Cross Endorsement Buy-Sell Plan

Transcription

1 THE PROBLEM Many closely-held businesses do not make formal plans for transitioning the business. A comprehensive business succession plan should contemplate the premature death or disability of the owners as well as retirement or a lifetime transfer or sale of the business. Because closely-held business owners often do not plan for the transition of their business, many closely held businesses are not successfully transferred to a second generation. Even fewer closely-held businesses survive transfer to a third generation. THE SOLUTION By utilizing a cross endorsement buy-sell arrangement ( CEBS Arrangement) funded with a permanent life insurance policy, the funds required to transfer the business efficiently as a result of one of these triggering events can be available. A cross endorsement buy-sell arrangement is a buy-sell plan that provides the owner and his or her family the liquidity needed to transfer the business when one of the business owners dies prematurely. However, since the business owner purchases a life insurance policy on his or her own life under this type of arrangement, the business owner can use the policy s cash values to supplement retirement income on a tax-favorable basis 1. By purchasing a permanent life insurance policy with a long term care or chronic illness rider, the business owner can protect himself or herself, as well as the owner s own family, against the devastating costs of long term care or chronic illness costs. It is estimated that as many of 50% of Americans will one day need long term care. A permanent life insurance policy is a flexible financial tool that can address your changing needs over the life of the business. HOW IT WORKS Under a cross endorsement buy-sell arrangement, the business owner purchases and owns a life insurance policy on his or her life while the other shareholders or partners purchase and own a policy on each of their respective lives. The value of each policy will be based on the projected value of the business and each business owner s proportional interest in the business. To minimize the owners' outof-pocket costs to pay premiums, the company may make annual bonus payments to each business owner in the amount of the premium. Each business partner will endorse 2 or rent out all or a portion of the death benefit on their policy to each of the other partners. Each of the business partners will pay a rental charge to each other for the amount of annual term death benefit being endorsed. Consequently, each business owner will recognize rental income in the amount of the rental charge. 1 Loans and withdrawals will reduce the death benefit, cash surrender value, and may cause the policy to lapse. Lapse or surrender of a policy with a loan may cause the recognition of taxable income. Policies classified as modified endowment contracts may be subject to tax when a loan or withdrawal is made. A federal tax penalty of 10% may also apply if the loan or withdrawal is taken prior to age 591/2. Cash value available for loans and withdrawals may be more or less than originally invested. 2 Each owner may desire to endorse some, or as much as one hundred percent (100%), of the death benefit to the other owners during the buy-sell period. Clients should consult their tax advisors to determine the appropriateness of this, or any, planning strategy.

2 HOW IT WORKS (Continued) The value of the rental charge is based on the economic benefit cost of the death benefit which ordinarily, at least initially, represents only a small fraction of the total premium. The economic benefit cost is measured annually using either a government or insurance company rate table. Essentially, each owner will pay a rental charge based on the attained age of the other owner(s) and the amount of the death benefit being endorsed. When the cross endorsement buy-sell plan is terminated, the rental charges stop and each business owner retains their respective policy. BENEFITS Buy-Sell Cash is available for the efficient transfer of the business due to an owner s death, retirement, or sale. CONSIDERATIONS Cash flow Cash flow to fund premiums is required. Increasing economic benefit cost The economic benefit costs increase with age and may be significant in later years. Split Dollar Final Regulations Under the split dollar final regulations, the economic benefit amounts received by each owner will be treated as rental income and taxed at ordinary income tax rates. While the buy-sell plan is in place, the life insurance proceeds are to be paid to each surviving owner to fund the buy-sell obligation. However, if the plan is terminated, each owner can continue to own his or her policy and use the policy cash values to supplement retirement income, pay long term care or chronic illness costs (assuming a long term care or chronic illness rider is purchased), or cover the owner s state or federal estate tax liability. Flexibility of permanent insurance Permanent insurance provides the flexibility needed to transition the business as well as the potential for policy cash surrender values for supplemental retirement income and/or estate liquidity. Potential Transfer For Value The owners may want to consider a partnership (if one does not already exist) between the owners to avoid any transfer for value issues with respect to the cross endorsements of the policy death benefits. Long Term Care Rider If you are considering creating a policy with a long-term care or chronic illness rider where the owner is not the insured (such as when an owner creates an irrevocable trust to own his or her policy), there may be adverse consequences - both tax and contractual in nature. You should review the particulars of your intended ownership arrangement with your legal and tax counsels in light of the income, gift, and estate tax provisions of the Internal Revenue Code PLANNING OPTIONS The following flowcharts and ledger pages illustrate the plan mechanics and the costs and benefits of the private split dollar cross-endorsement buy-sell plan to the business and each business owner.

