Buy-Sell Life Insurance Checklist

THE PRUDENTIAL INSURANCE COMPANY OF AMERICA Buy-Sell Life Insurance Checklist The following checklist details the items that are generally needed to fund a buy-sell agreement with life insurance. STEPS ACTION REQUIRED PARTIES INVOLVED 1 A buy-sell agreement is drafted/executed. The executed agreement is retained by the business owner(s). legal counsel 2 Quantify the value of the business. appraiser 3 Determine the face amount of life insurance coverage needed on each owner (proposed insured) and select the type of policy. lfinancial professional 4 Where the business is the premium payor, execute a board resolution authorizing payment of the stipulated premium. 5 Prior to policy issue, execute employer-owned life insurance notice and consent documentation as required under Internal Revenue Code 101(j). This documentation should be retained by the business to prove compliance. For a sample notice and consent document, see Attention Employers: Employer-Owned Life Insurance Rules Have Changed. legal counsel legal counsel 6 Complete life insurance application(s) with the owner(s) of the business as the proposed insured(s). lfinancial professional 7 Annually report with the business tax return the data requested for employer-owned life insurance for policies issued after August 17, 2006. 8 Periodically review the buy-sell agreement and reassess the adequacy of the life insurance coverage. Business owner, business s tax preparer Business owner, legal counsel, appraiser, financial professional 2010 The Prudential Insurance Company of America 751 Broad Street, Newark, NJ 07102-3777 0186986-00001-00 Ed. 12/10 Exp. 06/12

BUY-SELL LIFE INSURANCE - 2 Structure of Buy-Sell Agreements Funded with Life Insurance A buy-sell agreement is a legal document that specifies how a business or its owners will transfer ownership upon certain named events. The general goal of a buy-sell agreement is to spell out who can buy a departing owners share of the business; what events will trigger a buyout; and how the business will be valued. For a buy-sell agreement to be effective, the financial ability of the remaining owners (or the business) to purchase the departing owner s interest must be provided for in some manner. This is typically accomplished through the purchase of life insurance coverage on the owners. In general, there are four basic types of buysell agreements: Entity Purchase, Stock Redemption or Section 303 Agreement. Under this approach, the business has the right or obligation to buy back the owner s interest. When insurance is used to help fund the buyout, the business owner(s) is the insured(s) and the business is the owner, beneficiary, and premium payor. Cross Purchase Agreement. This type of buy-sell agreement is between the owners of the business. Under this approach, the remaining/surviving owners have the right or obligation to purchase the interest of a departing/ deceased owner. In a cross purchase agreement, each business owner is the owner, beneficiary and premium payor of an appropriate amount of life insurance on the other owners. If a cross purchase arrangement involves multiple owners and policies, a trustee or escrow agent may be used for management purposes to help ensure that the terms of the obligations are honored and policies are kept in force. When funded with life insurance, the trustee/escrow agent is the owner and beneficiary of one policy on the life of each business owner. Hybrid Agreement (also referred to as a wait-and-see agreement). This is a combination agreement that usually puts the responsibility for the buyout on the business but gives the business owners the option of purchasing a departing/deceased owner s interest if the business is unwilling or unable to do so. The wait-and-see approach allows the owners to defer the choice between an entity purchase and a cross purchase agreement until a triggering event occurs. When this form of buy-sell agreement is established, the life insurance is usually structured like a cross purchase agreement with each business owner the owner, beneficiary and premium payor of an appropriate amount of life insurance on the other business owners. If the ultimate decision is made for the business to purchase the departing/ deceased owner s interest, the remaining/surviving owners can either lend or make capital contributions to the business using the life insurance as the source of the funds. Unilateral Agreement. This is a oneway buy-sell agreement between a business owner and a willing buyer who typically is a key person and/or family member working in the business. When funded with life insurance, the potential business buyer is the owner and beneficiary of a policy on the life of the business owner.

