Owners of closely held businesses have long sought ways to buy the interest of an owner who dies. They also have sought ways to enjoy the business' success financially while avoiding estate tax upon their death. A new private letter ruling obtained for my client (at press time, it had yet to be assigned a number) approves a creative life insurance funding mechanism to fund the purchase and continues to facilitate the use of trusts to obtain these estate-planning goals. This is the first time that the Internal Revenue Service has rules on such a premium-splitting technique.

DIFFICULT CHOICES

Owners of closely held business typically use one or both of two basic approaches to buy a deceased owner's business interest. In a redemption, the business entity buys the deceased owner's business interest; in a cross-purchase, the remaining owners buy it.

Although often simpler than a cross-purchase, a redemption can pose business and tax problems. If a business has a temporary reversal, its creditors might get access to funds set aside for the cross-purchase. Even if the creditors do not actively seek the funds, state law might prevent the redemption if it makes the business technically insolvent.

From a tax perspective, insurance-funded redemptions also pose problems. The IRS might try to include, in the deceased owner's gross estate, value that is attributable not only to the actual purchase price, but also to a chunk of the life insurance proceeds. If the entity is a partnership or S corporation, the life insurance might not increase the remaining owners' tax basis as much as it should.

A cross-purchase avoids these problems but has its own issues. Multiple insurance policies might be required so that each owner has insurance on the other, a problem that multiplies dramatically as the number of owners increases. The surviving owners might have their own personal creditor or divorce issues. They also might wish to keep the insurance proceeds rather than spend them on the purchase, either because they prefer cash to an additional business interest or because they believe the purchase price is too high (with the former possibly being cloaked as the latter.)

Wouldn't it be nice to avoid using a lot of policies and keep the life insurance policies in a safer environment? One solution is to place the policies in a limited liability company (LLC) taxed as a partnership. The owners of the business entity also would be the members (owners) of the LLC. A trust company could serve as manager, taking charge of the policies and ensuring that the proceeds are used as intended. Each owner would have an interest in policies insuring the other partners' lives. Fortunately, on June 21, 2007, I obtained a private letter approving such a strategy.

THE PLR

In this case, an S corporation had three shareholders: Child A, Child B and BA. BA was an unrelated shareholder. Although the ruling does not disclose the percentage ownership, in fact, BA owned 5 percent of the stock, and Child A and Child B owned the rest in roughly equal amounts.

The grantor, parent of the two children, set up a trust for each (Trust 2A and Trust 2B). Each trust was a typical, flexible generation-skipping trust (GST). Each child was appointed trustee of his trust, and given the right to make distributions, under an ascertainable standard, to himself and to his descendants. Each child also had the right to appoint, upon his death, the assets of his trust to anyone other than himself, his creditors, his estate or his estate's creditors. The grantor had allocated the GST exemption to each of the trusts and these trusts were not subject to the rule against perpetuities. Thus, these trusts provided each child with the flexibility to use his assets during life and to pass them to practically anyone at death.

Under a buy-sell agreement, Child A would buy Child B's and BA's stock at their deaths. Child A owned policies on their lives to fund this purchase. Child A also had the right to assign his purchase rights and obligations to Trust 2A or other trusts controlled by him. Child A would then transfer these policies to the LLC. Child A and Trust 2A would contribute premiums to the LLC and receive the right to death benefits from policies on Child B's and BA's lives in proportion to the premiums that Child A and Trust 2A made. The goal was to maximize Trust 2A's proportion of contributions, because Trust 2A and any trusts created under it are excluded from the estate tax system. However, given the uncertainties of cash flow and the impracticality of frequently changing beneficiary designations, flexibility in sharing premiums was important, and the LLC's use of partnership accounting seemed to be the best way to accomplish that. Child A and Child B had virtually identical goals regarding the buy-sell arrangement.

The LLC had some other notable features. The manager was a corporate trustee, which helped ensure that no party to the buy-sell agreement would use the life insurance proceeds improperly. The manager was instructed to retain all life insurance proceeds until the parties agreed on its application toward the cross-purchase. Thus, the manager's roles were essentially the equivalent of a combination of trustee of an irrevocable life insurance trust before a shareholder's death and escrow agent for the buy-sell agreement after a shareholder's death.

The LLC's activity required special partnership accounting provisions. Each member had a separate capital account for each policy the member owned on a shareholder. Also, the members needed to contribute cash to pay the LLC's administrative expenses, requiring an additional set of capital accounts.

