Here's a strategy that improves upon traditional agreements
Traditional buy-sell agreements can't always solve all problems dealing with death, retirement, withdrawal and disability without creating difficulties with income tax, estate tax, step-up in basis, alternate minimum tax (AMT) and transfer for value — to name a few.
So here's a strategy suggestion: With an eye to the final regulations for split dollar, best practices from corporate owned life insurance (COLI) and technical advice memorandums (TAMs) issued in 1996, 2000 and 2005, endorse a life insurance death benefit to other shareholders or a trusteed cross-purchase arrangement so that each shareholder is allowed to own his insurance policy, properly fund a buy-sell agreement with life insurance, and use corporate dollars to pay the majority of the costs.
This approach gives policy cash-value control to the insured while funding a basic agreement like a cross-purchase plan. The technique addresses death, retirement, withdrawal and disability with the least amount of taxes and the client retains control.
And here's how it works.
Beauty and Limits of Buy-Sells
Buy-sell agreements are simple tools that over the years have grown to meet increasing needs of closely held businesses. They address a myriad of problems, including:
- death buyout;
- disability funding;
- withdrawal from employment, for competitive or noncompetitive purposes;
- retirement planning;
- tax issues (income, transfer, estate and gift);
- protection from creditors (corporate and individual);
- fixing the value of the business interest of the owner; and
- settling shareholder differences.
These goals are disparate and many available tools fail to address them all successfully.
Generally speaking, a buy-sell agreement contains a restriction on the right to transfer a business interest during the life and at the death of the business owners, as well as an option (or other right) to acquire property at a specified price. The agreement typically sets the value of a closely held business for transfer-tax purposes in the form of a fixed amount or a formula. Such a value may reflect the fair market value of the property at the time of the agreement (rather than a later date such as the date of the owner's death). Life insurance policies often fund buy-sell agreements.
The two basic types of buy-sell agreements are a redemption agreement and a cross-purchase agreement. A redemption agreement is a contract between the business owners and the business entity (for example, a corporation, a joint venture, a limited liability company (LLC) or a partnership) to redeem the owners' interests during their lives and/or upon their deaths.1
When a redemption agreement is funded with life insurance, the business owns the policies and pays the premiums. The premiums are not deductible by the business for income tax purposes, and the life insurance proceeds received upon the death of a shareholder are not included in the income of the business.
A cross-purchase agreement is a contract between the owners of the business to buy the interests held by the other owner(s) during their lives and/or upon their death. When such agreements are funded by life insurance, the policies are purchased by the individual parties to the agreement rather than by the business. Sometimes the business pays for the insurance policies through additional compensation or bonus payments passed through to the owners.
The decision whether to use a redemption or a cross-purchase buy-sell agreement (or a combination thereof) may be founded upon a number of non-tax and tax considerations. For example, when a business has two owners, one non-tax consideration is the cost of carrying the life insurance policy. That is to say, funding of a first-to-die policy may be made at a considerably lower premium than individual policies. Other non-tax considerations include whether a corporation may repurchase the stock under the state law; if an owner/officer/director is violating a fiduciary duty to owners and to creditors by repurchasing the ownership when the business may not be in a financial condition to do so; and whether percentage ownership and control of unequal owners changes significantly by the redemption.
Since the enactment of the Tax Reform Act of 1986, there also may be significant tax considerations involved in selecting either a redemption or cross-purchase agreement. A redemption agreement may create an AMT for C corporations. (S corporations are not subject to the tax.)
Also with redemption agreements, premiums paid for life insurance to fund the buy-sell agreement are not deductible to a corporation. Although the proceeds are not subject to corporation income tax, the insurance proceeds may trigger AMT issues.
On the other hand, a cross-purchase agreement requires the shareholders to use after-tax dollars to acquire the life insurance policies for purposes of funding the buy-sell agreement. But the insurance proceeds may not be subject to income tax at the corporation or individual level. This is not a concern for partnerships.2
Compliance tools can be used to overcome these planning issues. The strategy I suggest can be helpful in deals with two or more shareholders; there should be no upper limit on the number of shareholders that can be accommodated. The issues surrounding shareholder A's death, disability, retirement, or early termination would be arranged in place for shareholders B and C.
