There’s a little-known buy-sell strategy that avoids many of the pitfalls of traditional arrangements.1
The LLC buy-sell combines the benefits of a cross purchase buy-sell and an entity buy-sell while eliminating many of the challenges business owners and their advisors typically face.
The owners of a successful business should plan for the transfer of the business to the next generation. Buy-Sell plans can make all the difference in a successful transfer of the business to surviving business owners in the event of a triggering event, such as the death, disability or retirement of one of them — all while protecting the financial interest of the surviving family members.
Generally, there are 2 commonly used buy-sell arrangements:
- Cross Purchase Buy-Sell
- Entity Purchase Buy-Sell, or a Stock Redemption Agreement
Cross Purchase arrangements refer to each business owner having a life insurance policy on the life of each of the other business owners based on each business owner’s share of the business. Typically, the arrangement will look to buy-out the surviving owners with the insurance proceeds. Because this arrangement can be very cumbersome when there are more than 2 owners (requiring more than 2 policies), and inequitable when certain owners are older and unhealthy (requiring younger, healthier owners to pay higher premiums), an Entity Purchase agreement is often considered as an alternative.
Entity Purchase arrangements refer to the entity or business as owner of each policy, with the life insurance proceeds being paid into the business — at which point the business facilitates the buy-out of the shares with the surviving owners. Often, these Entity Purchase agreements are set up as stock redemptions.
Both arrangements have their own set of problems, several of which are illustrated in the following chart:
|PRIMARY CHALLENGES WITH TRADITIONAL BUY-SELL PLANS|
|Cross Purchase||Entity Purchase|
|Multiple policies can become unmanageable||The remaining owners do not receive a step-up-in basis when the stock is redeemed by the business|
|The individual policies are personally owned and may be subject to the claims of the policyowner’s creditors||The policies may be subject to the claims of business creditors|
|Taxation if Transfer-For-Value (TFV) rule may apply 1||TFV may apply but in limited circumstances|
1The proceeds from employer-owned life insurance policies issued after August 17, 2006 will be subject to income taxation unless specific employee notice and consent requirements are met and certain safe-harbor exceptions apply, as per IRC 101(j).
2 See IRC 101(a)(2). TFV applies when property is transferred for valuable consideration, such as a life insurance policy being transferred to a co-shareholder. Unless an exception to the rule applies, a portion or all of the death proceeds could be subject to taxation
What is an LLC?
A limited liability company is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. It must be valid under state law.
LLCs are well known for the flexibility that they provide to business owners. Depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, and, under certain circumstances, LLCs may be organized as not-for-profit.
The Best of Both Worlds: The LLC Buy-Sell
In order to establish a buy-sell arrangement with an LLC as a party to it, the following steps need to be taken:
- The business owners create an LLC as a separate entity from the business. This is the “entity” part.
- An attorney then drafts the “cross purchase” part; a cross purchase agreement, in which the business owners are named parties to the buy-sell arrangement with the LLC. The agreement can either be part of the LLC operating agreement or separate from it.
- The LLC holds the policies and acts on behalf of the business owners at a triggering event to facilitate the buy-sell transaction.
- The LLC buy-sell must then be funded. Life insurance is the most efficient way to fund it.
Take a look at the arrangement:
Premium Payments made by LLC
There are a number of factors to consider when the LLC pays premiums for its buy-sell arrangement, including tax and accounting factors. To keep it simple, there are two ways the premium on a life insurance policy is generally funded in an LLC buy-sell plan:
- The business contributes earnings (by way of the owners) to the LLC as capital contributions, or
- Each owner contributes an existing insurance policy to the LLC as a capital contribution if insurability is an issue.
If earnings are contributed as capital to the LLC, they are taxable to each owner. However, each owner’s cost basis is increased by the amount of the capital contributions.
The most common way the premium is funded is through its earnings.
Let’s go back to our chart of challenges to see how the LLC Buy-Sell may overcome these pain points:
|Primary Challenges with Traditional Buy-Sell Plans||Addressing Challenges with the LLC Buy-Sell|
|Cross Purchase (CP)||Entity Purchase (EP)|
|Multiple policies can become unmanageable||The remaining owners do not receive a step-up-in cost basis when the stock is redeemed by the business||Unlike the CP, it requires only one policy per owner. Unlike the EP, each purchasing owner receives an increase in cost-basis based on his/her share of the purchase price.|
|Relies on each owner paying his/ her premium amount||Receipt of death proceeds increase value of business||Unlike CP, the LLC owns the insurance and pays the premium on each policy. Unlike EP, the death proceeds are received by the LLC, not the business. The business is separate from the LLC.|
|The individual policies are personally owned and may be subject to the claims of the policyowner’s creditors||The policies may be subject to the claims of business creditors||Unlike CP and EP, an LLC is protected from the claims of business and personal creditors.|
|Taxation may apply if there’s a Transfer-For-Value (TFV)1||TFV may apply in limited circumstances||Under current law, a transfer of a life insurance policy to an owner of an LLC is an exception to the TFV rule. And, adding new owners to the arrangement does not cause a TFV.|
A Retirement Buy-Out
If the event that triggers the buy-sell plan is retirement, the policy on the retiring owner can be transferred to him or her as part of the buy-out. Transferring the policy to an insured is, again, an exception to the TFV rule. If the policy is designed properly, it is possible for the exiting owner to access cash values on a tax-favorable basis to supplement retirement income.
If the cash value of the policy on the existing owner is not sufficient to execute the full buy-out price, the cash values from multiple policies may be used to fund the difference.
A Death Buy-Out
At the death of an owner, the life insurance proceeds pay out to the LLC on an income tax-free basis, assuming the 101(j) notice and consent rules were followed. As the flowchart illustrates, the proceeds are distributed by the LLC to the surviving owners, income tax-free.
The surviving owners then use the proceeds to purchase the deceased owner’s share.
The LLC may decide to terminate the arrangement at some point. In this case, the policies are distributed to the insureds on an income tax-free basis as a return of cost basis. Moreover, this transaction would not be characterized as a transfer for value.
So, the next time you have business owners who are concerned about navigating the all too common challenges of structuring a buy-sell arrangement, offer up the powerfully simple, yet little known strategy of the LLC buy-sell.
Click below to access additional resources on LLC Buy-Sell Arrangements.