3 Renting to Fund a Cross Endorsement Buy-Sell Plan Ron Davis (40.00% Owner) Jim Endorses to Ron $6,000,000 Jim Pays Charge to Ron $7,320 Ron Endorses to Jim $4,000,000 Ron Pays Charge to Jim $21,900 Jim Smith (60.00% Owner) Shareholders rent a portion of their death benefit to each other equal to the each shareholder ownership in the company For illustrative purposes only. Not indicative of past or future performance. All guarantees subject to the claims paying ability of the issuing insurance company.

4 Assumptions Value of Business $10,000,000 Release Endorsement Year 15 Shareholder Name Age Ownership in Company Annual Years Face Amount Amount Endorsed 1) Jim Smith % $126, $6,000,000 $6,000,000 2) Ron Davis % $61, $4,000,000 $4,000, % $187,000 $10,000,000 $10,000,000 Breakdown of Life Insurance Endorsed 1) If Jim Smith Dies New Allocation Share Existing Allocation 40.00% New Allocation Ron Davis % $6,000,000 Ron % % $6,000,000 2) If Ron Davis Dies Jim Smith % $4,000,000 Jim 60.00% % % $4,000,000 For illustrative purposes only. Not indicative of past or future performance. All guarantees subject to the claims paying ability of the issuing insurance company.

5 Details for Jim Smith Jim Smith Collected Paid Ron Davis (60.00% Owner) (40.00% Owner) Year Age Annual Net Outlay Charge ,000 6,000,000 21,900 7, ,420 7,320 4,000, ,000 6,000,000 24,900 7, ,020 7,920 4,000, ,000 6,000,000 28,080 8, ,440 8,520 4,000, ,000 6,000,000 31,200 9, ,000 9,200 4,000, ,000 6,000,000 33,960 10, ,120 10,080 4,000, ,000 6,000,000 36,360 11, ,880 11,240 4,000, ,000 6,000,000 39,060 12,800 99,740 12,800 4,000, ,000 6,000,000 42,660 14,600 97,940 14,600 4,000, ,000 6,000,000 47,760 16,600 94,840 16,600 4,000, ,000 6,000,000 54,480 18,720 90,240 18,720 4,000, ,000,000 62,460 20,800 (41,660) 20,800 4,000, ,000,000 71,400 22,640 (48,760) 22,640 4,000, ,000,000 81,060 24,240 (56,820) 24,240 4,000, ,000,000 91,200 26,040 (65,160) 26,040 4,000, ,000, ,520 28,440 (73,080) 28,440 4,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, For illustrative purposes only. Not indicative of past or future performance. All guarantees subject to the claims paying ability of the issuing insurance company.

6 Details for Ron Davis Ron Davis Collected Paid Jim Smith (40.00% Owner) (60.00% Owner) Year Age Annual Net Outlay Charge ,000 4,000,000 7,320 21,900 75,580 21,900 6,000, ,000 4,000,000 7,920 24,900 77,980 24,900 6,000, ,000 4,000,000 8,520 28,080 80,560 28,080 6,000, ,000 4,000,000 9,200 31,200 83,000 31,200 6,000, ,000 4,000,000 10,080 33,960 84,880 33,960 6,000, ,000 4,000,000 11,240 36,360 86,120 36,360 6,000, ,000 4,000,000 12,800 39,060 87,260 39,060 6,000, ,000 4,000,000 14,600 42,660 89,060 42,660 6,000, ,000 4,000,000 16,600 47,760 92,160 47,760 6,000, ,000 4,000,000 18,720 54,480 96,760 54,480 6,000, ,000,000 20,800 62,460 41,660 62,460 6,000, ,000,000 22,640 71,400 48,760 71,400 6,000, ,000,000 24,240 81,060 56,820 81,060 6,000, ,000,000 26,040 91,200 65,160 91,200 6,000, ,000,000 28, ,520 73, ,520 6,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000, The hypothetical case study results are for illustrative purposes only and should not be deemed a representation of past or future results. This example does not represent any specific product, nor does it reflect sales charges or other expenses that may be required for some investments. No representation is made as to the accurateness of the analysis. This material is for informational purposes only and is not meant as Tax or Legal advice. Please consult with your tax or legal advisor regarding your personal situation. Revised 1/15/16 HCBLC060