Life insurance planning for the business owner

by Thompson Coburn LLP
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Thompson Coburn LLP

Life insurance is an effective tool that business owners can use to provide liquidity at their passing for both their businesses and their families. Having a properly drafted buy-sell agreement is key to avoiding conflict and memorializing how life insurance proceeds are to be used at the death of a business owner. 

When life insurance is used to provide liquidity for the purchase of a deceased owner’s interest, such purchase can be structured as a redemption, a cross purchase by the surviving owners, or hybrid of the two. In addition, an insurance limited liability company can also be used to maximize creditor protection and other tax benefits. 

Redemption. In a redemption, the company owns the life insurance policies insuring the lives of its owners. At an owner’s death, the proceeds are paid to the company, and the company uses the proceeds to buy the interests of the deceased owner from his or her personal representative. Once the company buys the shares, the shares are no longer outstanding and the interests of the remaining owners in the company are increased proportionately. A redemption is simple and provides centralized management to administer the policies and collect the death benefits. Since the policies are owned by the company, the policies are not subject to reach by the owner’s creditors, or includible in his or her estate. In addition, if an owner leaves the business, policies on the remaining owners would not be disrupted the way they would in a cross purchase (discussed further below). 

While a redemption can be a simple process, consider some issues: A redemption will not increase the basis in the interests of the surviving owners, even though their proportionate interest in the company increases; however, if the buy-sell agreement is properly structured, a basis step up can be achieved if the entity is a partnership or a cash basis S corporation. Without a basis step up, any future stock sales by the surviving shareholders could result in higher capital gains taxes than what otherwise would have been incurred if the deceased shareholder’s shares had been bought by cross purchase. In addition, where the entity is a C corporation, the life insurance proceeds could trigger the alternative minimum tax. Also note that life insurance policies owned by a company are subject to reach by its creditors.

Be sure to obtain proper consents on or before the issuance on any policy owned by a company that is insuring the life of a 5 percent or greater owner or a highly compensated employee. As discussed in a previous post, “How to avoid tax traps in life insurance,” failing to obtain these consents could cause insurance proceeds to be subject to income tax — even those proceeds that are otherwise to be received income tax free. In these instances, additional reporting is required.

Cross Purchase. In a cross purchase, the surviving business owners (not the company) purchase the deceased owner’s interest in the company. The business owners (or an insurance LLC, as discussed below) own the policies insuring each other’s lives. When a business owner dies, the proceeds are paid to those surviving owners who hold one or more policies on the deceased owner, and these surviving owners buy the shares from the deceased owner’s personal representative. Any shares the surviving owners buy from the deceased owner will have a basis equal to what they paid for the shares. Thus, if these shares are later sold at an amount greater than their basis, the surviving owners will recognize lower capital gains tax than the other shares they hold. Note that basis in S corporation stock or a partnership interest fluctuates from year to year, based on the company’s operations and distributions. A cross purchase agreement may also avoid lender or creditor restrictions imposed on a company’s cash flow, as sales of ownership interests occur between owners without company involvement. 

Consider some more issues before deciding on a cross purchase: With multiple owners, a cross purchase lacks a redemption arrangement’s centralized ownership and management of the policies and its proceeds. Rather, the owners individually hold policies, making the administration of these policies much more burdensome for the owners and company. 

For example, policies individually held by an owner could be includible in that owner’s estate should he or she pass away before the named insured on the policy. The policies may also be subject to reach by the owner’s creditors. Additionally, if an owner leaves the business, it may trigger bad tax results to transfer ownership of any of insurance policies the departing owner holds on the lives of the other owners.

Hybrid. A hybrid approach is often used where the owners want the flexibility for either the company or the surviving owners to buy a deceased owner’s shares, while requiring those who receive insurance proceeds at the death of an owner to be obligated to purchase the deceased owner’s shares. For example, if a company receives insurance proceeds at the death of a business owner, the company would first be required to purchase those shares whose value is equal to the insurance proceeds received, and any remaining shares could be purchased by the surviving owners or by the company. The benefits and burdens described above for cross purchases and redemptions would apply under a hybrid approach.

Insurance LLC. When multiple owners in a business seek the benefits of a cross purchase agreement but at the same time want to avoid the risks associated with a cross purchase, they could consider forming a separate manager managed limited liability company (“insurance LLC”). This insurance LLC would hold and administer the insurance policies insuring the lives of the business owners. Since all the policies will be held by the insurance LLC and not the individual owners, the insurance LLC provides centralized management and creditor protection for the policies and avoids estate tax inclusion for its owners. It also avoids bad tax results when an owner leaves the business and policy ownership needs to be adjusted. While incorporating an insurance LLC into a buy-sell agreement can add cost and complication, an insurance LLC’s benefits can often outweigh these costs.

When forming an insurance LLC, its ownership should mirror the company’s, and an independent person should serve as the manager. The members of the LLC make annual capital contributions to pay premiums. At a business owner’s death, the LLC’s manager distributes the proceeds to those business owners who are required to purchase the deceased owner’s interests under the buy-sell agreement when all of the purchase arrangements have been finalized.

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Your tax advisor can help you navigate the process of how to best structure your buy-sell agreement and the related ownership of life insurance policies insuring your employees and/or owners. Having properly drafted consents and buy-sell agreements (and possibly an insurance LLC) is critical in order to maximize the benefits of utilizing life insurance proceeds to purchase a deceased business owner’s interests.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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