For example: Let's say three shareholders of a company each control 33 1/3 percent ($1 million) of a $3 million business. Each purchases and is the owner of a $1 million policy (with a return of premium rider) on his own life. These policies are bought under an arrangement in which the corporation pays the actuarially determined cost of the current death benefit annually and the shareholder pays the remaining amount subject to a co-ownership agreement with the corporation-employer. The named beneficiaries are non-insured shareholders B and C or a trusteed cross-purchase agreement.
Because a portion of the death proceeds may be used to discharge the repayment obligation to the company for the premiums it has paid, the face amount should be increased appropriately. This increased coverage insures that B and C each receive a total of $1 million. This benefit to the employee-shareholder will relieve the company of the redemption of the shareholder's interest.
Because the tax on the shareholders is limited to an economic benefit, this arrangement is the most economically efficient available for a death buy-out.
This strategy requires A to assign the death benefit of his life insurance to B and C or to the trusteed cross-purchase agreement and to provide funding for the buyout on A's death. The Internal Revenue Code provides that all assets owned or controlled by A will be included in A's estate.3
Therefore, A's share of the value of the company ($1 million) will be included in A's estate, plus, because A owns the life insurance policy on his own life, the $1 million death benefit also will be included in the estate. This dual inclusion issue is resolved by endorsing the death benefits to B and C per capita,4 or to a trusteed cross-purchase agreement. A deduction is allowed from the value of a decedent's gross estate for such amounts as will be satisfied against the estate.5
This endorsement creates this liability. The amount that may be deducted as claims against the estate is limited to enforceable obligations of the decedent existing at the time of death. By A, B and C agreeing to the transaction in writing, it's claims are enforceable. As an enforceable claim against A's estate, there is an avoidance of double inclusion of the $1 million in A's estate.6
The company will be advancing the actuarially determined cost of the current death benefit annually. The shareholders (A, B and C) will carry the costs of the benefit equally. This will be the economic benefit and not the premium cost of the death benefit. The non-insured shareholders or a trusteed cross-purchase agreement will be the beneficiaries of the policy, so long as they are employees of the employer, so the economic benefit will flow to the beneficiaries not the insured.7
Using the Law
My suggested strategy looks to split-dollar insurance compliance, IRC Sections 79 and 409A principles and their related Treasury regulations, other IRS interpretations (including revenue rulings, field service advice, private letter rulings, and TAMs), COLI best practice compliance safe harbors, and court cases to justify the arrangement.
As for split dollar, the Internal Revenue Service in 19648 announced that income tax to an employee is the cost of the death benefit protection equal to the one-year term amount. Revenue Ruling 64-328 and advanced Rev. Rul. 55-713 used the government P.S. 58 tables as measurement of the economic benefit. Rev. Ruls. 78-420 and 66-110 expanded this position, further supporting the results that split-dollar arrangements were taxable to the employee only to the extent of the value of the death benefit's economic benefit. There was no other major modification until TAM 9600401 in 1996. The final split-dollar regulations permit a specific safe harbor for this approach in both the preamble and under Section 61-22(d).
Life insurance is a traditional tool in estate and tax planning. The regulations apply the concept of IRC Section 83 to restrict life insurance. It states that “in the case of a transfer of life insurance contract … providing life insurance protection, only the cash surrender value of the contract is considered to be property.”9
This provision likewise applies in the employer-employee split-dollar life insurance model. The life insurance is “transferred”10 for IRC Section 83 purposes when a life insurance contract is purchased by the employee-shareholder, with the “property” being the cash surrender value of the contract. The regulations do not state that there is another property transfer when compensatory life insurance is involved, such as, for example, upon an incremental increase in the cash value of the policy.
In our example, Shareholder A will recognize the cost of current death benefit as the economic benefit under Table I if the arrangement is integrated with group term life coverage. In TAM 20002047,11 the use of a permanent policy was permitted integrated into a Section 79 plan as long as the employer is paying all of the premiums. The employees covered by the group life carve out are taxed on the economic benefit as provided under Section 79 and Table I.
