The Own Your Own Policy Buy-Sell A New Strategy For Business Succession Planning

Transcription

1 Own Your Own Policy Buy-Sell A New Strategy For Business Succession Planning Spring Spring Quarterly Quarterly

2 Buy-Sell Agreements Are Critical. A buy-sell agreement is a written contract which establishes what will happen to a business owner s ownership interest when he/she leaves the business. Sometimes called business wills, these agreements usually list a variety of events which trigger duties to sell and buy the interest of a departing owner. Effective buy-sell agreements establish the terms and the procedures for transferring a departing owner s interest. Buy-sell agreements are important because every business owner will leave their business someday. It s not a matter of if an owner is going to leave; instead it is a question of when. Owners who don t leave during their lifetimes will leave when they die. Smooth transition of business ownership is important for maintaining a business value. Business owners who don t take the initiative to adopt a plan for transferring their ownership interests may create difficult problems for their families and other business owners. Life Insurance Funding. When a buy-sell agreement is triggered, legal obligations to buy and sell are usually activated. Because death is almost always one of the triggering events, life insurance is regularly used as part of the funding. Nearly all buy-sell agreements Association Association for for Advanced Advanced Life Life Underwriting Underwriting 45 45

3 that use life insurance have one thing in common: insured business owners do not own the life insurance policies that insure their own lives. In an entity purchase arrangement the business owns the policies. In a cross purchase arrangement the other owners or another entity (e.g. a trust or a general partnership) own the policies. fact that owners don t own their own policies has the potential to create a variety of problems, including: 1. Owners are precluded from making decisions about the policy insuring their lives. 2. If an owner leaves the business before death, he/she may not be able to acquire ownership of his/ her policy and use the death benefits for personal financial objectives. 3. If an owner s health deteriorates, he/she may become uninsurable and be unable to purchase other life insurance coverage and thus may need the buy-sell coverage for his/her family. 4. Even if a departing owner is insurable, the cost of purchasing new coverage could be prohibitive because of age, health or other conditions. Many buy-sell agreements are triggered when an owner retires, becomes disabled or voluntarily leaves for other reasons. In those cases the policy death benefit can t be used to purchase the departing owner s interest. Nevertheless, the departing owner s policy is a potentially valuable asset which could be quite useful in his/ her wealth transfer and personal financial planning. If owners owned their policies personally, they would control the death benefit after leaving the business and could change the beneficiary designation to use the death benefit to meet other objectives. Potential Advantages When Owners Own ir Own Policies. re are a number of potential advantages when business owners own their own buy-sell life insurance policies, including: 1. One Policy Per Owner re is no need for multiple policies on each owner. 2. Personal Ownership and Control Every owner owns and makes the decisions concerning his/her own policy (although each owner must manage the policy to satisfy any standards or requirements set in the buysell agreement). 3. Include Personal Death Benefit Coverage An owner may want more death benefits than the amount needed under the buy-sell agreement; he/she may wish to combine the coverage required under the buy-sell agreement with the coverage needed for personal protection and wealth transfer planning. 4. Personal Responsibility Each owner is responsible for his/ her own premiums; younger or healthier owners aren t forced to pay premiums on older or less healthy owners. 5. Set Own Premium Level Owners decide how much premium to pay; they may choose to pay in more than the minimum in order to increase cash vales potentially available for supplemental retirement income. 6. Policy is Portable Every owner who leaves the business before death takes the policy with him; there is no need to attempt to reacquire the policy from another owner or from the business. 7. Personal & Wealth Transfer Planning After an owner leaves, he/she has the option to reposition the death benefits to meet personal needs without going back through underwriting to purchase new coverage; problems with increased premiums and decreased insurability can potentially be avoided. Two Reasons Personal Ownership Is Rarely Used. In spite of the potential advantages, personal ownership of death benefits to fund buy-sell agreements is a strategy which is seldom used. This is true for two primary reasons: 1. Someone else (either another owner, entity or the business itself) has the legal obligation to purchase their interest. Because potential purchasers need to make sure they have sufficient funds to satisfy their purchase obligations under the agreement, it may make sense for them to own and control the policies. 