In many estate-planning situations, the primary estate asset will be the business entity. The disposition of the business should always be planned in advance. Many partnerships feature an insured buy/sell agreement. The structure of the insured buy/sell and the applicable tax aspects have a direct impact on the estate. The agreement can be designed to provide tax advantages to the deceased estate owner, surviving owner or, in certain situations, both. The arrangement will often depend on the estate tax situation applicable to the business owners, particularly in a family buy/sell.
Suppose Kevin and Karl are brothers who formed a partnership 25 years ago. They would like to review how the partnership’s current profit situation will impact the partnership balance sheet. They would also like to review the cost basis for the each brother’s interest in the partnership.
Beginning-of-Year Balance Sheet
Look at our balance sheet. (See “First Balance Sheet,” this page.)
We’ll assume that the partnership assets are valued at $9.8 million. Keep in mind that the assets will actually be worth more or less than $9.8 million. The balance sheet generally carries the partnership’s inside basis of the asset at the price paid to acquire the asset, less subsequent depreciation taken on the asset. For example, a partnership may have paid $1 million when it purchased a building. Over the years, the partnership may have taken depreciation deductions of $300,000. Therefore, on the balance sheet, that building would be carried at a value of $700,000.
The value of the assets is listed at their “book value” for accounting purposes, not their fair market value (FMV). If the brothers were going to sell the partnership, they would want to adjust the asset value to the FMV. This would provide a more accurate number for sale purposes.
Let’s assume the partnership has liabilities of $7 million. The book value of the partnership on the balance sheet would be $2.8 million. And, that’s also the net value of the partners’ capital accounts.
The capital accounts start with the partners’ initial capital contributions. Assume they put $200,000 in to start the partnership 25 years ago. So, $200,000 would be the initial amount of the capital accounts ($100,000 each). Then, we have the “previously taxed income.” This represents the after-tax income the partners have earned and paid income tax on. It’s money they put back into the partnership. So, the total capital accounts would be the original capital contribution of $200,000, plus $2.6 million for the previously taxed income. That’s a total of $2.8 million. It’s $2.8 million of after-tax money the partners should have contributed to the partnership. Because the partners have already paid income tax on this money, up to $2.8 million of cash may, generally, be withdrawn with no income tax consequences.
Partnership Income Statement
Let’s move on to the partnership income statement. Assume the partnership has gross income of $6 million. The partnership could then deduct its operating expenses of $5.4 million.
At the end of the year, the partnership would have net taxable income of $600,000. Bear in mind that a partnership is a pass-through tax entity. The partnership itself files an informational tax return, but it doesn’t pay any income tax. At the end of the year, the partnership provides each partner with a K-1 for his pro rata share of the partnership profits. The profits pass through the partnership and are taxed to the individual partners. Generally, each partner reports the income in direct proportion to his ownership interest.
In this case, Kevin and Karl will each report $300,000 of partnership income on their individual tax return. Of course, the brothers may also have other income, and they’re certainly going to need some cash to pay their individual income tax. Assume they collectively withdraw $400,000 from the partnership. That would leave the other $200,000 of previously taxed income in the partnership. That’s $200,000 of after-tax income that would be added to the partners’ capital accounts ($100,000 each). (See “Profits and Losses,” this page.)
Before leaving the partnership profit and loss statement, we should note that the partners themselves can’t be classified as employees of the business. This restriction isn’t a major income tax factor because the partnership is a pass-through tax entity; there’s only one income tax to be paid; and it’s paid by the partners. So, whether the reportable income to the partners comes from employment compensation or their pro rata share of the partnership profits, they’ll pay income tax on the $600,000.