This approach complies with both IRC Section 409A and COLI best practices.12 A shareholder pays full value for the property transferred, realizing no bargain element in the transaction. Therefore, IRC Sections 72(e) and 101 govern the income taxation of the life insurance in this case. These sections generally provide that the inside buildup of cash in a permanent life insurance contract is subject to tax when the contract is surrendered before death or the cash value is otherwise accessed (other than by a loan). If the policy is surrendered, cash value buildup is taxed as ordinary income in the amount of the cash received in excess of the recipient's investment in the contract. If the policy is not surrendered and cash value is not withdrawn prior to death, the cash value buildup is used either to pay ongoing insurance costs or paid to the beneficiary at death, free from income taxation.
From a conservative point of view, Treasury Regulations Section 61-22(d) applies and permits the safe harbor and exclusions under IRC Section 79. Regulations and recently released IRS opinions support the income and transfer tax consequences of the split-dollar arrangements being the economic value of the insurance protection provided in accordance with the Table I rates.
The IRS has provided us with a response to an actual fact pattern in this area. In Field Service Advice 1998-252, a taxpayer (who was an employee and shareholder of a closely held, family-owned corporation) formed a trust to hold a second-to-die life insurance policy. The trust owned the policy and had the right to exercise all incidents of ownership with respect to the policy. The trust entered into an agreement with the corporation in which the trustee agreed to pay that part of the premium equal to the economic value of the insurance coverage; the corporation agreed to the balance of each premium. In exchange for the corporation's payment of its premium contribution, the trust agreed to return the amount of premium advanced on the earlier of termination of the plan, or the death of the second to die of the insureds. The agreement to return only the premiums advanced — and not the greater of premiums or cash value — describes an “equity” split-dollar arrangement (an issue that was not addressed in the field service advice).
The company received no form of security in the transaction. The documents merely reflected the arrangement to cause it to qualify as described in Rev. Rul. 64-328. The taxpayer was audited and the revenue agent characterized the advances as “dividend income” under IRC Section 7872, under which interest is imputed as a loan from a corporation to a shareholder, and is taxable as a dividend. When the shareholder is considered to have repaid the amount as interest to the corporation, this payment is personal interest and not deductible by the taxpayer. The position gets worse, because Treas. Regs. Section 1.7872-4(d)(2)(ii) indicated such interest is dividend income where an employee is also a 5 percent owner of the corporation.
The IRS rejected the Section 7872 argument and viewed the transaction as a split-dollar arrangement under Rev. Rul. 64-328. In this case, however, there was neither an endorsement nor a collateral assignment to substantiate the split-dollar agreement. The Service looked at substance over form, however, citing Rev. Rul. 64-328 that “the same income tax results obtain if the transaction is cast in some form resulting in a similar benefit to the employee.”
My strategy includes tracking TAM 20002047, even if split-dollar rules apply, to ensure compliance. The cost of the life insurance coverage provided qualifies under a “group life carve-out program” and is an economic benefit includible in the employee's gross income under IRC Section 79.
The rules of IRC Section 79 also apply, to determine the taxes on the life insurance benefit provided to employees by the employer under a “group life carve-out program.” The IRS determined in TAM 20002047 that the employer can provide a basic group-term life insurance plan for its employees in which the employer pays all premiums and individual coverage for employees over a salary floor of $50,000. The IRS determined the amount of the premium attributable to the permanent policy for employees earning over $50,000 is not taxable to the employees. The employees covered by the group life carve out are taxed on the economic benefit as provided under IRC Section 79.
The last hurdle in this strategy is to assure it does not create a “permanent” benefit as defined under Treas. Regs. Section 1.79-O. The test under the regulation is satisfied three different ways:
- The economic benefit to the covered employees does not extend beyond one policy year. The employees are covered on a year-to-year basis only so long as they are employed by the employer. The employees cannot take the death benefit with them if they terminate their position.
- The only benefit provided to the employee is the current insurance protection. Covered employees only receive the rights to the death benefit so long as they are in the employment of the employer.
- The term life coverage is not provided on a level premium for a period of more than five years. The contribution for the current death benefit provided to the employees is determined annually by independent actuaries using stable funding. The cost of the death benefit will be subject to change annually.