BUY-SELL LIFE INSURANCE - 3 It is important that a cover letter clearly explain how the buyout is structured, list the parties respective ownership interests in the business, and state the value of the business. If the buy-sell does not follow one of the above formats, it is important to outline the structure. A cover letter should explain why some of the owners are not being insured if coverage is not applied for on all the owners. Quantifying the Face Amount of Coverage When life insurance coverage is being used to help fund a buy-sell agreement, the face amounts should reflect each business owner s proportional share of the current fair market value of the business, with adjustments made for its future financial growth. Thus, providing documentation that supports the value of the business is the key to quantifying the face amount of the insurance coverage. The ultimate document is a formal business valuation done by an accredited appraiser. However, such documentation is rarely available. If a formal valuation does not exist, three years of business financial statements (i.e., balance sheet, income statement, cash flow statement and any footnotes) should be submitted with the application. The financial statements can be used to estimate the value of a business. Generally, the focus is on the income and cash flow statements, not the balance sheet, except where the business is asset-intensive. The value of a business can be estimated by taking an earnings approach, referred to as the capitalization method. Under the capitalization method, the value of a business is determined by dividing the adjusted net income from the business (earnings before interest, taxes, depreciation and amortization EBITDA ) by the desired rate of return (referred to as the capitalization rate or cap rate ) that an investor would reasonably expect. For example, if the EBITDA of a business is $100,000 and the cap rate is 20%, the business would have an estimated value of $500,000. The cap rate for most closely held established businesses ranges from 10-30%. When the requested coverage falls outside the guidelines, it is always beneficial to submit a cover letter that addresses all the important and relevant information. 1 Selection of a Policy and Premium Payment Careful consideration should be given to the policy choice. Often, permanent life insurance is used to help fund a buy-sell agreement because of the long-term nature of the obligation. However, where the business has limited cash flow or where the need for the coverage is expected to be for a limited period of time, term insurance may be a better option. Where the business is the owner of the policy, such as in an entity purchase agreement, the premiums will be paid by the business. The premiums are not tax deductible to the business in this situation, regardless of the type of policy. In contrast, where individuals own the policy/policies, such as in a cross purchase agreement or unilateral agreement, the business often advances the premiums to the individuals. If the business funds are structured as reasonable compensation, the premiums are deductible to the business and taxable to the individuals. 1 The financial professional can access more information on buy-sell arrangements and financial underwriting considerations through Financial Profiles: Buy-Sell Arrangements, Frequently Asked Questions: The Benefits of Establishing a Buy-Sell Arrangement, PruPower Minute (Brainshark): Buy-Sell Arrangements Using Life Insurance, and Producer Marketing Guide: Buy-Sell Agreements Using Life Insurance.

BUY-SELL LIFE INSURANCE - 4 Regardless of who owns the policy(s), a decision should be made on where the premium notices and other correspondence relating to the policy(s) should be sent. This location should be identified in the billing area of the application. Business Resolution The board of directors for the business should adopt a resolution expressing the business s intention to establish a buy-sell arrangement and authorizing payment if the business will be the source of the premium payments. Notice and Consent Requirements for Employer-Owned Contracts under Section 101(j) For so-called employer-owned contracts issued after August 17, 2006, Section 101(j) of the Internal Revenue Code generally provides that death proceeds will be subject to income tax. However, death proceeds may be received income tax-free where specific employee notice and consent requirements are met and certain safe harbor exceptions apply. 2 Life insurance issued to help fund a buy-sell agreement may be considered employerowned even where the policies are owned by individuals or a trust. It s critical that, prior to policy issue, the business comply with the specific written requirements for notice and consent. In addition, at the time of policy issue, the policy must fall within one of the safe harbor exceptions. Some of the safe harbor exceptions are based on the status of the insured such as being a director, highly compensated employee 3 or highly compensated individual. 4 Another safe harbor exception is based on who receives the death proceeds. This exception provides that Section 101(j) will not apply to an amount received at the death of the insured to the extent the amount is paid to purchase an interest in a business from a family member, beneficiary, trust or estate. Documentation of compliance does not need to be submitted to The Prudential Insurance Company of America, but the business owner should retain proof that he/she met both the notice and consent requirement and the requirement that the employee falls within the safe harbor exceptions for as long as the policy is retained as an employerowned contract. To assist the business owner, Prudential has developed a sample Acknowledgement and Consent to Employer-Owned Life Insurance document as part of :Attention Employers: Employer- Owned Life Insurance Rules Have Changed. Policy Application The application is generally completed in the same way as for personal insurance, however the following differences are worth noting. The business owners will be the proposed insureds. The identity of the owner and beneficiary will depend on the structure of the buy-sell agreement. Specifically: 2 Life insurance death benefits are generally received income tax-free under IRC 101(a). For more information on the IRC 101(j) employer-owned life insurance requirements, the financial professional can access PruPower Minute (Brainshark): Understanding the New Rules Employer-Owned Life Insurance and Frequently Asked Question: Death Proceeds on Employer-Owned Life Insurance Subject to Taxation. 3 Highly compensated employees include employees who, during the preceding year, were 5% or more owners of the business or had compensation in excess of a specific amount during the preceding year ($110,000 for 2010 and 2009, indexed for inflation) 4 Highly compensated individuals include the five highest-paid officers or individuals who are among the highest paid 35% of all employees.