End-of-Year Balance Sheet
Take a look at our end-of-year balance sheet (see “End-of-Year Balance Sheet,” this page). Assuming no other changes, the $200,000 of previously taxed income that was left in the partnership would increase the assets from $9.8 million to $10 million. The liabilities would remain at $7 million. The partnership would now have a book value of $3 million, and the brothers would have a total of $3 million in their capital accounts ($1.5 million each). This doesn’t mean the partnership’s FMV is $3 million. The FMV of the partnership would consider many other factors, such as the FMV of the assets and a factor for goodwill, which would consider the current and future earnings of the partnership.
The partner’s personal outside basis equals the initial investment plus all income, less expenses and distributions to the partners. Thus, income increases basis; expenses and distributions reduce basis. Go back and look at the profit and loss statement.
The partnership had income of $6 million, but it paid out $5.4 million of expenses. The net partnership income would be $600,000. So at this point, the brothers would have a total cost basis increase of $600,000 ($300,000 each). They collectively withdraw $400,000. That distribution from the partnership to the partners causes total cost basis to go down by $400,000 ($200,000 each). Assume the partners are going to leave the remaining $200,000 of previously taxed income in the partnership. At the end of the year, the partners’ capital accounts and cost bases would each increase by $200,000.
As we mentioned earlier, the partnership is a pass-through tax entity. What does this mean in terms of cost basis to the partners? At this point, the partnership has a total cost basis of $3 million, which in this situation, is the value of their combined capital accounts ($1.5 million each). The capital accounts represent the original capital contributed to the partnership and the previously taxed income that the partners left in the partnership. This means that at any time during the year, the brothers, generally, could collectively withdraw up to $3 million of cash from the partnership. The cash distribution wouldn’t be taxable because the partners have already paid the income tax on this money. If the brothers sold the partnership for, say, $5 million, under normal circumstances, they would each pay capital gains tax on their pro rata share of the $2 million gain. Note, however, that in some cases, there may be “hot assets” that result in ordinary income (for example, accounts receivable or depreciation recapture).
Before we get into buy/sell arrangements, let’s talk about any life insurance owned and payable to the partnership. Assume the partnership had a $500,000 life insurance policy on each partner. If the insured dies, the partnership would receive $500,000.
How does this $500,000 impact the financial statements and cost bases of the individual partners?
The premium paid for life insurance on this partner isn’t a tax deductible expense, however, it does reduce this partner’s outside cost basis.
It’s helpful to think of life insurance as providing tax-free income to the partnership. Think back to the partnership profit and loss statement. How did partnership income impact the cost basis of the partners? Remember, in our profit and loss statement, we covered a situation in which the partnership had $600,000 of taxable income. That income caused their cost bases to go up by $600,000 ($300,000 each).
In the case of life insurance, the $500,000 of income is, generally, not taxable. But, all income increases the partners’ personal outside cost bases. So, the life insurance produces the same results as previously taxed income. Both the tax-free life insurance death proceeds and previously taxed income would increase the value of the partnership assets and the partners’ cost bases. So, $500,000 of tax-free life insurance would result in a $500,000 increase in the partners’ capital accounts, which in turn, increases the partners’ personal outside cost basis by $500,000 ($250,000 each in both cases). This increase only happens in a pass-through tax entity. (See “Effect of Life Insurance on Profits and Losses,” this page.)
That pretty much covers the partnership tax situation.
Assume Kevin and his brother Karl are equal owners of a partnership with an FMV of $4 million. They’re considering a buy/sell agreement that will be funded with life insurance. They want to minimize the income tax to the surviving partner on a potential subsequent sale of the partnership.
In this case, the brothers would consider a cross-purchase buy/sell. Kevin would purchase a $2 million policy on Karl, and Karl would purchase a $2 million policy on Kevin. Each brother would use his personal after-tax income from the partnership to pay premiums for the life insurance he owns on his brother.
Let’s assume Karl dies. Kevin collects the $2 million of life insurance proceeds and uses the money to buy the partnership interest from Karl’s estate. The transaction is between Kevin and Karl’s estate. Although the partnership isn’t involved, the Internal Revenue Service considers it to be liquidated, which could cause a tax on the surviving owner. It’s generally recommended that before a buyout takes place, a new partner acquires an interest (for example, a spouse and/or children).