Because this strategy using employer funding does not provide permanent benefits to employees, it does not have to meet the requirements of IRC Section 79-1(b). Accordingly, the insurance provided is “group-term life insurance” for purposes of IRC Section 79.
- Transfer tax issues — In return for paying for the premium, the company receives an income tax deduction for the cost of the current death benefit and will not have to redeem the employee shareholder stock interest. In the event A dies before retirement, or terminates his association with the company, the company would have funded the death benefit and the employee would have recognized the economic benefit of the coverage.13 The employee-shareholder will have assigned their interest in the death benefit to the remaining shareholders or a trusteed cross-purchase agreement.14
- Death of a shareholder — Structured as outlined, shareholder A owns the insurance policy and is the insured, thereby giving him control over the cash value of the policy. The remaining shareholders, B and C, are the recipients of the death benefit. Should A die before retiring, B and C each receive a per capita share (one-half) of the death benefit as the endorsed beneficiaries.15 At A's death, his shares of ownership in the company pass to his heirs and receive a step-up in basis.16 B and C will purchase those shares for the fair market value stipulated in the buy-sell agreement; therefore, B and C will have acquired A's share of the company, thereby increasing their overall cost basis17 in the company.
- Termination before retiring — If A terminates his association with the corporation before retiring, shareholders B and C would release the death benefit endorsement. The death benefit on A's life would be available to pay the death buyout or could be further consideration for a life time buyout. This payment could relieve the company from the redemption of stock from A or provide for benefits under the trusteed cross-purchase agreement, or could be used by B and C to fund their own retirement or benefit package.
- Retirement of a shareholder — The next consideration is the issue of A's retirement. Shareholders B and C, or the trusteed cross-purchase agreement, could retain the death benefit or exchange one benefit for A, dropping the right in B and C's policies. The cash value of the policy would be under the control and for the benefit of A under the terms of the deferred compensation arrangement and consistent with the covenant not to compete, A could access the cash value subject to the terms of the contracts. Release of the endorsement returns to shareholder A the right to transfer the ownership of the policy to an irrevocable trust, an insurance limited partnership, his spouse, other family members or appropriate charity as the beneficiary of the policy depending on the licensing requirement, A could have assigned his rights previously.18 As the owner of the policy, shareholder A would also have the opportunity to convert the residual cash value into a stream of supplemental retirement income.19
- Transfer-for-value issue — Adverse tax treatment can occur when a traditional cross-purchase agreement expires. This situation occurs when existing policies are transferred when owned by departing shareholders who do not meet one of the exceptions to transfer for value rules.20 Ordinarily, in a cross-purchase agreement, each shareholder owns a life insurance policy on the life of each of the shareholders. Upon the death of the first shareholder, each of the remaining shareholders will use the proceeds of the policy they own on the life of the deceased shareholder to carry out their obligation to purchase a pro rata share of the deceased shareholder's stock. After this, the remaining shareholders will need to acquire additional insurance to fully fund their continuing obligations under the agreement because each remaining shareholder will now own an increased portion of the business. If the remaining shareholders purchase the policies held by the estate of the deceased shareholder, the purchase will be a transfer for value.21
The redemption agreement approach does not have this problem, but on termination of the agreement during the life of the shareholder or upon withdrawal from the corporation the transfer of policies may also trigger transfer for value issues. (Sometimes the transfer-for-value rule can be avoided after the death of the first shareholder by allowing the deceased shareholder's estate to sell policies (on the other shareholders) to the company and then converting the agreement to an entity agreement.)
This strategy innovation resolves key issues in structuring buy-sell agreements for client corporations:
- The death benefit could be paid directly to shareholders B and C; therefore, it would not trigger an AMT issue for the corporation.
- Shareholders B and C would have cash available at A's death, termination, or retirement to purchase A's shares outright or to make a substantial initial payment toward the purchase of those shares.
- Direct purchase by B and C would increase the cost basis of their share of the corporation equal to the purchase price.
- Transfer-for-value problems would be eliminated.
It also achieves a number of goals:
- Death buyout — death benefits are available during employment to buyout a shareholder-employee's interest.