The IRS limited the members' ability to make decisions on the LLC's holding of policies. Not mentioned in the ruling is that the operating agreement originally allowed the members voting rights customarily given in a manager-managed LLC. It limited them only to the extent that no member could vote regarding insurance on that member's life. The IRS was concerned that the members could collude in a manner akin to the reciprocal trust doctrine, so the Service required that the operating agreement preclude members from voting on anything relating to any life insurance policy. Similarly, the IRS required that the operating agreement not expressly authorize amendments by the members, preferring that applicable state law defaults control the situation.

What the ruling didn't do was address the effect of the members assigning their interests in the LLC to others. Although the IRS was not troubled by the prospect of that occurring, it did consider situations that might arise by reason of such an assignment.

PLANNING THE LLC

There are other ways to apply this ruling. Using a corporate trustee as manager of the LLC to hold the policies provides security that the proceeds will be used as intended. As mentioned, one of the disadvantages of a cross-purchase is that a shareholder's creditors might be able to prevent application of the proceeds to the purchase of shares. The insurance being in an LLC makes an action against a member's interest the exclusive remedy rather than subjecting the life insurance itself to creditors. The manager's duty to the other members would prevent the proceeds from being distributed without the consent of the deceased shareholder's beneficiaries.

The operating agreement's original restrictions on members' voting rights generally should be sufficient to avoid estate inclusion. The additional restrictions should be placed in the operating agreement only if seeking a PLR or advising a client who is willing to sacrifice flexibility to be as close as possible to the letter ruling's facts.

The ruling we obtained is not geared towards a policy with cash values. However, through an endorsement split-dollar arrangement, one might carve out the term portion for the LLC and make other arrangements with the cash value. Although the term portion eventually becomes uneconomical, one could use a variety of estate-planning techniques with the cash value portion before that happens so that, ultimately, the insurance arrangement becomes sustainable.

ESTATE TAX PLANNING

The ruling also held that Trust 2A was a grantor trust, in which Child A was treated as owning Trust 2A's assets for income tax purposes under Internal Revenue Code Section 678; Child B was similarly treated as the owner of Trust 2B. This was critically important to allow Trust 2A and Trust 2B to own stock in the S corporation. Child A initially had a withdrawal right in Trust 2A that had since lapsed; the same tool was used for Child B and Trust 2B. Although such withdrawal rights are usually used to obtain the gift tax annual exclusion, in this case, the withdrawal rights' strategic value was to obtain grantor trust status, consistent with prior PLRs regarding IRC Section 678.

That was it as much as the ruling sought to cover. However, this structure has uses far beyond the issues addressed in the PLR.

First, Trusts 2A and 2B were originally funded with modest gifts that they invested in LLCs that used bank financing to buy real estate. These LLCs leased the real estate to the S corporation. The net cash flow from the rental operations would be used to pay the life insurance premiums through the insurance LLC. Thus, we “married” the income tax goal of holding real estate in partnerships to leveraging gifts to GSTs.

Second, Trusts 2A and 2B were ideal for the tactic of selling stock to an irrevocable grantor trust. For example, Child A could sell S stock to Trust 2A in exchange for a promissory note. No income tax would result during Child A's life, because Child A is treated for income tax purposes as owning Trust 2A. If the IRS determined that the stock's value was too high and that therefore Child A made a gift, Child A would pay no gift tax because the gift is an incomplete gift due to Child A's power to appoint the trust's assets at death. If Trust 2A were thinly funded, Child A and other trusts created by the grantor for Child A could guarantee the promissory note to provide additional economic reality to the sale.

If the sale of S stock to Trust 2A generates cash flow in excess of the note payments, the excess cash could be used to pay premiums through the insurance LLC. Note that Child A has access to the excess funds for his own support. The excess funds also could be used to help Child A's children when they are no longer legally dependent, without being limited by the annual gift tax exclusion or using Child 2A's applicable exclusion amount.

If Child A dies during the term of the note, Child B and BA would use the insurance to buy Trust 2A's stock, thus providing cash to retire the note to Child A.

Child B would use the same strategy.

TELL YOUR CLIENTS

The insurance LLC in the letter ruling provided security for the owners, facilitated flexibility in making premium payments and gave us all a model for reducing the number of policies that must be used in a cross-purchase. Convincing a business owners' parents to set up generation-skipping perpetual trusts to buy real estate used in the business can help the business owners continue to enjoy the business' financial success while moving the business outside of the estate tax system.