The tax situation is relatively simple. Let’s look at the surviving partner, Kevin, first. He collected $2 million from the insurance company and will use the money to buy the 50 percent interest from his brother’s estate. As a result, Kevin’s personal outside cost basis goes up by the $2 million he paid to buy his brother’s 50 percent interest.
Now, let’s look at the cost basis for Karl. When Karl dies, the basis of his partnership interest will step-up to the FMV at his date of death. Because the buy/sell was for $2 million, that would, generally, be the FMV of Karl’s 50 percent interest. So, the estate would now have a $2 million outside cost basis. Also, because the estate received $2 million under the buy/sell agreement, there would be no capital gain to recognize. (See “Tax Considerations,” this page.)
The insured cross-purchase arrangement is fairly simple and straightforward.
Entity Purchase Buy/Sell
We’ll now cover something different: the insured partnership entity purchase buy/sell. As we go through this scenario, keep in mind our previous review of how life insurance is treated in a pass-through tax entity.
Let’s assume Kevin will have three partners. The four individuals are equal partners of a $4 million partnership. In a situation like this, the previously illustrated cross-purchase buy/sell would require each partner to purchase a $333,333 policy on each of the other three. So, you need 12 policies to fund the entire agreement. Plus, when one partner dies, the policies owned by the deceased partner have to be transferred to the surviving ones. These complicated arrangements are what make the cross-purchase arrangement so cumbersome when there are more than two or three owners.
The partners want a simple arrangement, so they’ll consider an insured entity purchase buy/sell agreement. They want to know the tax aspects of this type of buy/sell.
Under the entity purchase buy/sell, the business entity will purchase a $1 million life insurance policy on each partner (total of $4 million). A total of four policies are required. The partnership will be the owner and beneficiary of each policy and will pay the premiums. The premiums aren’t tax deductible to the partnership. In most circumstance, each partner’s capital account or share of income will be charged for 25 percent of the total premium (unless otherwise provided for in the partnership agreement).
Think back to our previous end-of-year balance sheet. You’ll recall that the partnership book value was $3 million. The book value consists of the original $200,000 contribution and $2.8 million of previously taxed income that was left in the partnership. Because we now have four partners, each partner will have a personal cost basis of $750,000. That’s 25 percent of the
$3 million of capital accounts.
Assume one partner dies and his $1 million of life insurance is paid into the partnership. Remember, the life insurance proceeds provide tax-free income to the partnership. Assume the pure life insurance amount is equal to $1 million. So, now we have $1 million of tax-free income paid to the partnership. The income increases cost basis to the partners. We have $1 million and four equal partners. In this situation, each partner receives a personal outside cost basis increase of $250,000.
Many planners want a cross-purchase buy/sell because the surviving partner gets a personal step-up in outside cost basis for the amount he paid under the buy/sell. But as you can see, in our insured entity purchase plan, the three surviving partners now have a combined outside cost basis increase of $750,000 ($250,000 each). Why $750,000? Because 75 percent of the $1 million of tax-free life insurance income is attributable to the three surviving partners. And remember, it’s the life insurance proceeds that create the tax-free income, which in turn, creates the cost basis. This distinction is important because many advisors don’t realize that the surviving partner gets a pro-rata step up in the inside cost basis of this asset for the life insurance under the entity purchase arrangement. This is true in all cases, unless the partnership makes a special complex election.
What about the $250,000 cost basis increase that was allocated to the deceased partner? He owned a 25 percent interest, so his basis was also increased by $250,000. That basis increase is essentially wasted because the deceased partner will automatically receive a 100 percent cost basis increase when his business interest is redeemed for $1 million. (See “Step-Up in Cost Basis,” this page.)