- Disability funding — the benefit (cash values) may be accessed by an owner, income tax-free.
- Withdrawal from employment — when the shareholder-employee owns the policy there would be no transfer of the policy upon the triggering event. The buy-sell agreement (restricted endorsements or collateral assignment) can limit access to the cash value. The ability to provide benefit tax efficiently may reduce the cost in providing the benefits.
- Retirement planning — the value of the strategy can offset the funding need for retirement.
- Tax issues — the use of these tools may reduce the income and transfer tax consequences and with proper assignment and ownership, the benefits may be available in a more efficient way.
- Protection from creditors — both corporate and individual. The benefits may not be subject to the claims of either corporate or individual creditors because of restrictions.
- Fixing the value of the business — the policies can assist increasing value for the buyout in line with the buy-sell agreement.
- Settle shareholder differences — it can create a funding vehicle to permit settlement of shareholder controversy with tax efficient dollars and create golden handcuffs or a golden parachute, when appropriate.
As with any strategy, there are some caveats:
- The volatility of the market may cause the value placed on the business and funded by life insurance to no longer be adequate to meet the clients needs. This means that the strategy requires continued diligence to assure that the funding level is adequate to meet clients' needs. Prudent advisors will suggest a review of the valuation and the client's goals.
- The creditworthiness of the insurance company is more important than ever. Qualified advisors should consider not only the type of insurance product used, but also the ratings of the company providing the coverage.
- Because the funding vehicle provides multiple benefits, the costs are greater than a pure group coverage that provides only death benefits. This may be offset to some extent by the deduction available for the cost of the current benefit.22
- This approach makes the most sense when we are looking at a commitment of 10 years or longer. When there are multi-generational planning opportunities, this approach becomes even more attractive.
- As with many planning opportunities, working with qualified advisors is paramount.
Buy-sell agreements often are used as planning tools that can assist and address death buyouts, disability, and withdrawal of principals. By using existing and recognized tools, employers also can provide for tax efficient retirement benefits with cost containment and/or corporate reimbursement.
Lawrence L. Bell is counsel for special projects for Lynchval Systems Worldwide in Washington and the principal of Advisors, LLC in Chevy Chase, Md.
- Such an agreement may be subject to limitations imposed by state law. For example, there may be a restriction on the ability of a corporation to purchase its own stock due to capital surplus requirements or insolvency.
- Lawrence L. Bell, “Valuation of Buy-Sell Agreements Under Chapter 14 of the Internal Revenue Code,” Journal of the American Society of CLU & ChFC, September 1992, at p. 48.
- Internal Revenue Code Section 2042.
- Private Letter Ruling 93-09-021 (March 5, 1993).
- IRC Section 2036.
- IRC Section 2053(a)(4); PLR 90-26-041 (June 29,1990); Revenue Ruling 76-113,1976-1 C.B.276.
- Rev. Rul. 64-328,1964-2 C.B. 11, Table I, IRC Section 79.
- Rev. Ruls. 64-326 and 66-110.
- Treasury Regulations Section 1.83-3(e).
- Treas. Regs. Sections 1.83-1 (a)(2) and 1.72-16(b)(3).
- Jan. 18, 2000; IRC Sections 61 and 79.
- Technical Advise Memorandum 9600401; Treas. Regs. Section 1.31.3121 and Notice 2005-1.
- IRC Section 83(b).
- IRC Section 1014(b)(9); Lawrence L. Bell and James M. Hoffman, “Proper Use and Abuse of Family Limited Partnerships,” J. Am. Soc. of CLU & ChFC (July 1998).
- IRC Section 1012; Lawrence L. Bell and Kevin R. Beck, “GREIT Plan Resolves Conflicting Issues of Buy-Sell Agreements,” Journal of Financial Planning, October 2001.
- Lawrence L. Bell, “Qualified Plan Beneficiary Designation: An Alternative Approach,” Trusts & Estates, August 2000, at p. 12.
- IRC Section 1012.
- Rev. Rul. 82-13.
- IRC Sections 101(a)(2) and 72(e).
- IRC Section 101(a)(2).
- IRC Section 101.
- Treas. Regs. Section 1.162-10 and IRC Section 419A 2.