2. transfer for value rule of Internal Revenue Code (IRC) Section 101. One of the advantages of using life insurance as part of the buy-sell funding is that policy death benefits are generally paid federal income tax free to the policy beneficiary when the insured owner dies. This valuable income tax benefit may be lost if the business owners own their own policies because they may violate the transfer for value rule. A transfer for value occurs when the owner of a life insurance policy transfers an interest in the policy to someone else and receives something of value in return. Under IRC section 101 value isn t limited to just cash or tangible assets; value can also include an enforceable promise which could potentially benefit the recipient (such as a promise to purchase the owner s interest). Violating the transfer for value rule results in taxable income to the policy beneficiaries to the extent of the difference between the policy death benefit and the total of the consideration paid plus all premiums paid after the transfer. Here s an example to illustrate the point. A and B are each 50% owners of a business. Each purchases a $1,000,000 life insurance policy on his own life and names the other as a beneficiary. Normally neither A or B would name each other as a policy beneficiary. Reciprocal promises to name each other as beneficiaries can be implied from their respective actions (or from the terms of the agreement). se reciprocal promises are the value that triggers Association for Advanced Life Underwriting 47

4 the transfer for value rule. Thus, if A dies, part or all of the $1,000,000 death benefit B receives as the beneficiary of A s policy may be taxable income to B. Partnership Exception. Fortunately, it is possible to avoid the harsh income tax consequences of the transfer for value rule. In IRC Section 101(a)(2) Congress created a number of exceptions to the rule; if one of those exceptions applies, then it is possible the policy beneficiary may still receive the life insurance death benefits free of federal income taxes. exception most likely to apply to buy-sell arrangements is the partnership exception. This exception shields transfers for value from federal income taxes if the transfer is to a partner of the insured or to a partnership in which the insured is a partner. re are some fine points to this exception which should be kept in mind, including: partnership must actually be operated as a partnership and not merely exist in form only. If a limited liability company (LLC) has elected to be taxed as a partnership then the members are considered to be partners for purposes of the transfer for value rule. Private Letter Ruling (PLR) ). A transfer for value from a corporation to a partnership in which an insured shareholder is a partner comes within the exception (PLR ). Transfers to shareholders who are partners, even though in an unrelated partnership, fall within the exception (PLR , PLR ). transfer of policies insuring shareholders/partners from a corporation to a partnership established specifically to receive and manage the policies comes within the exception (PLR ). Internal Revenue Service (IRS) has ruled that it will not issue rulings concerning whether or not the exception applies to a transfer of a policy to an unincorporated organization where substantially all of the organization s assets consist of or will consist of life insurance policies on the lives of its members (Rev. Proc , IRB 122). Thus, it may advisable for the partnership to have other assets in addition to life insurance policies. Own Your Own Policy Buy-Sell. ability to use the partnership exception to avoid the transfer for value rule may create an opportunity for a new type for life insurance-funded buy sell arrangement the Own Your Own Policy (OYOP) Buy-Sell. In this approach each owner owns his/her own policy and assigns or endorses part of death benefit to the other owners so they will have the funds to meet their purchase obligations under the agreement. If these owners are in a partner/partnership relationship, income taxation of the death benefits under the transfer for value rule may be avoided. How the Own Your Own Policy Buy-Sell Works. Assuming there is valid partnership in place or the business is organized as an LLC, LLP or a partnership, these steps may be taken: 1. owners enter into a cross purchase arrangement; each owner agrees to purchase his pro rata share of the interest of the other shareholders when they die. 2. Each owner purchases and pays the premiums on a policy on his/her own life with a face amount at least as large as the value his/her interest in the business; an option B death benefit approach (death benefit payable is the face amount plus premiums paid) may be appropriate because the insured s estate will then recover premiums paid into the policy. 