Many companies engaged in succession planning will find themselves using life insurance as a funding mechanism for buy-sell agreements. There are advantages and disadvantages to this approach, but with the assistance of experienced and knowledgeable legal and insurance experts, co-owners can create a customized buyout agreement to protect their interests and secure their company’s future. What type of insurance-funded, buy-sell agreement might be best for your company.
Do you co-own a small business, family business or closely held company with less than five owners? Consider a cross purchase buy-sell agreement.
The most popular form of buy-sell agreement for smaller companies and closely held family businesses, a cross purchase agreement requires each owner to be the beneficiary, payor and owner of an individual life insurance policy on each one of their fellow co-owners. The value of the policy purchased for each co-owner must be equal to their share of the business.
For example, a cross purchase agreement for a corporation or closely held business with three owners would require six total life insurance policies, as each co-owner must purchase a policy for their other two partners. When properly structured by business transition experts, cross-purchase agreements can be calibrated to smooth out potential differences in premiums, which can be very helpful for a closely held company or family business with a difference in ages between co-owners. It can also provide positive tax consideration, and will state clearly how any deceased owner’s heirs will sell their interest to remaining shareholders using the insurance proceeds.
While a cross-purchase agreement can be used for larger shareholder groups, the agreement’s structure can quickly become very complex.
What are the tax considerations of a cross-purchase buy-sell agreement?
Surviving shareholders typically receive proceeds from the policy tax-free. The cross purchase policies owned by other shareholders on the decedent’s life are not considered part of the decedent’s estate. It is possible the agreement may be acceptable to the IRS as defining the fair market value of the decedent’s business interest for inheritance tax purposes. If so, the estate or its beneficiaries will not recognize income tax on the purchase of the owner’s interest, as the basis of the interest will be equal to the sale price. A benefit of this type of agreement is that the family of the deceased owner’s tax basis will be equal to the fair market value at time date of death, making for favorable tax treatment on the death proceeds. The following are some tax considerations carried with cross-purchase agreements:
- Premiums used in funding a buy-sell agreement are not tax deductible.
- Death proceeds are received free of income tax regardless of who is the owner of the policy unless the proceeds are payable to certain C-corporations, which may generate an “alternative minimum tax.” Additionally, the proceeds may not be free of income tax if there is an exchange for “valuable consideration.”
- The payment of premiums made by a business in which the shareholder or owner is the insured are not considered taxable income.
- Example: if ABC Corporation pays $25,000 a year in premiums on a policy owned by ABC, where John is the insured and the corporation is the beneficiary, the premiums of $25,000 are not considered taxed income to John.
- In a cross purchase agreement, the cash value of the policies owned by the decedent on the other shareholder’s lives is considered in the decedent’s estate. However, the policies owned by the other shareholders on the decedent’s life are not considered in the decedent’s estate.
- No gift tax is generated upon the execution of the agreement.
- In a cross-purchase agreement, one must take note of the transfer for value rule.
- Exchange for fair market value
Do you co-own a larger company, with more than five shareholders? Consider a stock redemption buy-sell agreement.
This is a buyout agreement where each shareholder enters into a contract agreeing to sell their shares back to the corporation upon death/disability. The redemption agreement specifies the terms, price and circumstances of the stock repurchase. These stock redemption agreements usually offer a “right of first refusal,” allowing the corporation to sell the shares to a third party. When funded by life insurance, the corporation owns the insurance policy and pays the premiums. Costs are carried proportionately to shareholder, preventing a younger shareholder or shareholder owning fewer shares from paying larger premiums for older shareholders or those owning more shares.
What are the tax considerations of a stock redemption buy-sell agreement?
There are no income tax implications for the corporation when it receives the insurance proceeds of the deceased shareholder. However, the corporation will need to heed the effects of the transaction on the company’s earning and profits sheet. The earnings and profits should increase with the life insurance proceeds received, and decrease as a result of the stock redemption. The corporation must adhere to the net effect on earnings and profits and should consider how that might affect the dividend policy of shareholders.
Upon the death or disability of one of the shareholders, remaining shareholders will not receive any increase in their tax bases. This one of the disadvantages of stock redemption agreements. Stock redemption payments treated as non-liquidating corporate distributions may result in a taxable dividend for the recipient if the transaction does not qualify as a stock sale under one of the Sec. 302 or 303 exceptions. The following are some tax considerations carried with stock redemption agreements:
- If the corporation pays more than the stock’s fair market value, the selling shareholder may have received a gift from living shareholders or compensation from the corporation.
- Conversely, if the corporation pays less than the stock’s fair market value, the remaining shareholders may have received either a gift or compensation (Rev. Rul. 58-614).
- To qualify for sale or exchange treatment, the stock redemption must meet the applicable requirements. For example, if the redemption agreement calls for a sale of less than 100% of the shareholder’s interest, the complete termination or substantially disproportionate requirements of Sec. 302(b) may not be met, causing the distribution to the shareholder to be taxed as a dividend.
- If the corporation is the beneficiary of a life insurance policy funding the stock redemption, the insurance proceeds could trigger the corporate alternative minimum tax because the insurance proceeds would be included in the accumulated current earnings.
If you or your company are considering cross purchase or stock redemption buy sell agreements as part of your long-term succession planning, it’s time to sit down with a personal adviser from our skilled Business Transition team.