Under the partnership arrangement, there’s no need to transfer any policy after the first partner dies. The partnership will still have $1 million of life insurance on each of the three surviving partners. Because the $1 million of life insurance proceeds provide the funds to purchase the deceased brother’s interest, the partnership will still have a $4 million value and $3 million of life insurance on the three remaining partners. The partnership will then purchase a $333,333 policy on each of the three surviving partners to fully insure the buy/sell.
Under the entity purchase arrangement, the partners receive a personal step up in outside basis of $250,000 each. Under the cross-purchase, each partner would purchase a $333,333 policy on the other three partners. Therefore, they each receive a personal step-up in cost basis of $333,333. (See “Step-Up in Cost Basis,” this page.)
100 Percent Cost Basis Step-Up
It’s possible to structure the partnership agreement to provide for a special allocation of 100 percent of the pure life insurance proceeds to the surviving partners and none to the deceased partner. The special allocation must be justified by providing a substantial economic effect to the partnership. If the partners all agree, the partnership agreement could be structured to provide that the entire $1 million of life insurance on the deceased partner is allocated to the three surviving partners.
This structure will eliminate the allocation of $250,000 of the life insurance proceeds to the cost basis of the deceased partner. Remember, his $250,000 of cost basis is essentially wasted because the estate of the deceased partner will receive an automatic step-up in cost basis anyway when the the estate sells his 25 percent interest.
Let’s take that $250,000 and allocate it to the surviving partners. Instead of the three surviving partners splitting $750,000 of cost basis increase, they’ll be allocated 100 percent of the $1 million of life insurance proceeds and have a cost basis increase of $333,333 each.
The question is: Will the IRS recognize the special allocation of the life insurance proceeds? This recognition would benefit the surviving partners because if a partner subsequently sells his partnership interest, the higher cost basis would mean a smaller gain on the sale and a smaller capital gain tax.
There must be a substantial economic effect to justify this special allocation, otherwise the IRS won’t allow it. What can be done to provide economic substance to this partnership arrangement?
One way would be to put a special provision in the buy/sell agreement. This provision would provide that an insured partner wouldn’t be charged for any portion of the life insurance premium paid by the partnership for the policy on his own life. Let’s use Kevin as our example. Instead of his share of the partnership income being charged 25 percent of the total premium on the four policies, he wouldn’t be charged for any portion of the premium for the policy on his life. However, he would be charged for 33.3 percent of the premium on the $1 million life insurance policy on each of the other three partners. These adjustments must be made to their individual capital accounts and outside cost bases.
In other words, the premiums would be allocated as though this was a cross-purchase plan instead of an entity purchase plan. This should work because the premium allocation provides potential economic affect to each partner. They would have paid for 33.3 percent of the premium on the policy of the deceased partner; therefore, they’re entitled to
33.3 percent of the cost basis attributable to that policy.
Let’s take a look at “Structuring the Partnership” (this page). It’s relatively simple. The partnership purchases $1 million of life insurance on each partner. When the first partner dies, the partnership uses the $1 million of life insurance to redeem the deceased partner’s 25 percent interest for $1 million.
The surviving partners would then each own 100 percent of the partnership and have a cost basis of their original $750,000, plus $333,333 cost basis for their interest on the life insurance of the deceased partner.
This arrangement produces the same results that would be obtained under a cross-purchase plan. The advantage is that only four life insurance policies are required, and there’s no need to transfer the policy owned by a deceased partner’s estate after that partner dies.
Of course, this technique requires the assistance of a tax attorney in properly drafting the partnership agreement to comply with IRS regulations.
Taxability of Death Proceeds
The death proceeds of business life insurance are, generally, exempt from income tax under IRC Section 101, so long as: 1) the insured is notified of the coverage and provides his written consent, and 2) the insured completes IRS Form 8925 and submits it to the IRS.
The buy/sell agreement may, generally, be structured to fix the value for estate tax purposes.1 However, in the family’s (siblings’) buy/sell, the IRS may disregard the purchase price if it doesn’t reflect FMV.
1. Internal Revenue Code Section 2703.