3. Each owner assigns or endorses part of the policy death benefit to the other owners according to their pro rata shares of the business; the necessary assignment forms are filed with the insurance company 4. At an insured owner s death, the death benefits are paid out according to the assignment/ endorsement and the policy beneficiary designation; each surviving owner uses his/ her share of the death benefit to purchase part of the deceased s share of the business from his/her estate as required by the agreement 5. If an owner retires or otherwise leaves the business before death: - remaining owners may use the cash values in the policies they own on themselves and/or other personal assets to purchase their respective shares of the departing owner s interest. - owners complete all paperwork necessary to release the assignment /endorsement they hold against the departing owner s policy; the departing owner releases his assignments/ endorsements against their policies. Incentive to Use Cash Value Insurance. Many business owners consider the need for buy-sell life insurance to be temporary. That s because they often expect to sell their interests when they retire (usually between ages 60-70). As a result, they often use term life insurance to fund their obligation to purchase at another owner s death. Own Your Own Policy Buy-Sell structure creates incentives to use cash value insurance for the buy-sell funding. Because the policy death benefit can meet other personal and wealth transfer objectives after the owner leaves the business, the policy should remain in force for the balance of the owner s life. Cash value insurance may also be attractive because of its potential to provide some degree of supplemental retirement income. fact that the policy has a variety of potential uses after an owner leaves the business increases the odds of selling cash value policies. Managing Policy. A business owner may be able to combine both his/her business and personal life insurance planning in one personally owned policy. total death benefit could include components for buy-sell funding, spousal support, mortgage and personal debt repayment, and estate 48 Spring 2011 Quarterly

5 liquidity. Of course, the personal portion of the death benefit will be included in the taxable estate for estate tax purposes. If this is a problem, then it may be possible for the insured owner to establish an irrevocable life insurance trust (ILIT) and have it own the policy. portion of the death benefit needed to fund the buy sell arrangement could be handled by naming the other owners as beneficiaries of the ILIT to the extent of ownership in the business. ILIT could be drafted so that their status as beneficiaries would end if they die before the owner or if the owner left the business prior to death. insured is responsible for paying policy premiums. He/she can use personal funds or may enter into a premium sharing arrangement with the business or an outside entity. If it makes financial sense, the business may be able to supply some of the premium dollars through an IRC 162 Bonus Plan, an economic benefit split dollar arrangement or a split dollar loan. It is also possible that some assets from the business could be distributed to the owners as dividends or depending on the business tax structure, return of basis. Savvy business owners will want to make sure the death benefits they need from another owners policy will be paid to them so they can meet their purchase obligations at another owner s death. Thus, their status as beneficiaries entitled to receive a portion of the death benefit must be nailed down. ir rights can potentially be secured through a written assignment, an endorsement of death benefits or an irrevocable beneficiary designation. y should consult with their tax and legal advisors to determine which option is best suited to their needs. Potential Tax Consequences of the OYOP Buy-Sell. year-to-year income tax treatment of on OYOP Buy-Sell arrangement is not known with certainty. transfer for value issue should only arise when an insured owner dies, not while he/she is alive. It does not create any year-to-year income tax consequences during an insured s lifetime. Also, it is possible to cure a transfer for value before the insured s death by transferring the policy back to the insured. Are there any year-to-year tax consequences when a policy owner names a business partner as a temporary beneficiary of all or part of the death benefit of his policy in return for a business partner doing the same for him? authors are not aware of any regulations, rulings or cases which have directly addressed an OYOP buy-sell arrangement. Because the business is not involved in the arrangement, we believe that income taxation under the following IRC sections is not applicable: Section 162 no compensation from the business Section 79 no plan of group insurance Section 264 no benefit provided from the business to the owners. We believe OYOP arrangements could potentially be handled in at least three different ways but business owners should consult with their tax and legal advisors: 1. No Taxation. An OYOP Buy-Sell arrangement can be compared to how life insurance is sometimes used in divorce/ marital dissolution situations. In addition to alimony and child support, divorce decrees may require one spouse to purchase and maintain life insurance coverage on his/her life for the benefit of ex-spouse for a stated number of years. After the term expires the insured ex-spouse is entitled to do anything he/she wishes with the policy. When a provision like this is included in a divorce decree, a binding legal obligation Association for Advanced Life Underwriting 49