BUY-SELL LIFE INSURANCE - 5 If the buy-sell is structured as an entity purchase, stock redemption, or Section 303 agreement, the owner and beneficiary section of the application should contain the complete name of the business including the full address. An authorized person of the business must sign as owner on behalf of the business. When signing on behalf of the business the authorized person will sign his/her name followed by title and name of the business (e.g., Jane Doe, President of XYZ Company). The business s federal tax identification number will need to be provided in the tax certification area of the application. If the buy-sell is structured as a cross purchase agreement, each business owner will be the owner and beneficiary of a policy on the other business owners (e.g., A is the owner beneficiary of a policy on B and B will be the owner and beneficiary of a policy on A). If the buy-sell is structured as a trusteed agreement, the Prudential Trustee Statement and Agreement form COMB 86044 must be completed. The insured business owner signs as the proposed insured and the trustee signs as the owner and beneficiary (e.g., John Doe, trustee of the Acme Group Trust, dated March 1, 2008). If the buy-sell is a unilateral or one-way purchase agreement, the owner and beneficiary area of the application should contain the name of the proposed purchaser of the business. To help the underwriter quantify the financial basis for the coverage requested, it is helpful to include a cover letter with an explanation of how the amount of coverage was established and provide the financial documentation that supports the coverage amount (or complete the Confidential Business Fact Finder). It should be noted that where the policy face amount is in excess of $10 million, independent thirdparty documentation is required. If applications are being submitted simultaneously on other owners of the business, this should be discussed in the cover letter or remarks section of the application. Doing so will help the underwriter understand the overall structure of the case. Annual Tax Reporting Businesses who have employer-owned contracts are required to file a report with the Internal Revenue Service each year they maintain ownership of a contract. In addition to including information on the amount of employer-owned life insurance in force and the number of employees insured under such contracts, the business must attest that it has obtained valid consent from each insured or, where consent was not obtained, it must indicate the number of insureds from whom it was not obtained. If you want the premium billing notice sent to a location other than what is provided on the application or if you want duplicate notices, this should be noted in the premium billing section of the application.

BUY-SELL LIFE INSURANCE - 6 This material has been prepared by The Prudential Insurance Company of America to assist financial professionals. It is designed to provide general information in regard to the subject matter covered. It should be used with the understanding that Prudential is not rendering legal, accounting or tax advice. Such services should be provided by the client s own advisors. Accordingly, any information in this document cannot be used by any taxpayer for purposes of avoiding penalties under Internal Revenue Code. Life insurance is issued by The Prudential Insurance Company of America and its affiliates Newark, NJ. Each company is solely responsible for its own financial condition and contractual obligations. Like most insurance policies, our policies contain exclusions, limitations, reductions of benefits and terms for keeping them in force. A financial professional will be glad to provide you with costs and complete details. Securities and Insurance Products: Not Insured by FDIC or Any Federal Government Agency. May Lose Value. Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities. 2010 The Prudential Insurance Company of America 751 Broad Street, Newark, NJ 07102-3777 www.prudential.com 0186986-00001-00 Ed. 12/10 Exp. 06/12