's interest to any outside third party without the approval of the other owners, so full ownership of the business will remain with the current ownership group.

A buy-sell agreement can play a major role in the estate tax planning of a business owner as well, since an owner's interest in a business is likely to be a major part of the owner's estate.

The agreement here serves the key role of fixing a dollar valuation for an owner's interest in the business, which can be used for estate- planning purposes.

The IRS generally will not challenge the valuation of an interest in a business that results from a buy-sell agreement that has been negotiated by unrelated individuals and contains certain key elements. (Buy-sell agreements for family-owned businesses can expect more scrutiny.)

Making it Work
Providing the financing for future buybacks that will take place under a buy-sell agreement is of course a key concern. Financing can come from any source of available funds but the logical and most common method of funding buyback agreements is with life insurance.

There are two basic methods of structuring a buy-sell agreement, each typically using life insurance. Pros and cons...

Redemption agreement. The company buys the shares of an owner who dies. It finances the arrangement by buying life insurance on each owner.
Example: A corporation has three equal owners. If one dies, the company buys his shares using insur- ance proceeds and retires them. The two surviving owners then become 50% owners of the business. The advantage of this arrangement is that it is simple and the company pays for the insurance needed to finance it.

A disadvantage is that if the business is a regular (C) corporation and doesn't qualify as a "small" corporation, insurance proceeds may be subject to the Alternative Minimum Tax (AMT) at an effective rate of 15% (only 75% of the insurance proceeds are potentially subject to the 20% AMT, creating an effective rate of 15%). And because a buyback may take place many years in the future, and AMT rules are very complex, there may be no way of predicting with certainty whether or not it will be subject to AMT.

Cross-purchase agreement. The owners agree to purchase shares from each other.
Example: A corporation has three equal owners. They all agree that if one dies, the other two will personally purchase the deceased owner's shares.
The disadvantages are that these agreements can grow quite complex if a business has several owners, and that the owners must pay for the insurance themselves. (The company can help them by increasing their compensation.)
Cross-purchase advantages...

Owners get "stepped-up basis" when they purchase another owner's shares at the death of that shareholder, reducing the future capital gains tax on the sale of the company.
Example: Three equal owners start a business from scratch and have zero basis in their shares. When the business is worth $3 million, one owner dies and the two survivors become 50% owners of the business through a buyback agreement.

If the agreement is a...

Redemption, the company buys the deceased owner's shares so each surviving owner's basis in his 50% interest remains zero. If the surviving owners then sell the business, together they will have a taxable gain of $3 million.
Cross-purchase, the surviving owners buy the deceased owner's shares personally, paying $500,000 each. So each emerges with basis of $500,000 in his 50% interest in the business. If they then sell the business, together they will owe tax on only $2 million of gain, and avoid tax on a combined $1 million of gain.

No risk of the company incurring the AMT on a cross-purchase agreement-potentially saving up to 15% tax.

Which agreement to use-redemption or cross-purchase-will depend on the specific facts of the case. But the advantages of a cross- purchase agreement generally make it more favorable.

Kinds of Insurance
There's also choice among the kinds of insurance that can be used to fund buy-sell agreements It's possible to use low-cost term insurance, or any of the range of cash value products that are now on the market, such as whole life universal life, etc. If the buyback agreement will be in effect...

For a limited time, perhaps because the owners expect to sell the business in a few years, it can be funded with low-cost term insurance.
Permanently, it can be funded with cash value insurance. If the insured owner lives to retirement the cash value of the policy can be used to help fund the buyback. If the owner dies prematurely, the death benefit will finance the buy- back of his interest.

Reprinted with permission of:
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