6 on the part of the ex-spouse to provide life insurance protection is created. If the spouse receiving the life insurance protection does not own the policy, then the premium payments are not considered alimony and the value of the life insurance coverage is not taxable income (Temp. Treasury Reg T, A-6). It is quite possible that the taxation of the temporary year-to-year life insurance protection in an OYOP Buy-Sell arrangement could avoid taxation in a similar way. 2. Taxation Under the Split Dollar Rules. Could the split dollar regulations apply to the temporary assignment of policy death benefits? An analysis of the regulations creates doubt as to whether an OYOP arrangement qualifies as a split dollar arrangement. regulations state that in a split dollar life insurance arrangement at least one of the parties to the arrangement paying premiums is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract. See Treasury Reg In the OYOP strategy the insured owner (who is also the sole premium payor) makes a simple temporary and unrestricted assignment of the death benefit and does not retain a right to recover any portion of the premiums he/she has paid from the death benefits assigned. If the IRS applies the split dollar rules to an OYOP Buy-Sell arrangement, it could possibly conclude that the arrangement should be considered a private split dollar plan. In such a case, an owner who assigns an interest in his policy death benefit to another owner could be deemed to be making a gift to the other participating owners. value of the gift could be the economic benefit value of the death benefit assigned. economic benefit value is determined by multiplying the IRS Table 2001 rate for the insured s current age by the number of $1,000 units of death benefit that would be paid to that owner if the insured died during the current year. If the necessary requirements are met, it is possible the rates of an insurance company s qualifying term policy could be used in place of the IRS Table 2001 rates. se would be cashless gifts since no money changes hands. Split Dollar Example. Suppose A, B & C are equal owners of Wacky Widgets LLC. business is appraised to be worth $3,000,000 and the owners decide to use the OYOP Buy-Sell. ir respective ages are A-55, B-45 and C-35. Each purchases a $1,000,000 policy on his own life. Each assigns his $1,000,000 of the death benefit to the other two. Based on the IRS Table 2001 rates, over the next five years each could be deemed to make economic benefit gifts under the private split dollar rules in these amounts: 3. No Taxation as a Fair-Market Value Sale. It may be possible to avoid taxation on the assignment of the life insurance benefits if each owner annually pays the other owners fair market value for the policy death benefits assigned to him. What is that value? A good argument could be made that it is the economic benefit value determined under the split dollar rules. This alternative could be compared to old-style reverse split dollar plans which were sometimes used in the 1980 s and 1990 s before the IRS revised the split dollar rules. In these old reverse split dollar plans, a corporation rented life insurance death benefits from an insured owner s personal life insurance policy to meet its need for key person life insurance. It paid the owner-insured an annual rental fee for the use of the death benefit protection. amount of the rental check was the economic benefit value. A fair market rental payment for temporary use of the death benefit coverage could be considered to negate any potential gift from the policy owner. By making this rental payment, the parties could be deemed to have exchanged things of equal value. If the value of the death benefit protection is equal in value to the rent paid, then it can be argued that the assignment of the death benefit creates no tax consequences because items of equal value are exchanged. Keep in mind the possibility that the rental income each owner receives from assigning his/her policy death benefits to other owners could be treated as taxable income. Federal Estate Tax Issues. re may be some concern that both fair market value of a deceased owner s business interest and the portion of the death benefits paid to the surviving owners to fund their purchase will be included in the deceased s taxable estate. This is A s Annual Gift (55) B s Annual Gift (45 C s Annual Gift (35) Year 1 $4,150 $1,530 $ 990 Year 2 4,680 1,670 1,010 Year 3 5,200 1,830 1,040 Year 4 5,660 1,980 1,060 Year 5 6,060 2,130 1,070 possible but unlikely if the OYOP