Psst.
I’ll let you in on a little-known buy-sell strategy that avoids many of the pitfalls of traditional arrangements.1
The LLC buy-sell combines the benefits of a cross purchase buy-sell and an entity buy-sell while eliminating many of the challenges business owners and their advisors typically face.
The owners of a successful business should plan for the transfer of the business to the next generation. Buy-Sell plans can make all the difference in a successful transfer of the business to surviving business owners in the event of a triggering event, such as the death, disability or retirement of one of them-- all while protecting the financial interest of the surviving family members.
Generally, there are 2 commonly used buy-sell arrangements:
Cross Purchase arrangements refer to each business owner having a life insurance policy on the life of each of the other business owners based on each business owner’s share of the business. Typically, the arrangement will look to buy-out the surviving owners with the insurance proceeds. Because this arrangement can be very cumbersome when there are more than 2 owners (requiring more than 2 policies), and inequitable when certain owners are older and unhealthy (requiring younger, healthier owners to pay higher premiums), an Entity Purchase agreement is often considered as an alternative.
Entity Purchase arrangements refer to the entity or business as owner of each policy, with the life insurance proceeds being paid into the business-- at which point the business facilitates the buy-out of the shares with the surviving owners. Often, these Entity Purchase agreements are set up as stock redemptions.
Both arrangements have their own set of problems, several of which are illustrated in the following chart:
A limited liability company is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. It must be valid under state law.
LLCs are well known for the flexibility that they provide to business owners. Depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, and, under certain circumstances, LLCs may be organized as not-for-profit.
In order to establish a buy-sell arrangement with an LLC as a party to it, the following steps need to be taken:
There are a number of factors to consider when the LLC pays premiums for its buy-sell arrangement, including tax and accounting factors. To keep it simple, there are two ways the premium on a life insurance policy is generally funded in an LLC buy-sell plan:
If earnings are contributed as capital to the LLC, they are taxable to each owner. However, each owner’s cost basis is increased by the amount of the capital contributions.
The most common way the premium is funded is through its earnings.
Let’s go back to our chart of challenges to see how the LLC Buy-Sell may overcome these pain points:
If the event that triggers the buy-sell plan is retirement, the policy on the retiring owner can be transferred to him or her as part of the buy-out. Transferring the policy to an insured is, again, an exception to the TFV rule. If the policy is designed properly, it is possible for the exiting owner to access cash values on a tax-favorable basis to supplement retirement income.
If the cash value of the policy on the existing owner is not sufficient to execute the full buy-out price, the cash values from multiple policies may be used to fund the difference.
At the death of an owner, the life insurance proceeds pay out to the LLC on an income tax-free basis, assuming the 101(j) notice and consent rules were followed. As the flowchart illustrates, the proceeds are distributed by the LLC to the surviving owners, income tax-free.
The surviving owners then use the proceeds to purchase the deceased owner’s share.
The LLC may decide to terminate the arrangement at some point. In this case, the policies are distributed to the insureds on an income tax-free basis as a return of cost basis. Moreover, this transaction would not be characterized as a transfer for value.
So the next time you have business owners who are concerned about navigating the all too common challenges of structuring a buy-sell arrangement, offer up the powerfully simple, yet little known strategy of the LLC buy-sell.
