Buy-Sell Agreements
1. Entity Agreement--Overview
Purpose: Business owners who wish to have the life insurance used for a Buy-Sell Agreement paid for and owned by the business.
Set up the Plan
1.) An entity purchase agreement is drawn up. The document spells out what would happen if the business owner die or disability, of an owner occurred. This happen could include personal bankruptcy, retirement, or voluntary or involuntary termination of the owner. The owners agree to sell their business interests in the company back to the company at the owner's death or disability.
2.) Life insurance policies are purchased on each owner in an amount that is equal to the value of their interest in the business. Some businesses will take into account the fact that the value may increase over time and purchase an amount greater than the actual value, with the balance being used as “key person “ coverage. The business will be the owner and beneficiary of the policies. The business will also pay all premiums. This will be a non-deductible expense of the business.
At Death
3.) At death the insurance company pays the tax-free life insurance benefit directly to the business.
4.) The business uses the death benefits to pay the estate of the deceased an amount equal to the value of the business interest of the deceased owner. Additional coverage may have been purchased as “key person“ coverage, which would provide the business with a cushion to offset the loss of the owner.
5.) While term insurance will provide a death benefit, the use of permanent life insurance can provide funds for other types of buy-outs when death does not occur prematurely. The cash value from the policy can be accessed in a tax efficient manner, providing more flexible plan funding.
Advantages
Cash value of policy is asset of the business,the business may have funds to help purchase a deceased owner's business interest.
Easy to administer.
Premium paid for by business–• equalizes the premium payments across owners.
Disadvantages
Policies and cash values subject to business creditors.
Surviving owners receive no increase in cost basis of percentage of business redeemed.
Business value may increase for estate tax purposes because death benefits flow to business.
Premiums paid for life insurance used to fund an entity or stock redemption buy-sell agreement are not tax-deductible to the business.
Policy death proceeds may be exempt from the federal income tax if the Notice and Consent requirements of IRC Sec. 101(j) have been met.
2.Cross Purchase-Overview
Set up the Plan
1.) A cross purchase agreement is drawn up. The document spells out what would happen if the business owner die or disability also include personal bankruptcy, retirement, or voluntary or involuntary termination of the owner. The surviving owners agree to purchase the business interests of the other owner in the event of a triggering event.
2.) Life insurance policies are purchased on each owner in an amount that is equal to the value of their interest in the business. Each owner must purchase a policy on each other owner, which is often a cumbersome process.
At Death
3.) Each business owner uses the income tax-free death proceeds to purchase a portion of the business from the estate of the deceased. The surviving owner will receive a full basis step up for that portion purchased from the deceased owner’s estate.
4.) The stock value receives a step up in basis at the decedent’s death. Provided the transaction takes place in a timely manner, the estate usually realizes no capital gain and no income tax is payable.
Advantages
Cash value and policy generally not subject to the creditors of the business.
Surviving owners receive full basis credit in stock purchased from estate.
Minimal taxes due on sale of stock for heirs
Disadvantages
Cash value and policy are not asset of corporation, therefore cannot be shown on books.
Policies are subject to individual’s creditors.
Premiums are paid from personal funds are not tax-deductible and may be disproportionate since younger owners must buy and pay premiums for older owners.
If the corporation pays the premiums on behalf of shareholder-employees, the corporation may be able to deduct the premiums as reasonable and necessary compensation, and the shareholder-employees would report that compensation as income.
Very cumbersome to purchase and administer the policies.