buy-sell document is properly drafted. When the insured has a legal obligation under the buy-sell agreement to pay out the policy death benefit received, that obligation can be construed as a debt which may offset a similar amount of life insurance death benefits. Thus, when the agreement requires an insured to provide others an identifiable sum of death benefits which will be used to purchase an asset from the deceased s estate, there should be an offset which reduces the amount of death benefits included in the taxable estate. See Blount v. Commissioner 428 F 3rd 1338 (11th cir., 2005) and Cartwright v. Commissioner 183 F 3rd However, any part of the death benefit not related the repayment, is potentially includable in the deceased owner s taxable estate. Potential Disadvantages. Possible disadvantages to an OYOP Buy- Sell arrangement include: 1. Implementing an annual procedure for monitoring the policies. 2. Ensuring the death benefit assignments/endorsements are filed with the insurance company. 3. Doing annual economic benefit calculations if it is determined the split dollar rules apply. 4. Using up either a portion of the business owner s $13,000 per donee gift tax annual exemption 50 Spring 2011 Quarterly

7 or part of the $1,000,000 lifetime gift tax exemption if the OYOP Buy-Sell arrangement is determined to be a taxable gift and this may also reduce the amount of the estate tax unified credit available at death; as a result, the amount of property an owner may be able to transfer federal estate tax free at death may be reduced. Widespread Potential For Use. OYOP Buy-Sell concept could potentially be used by a large number of businesses. That s because many existing businesses are organized as limited liability companies (LLCs), limited liability partnerships (LLPs) and general partnerships. LLC form of business is a legal structure that is often adopted by new businesses. Owners of C corporations and Subchapter S corporations often have assets that are used in the business but are owned outside the corporation in a partnership. C corporation and Subchapter S corporation owners may choose to create a partnership by contributing personal assets and/or taking distributions from the corporation and funneling the after-tax portion of those distributions into a new partnership. Conclusion. For many years business owners and their advisors have avoided having owners own the life insurance policies funding their buy-sell arrangements. This no longer has to be the case. Own Your Own Policy Buy- Sell is a strategy which has the potential to provide many business owners with the ability to own and control their life insurance policies while still maintaining policy death benefits to fund buy-sell obligations triggered by death. Because the OYOP strategy has the potential to combine buy-sell funding with personal life insurance needs, it gives business owners sound incentives to apply for larger death benefits and to use cash value policies that will be in force when they die. Consider discussing the Own Your Own Policy Buy-Sell with your business owner clients and their advisors. information presented is for general information or educational purposes only and the strategies suggested may not be suitable for everyone. It is not intended to provide specific tax, legal or other professional advice. You should seek advice from your tax and legal advisors regarding your individual situation. ING is a global financial institution of Dutch origin offering banking, investments, life insurance and retirement services to over 85 million private, corporate and institutional clients in more than 40 countries. In the U.S., the ING (NYSE:ING) family of companies offer a comprehensive array of financial services to retail and institutional clients, which includes life insurance, retirement plans, mutual funds, managed accounts, alternative investments, direct banking, institutional investment management, annuities, employee benefits and financial planning. For more information, visit About the Authors Maggie Mitchell is vice president of Advanced Sales for ING. She has more than 25 years experience in the financial services, tax, legal and insurance industry. Prior to joining ING, Maggie worked as a life insurance consultant, where she provided expertise for life insurance needs of high net-worth individuals and business owners, and practiced law as an estate planning attorney. She is the chair of the LIMRA Advanced Sales Committee. Maggie can be reached at maggie.mitchell@us.ing.com. Peter McCarthy is a senior advanced marketing consultant on ING s Life Sales Support Team. He has over 30 years of experience in estate and business planning. Peter joined ING in Prior to that, he served as advanced marketing counsel for Minnesota Life, Prudential and American Express Financial Advisors. He has also practiced law as an estate planning attorney with Ameriprise. Peter graduated from Rollins College. In 1975, he earned his JD degree from the University of Miami. Peter can be reached at peter.mccarthy@us.ing.com. Association for Advanced Life Underwriting 51