Entity Buy/Sell:

May 25, 2005 at 08:00 PM
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When the dreaded alternative minimum tax went into effect in the 1980s, entity buy/sell agreements were quite common. The AMT potentially taxes the collection of a life insurance death benefit.

That possible taxation prompted many tax professionals to convert entity agreements to cross-purchase agreements. However, the entity buy/sell approach has many advantages and is now making a comeback.

In addition to avoiding the AMT, the advantages of a cross-purchase include creditor protection and a step-up in basis when the decedent/retiree is bought out. However, the entity advantages are its:

o simplicity;

o lower policy count;

o financial strength;

o efficient rollout at retirement; and

o equitable sharing of premium commitments.

A real-life example

Consider twins Jim and John Blackford, 50/50 owners of Blackford Mechanical, LLC, a heating and cooling contractor. They started the business 10 years ago, worked hard, were frugal and put money back into the business.

The company is now worth $3 million with 30 employees. Jim and John want to grow the business and remain co-CEOs, but they want to hire professional management. They are looking for a CFO, a COO and a comptroller.

Beyond that, they have capable teenagers who want to get involved in the family business. Because the local business climate is good, Jim and John believe the company could easily handle the additional management personnel, add more construction personnel and grow quickly. They expect the operation to be worth $10 million in 10 years.

Jim and John know they will have to allow more owners. The professional managers will want to become owners, and so will Jim's and John's children. The business could have seven or more owners. Eventually, Jim and John want to retire; so while they're contemplating expansion, they also need exit strategies.

Jim and John created a cross-purchase buy/sell when they started the company. They funded it with permanent life insurance. Currently, each of their cross-owned $500,000 policies has $100,000 of cash value with premiums paid of $75,000. Current re-proposals indicate that in 10 years total premiums will be $150,000 and cash value will be $250,000.

Benefit of an entity agreement

An entity agreement benefits Jim and John, first, by cutting the policy count. A cross-purchase agreement can require each owner to have a policy on the life of every other owner. For 7 owners, 42 policies would be needed.

Accompanying the policy count would be the necessary changes every time an owner joins or leaves. Blackford Mechanical has an advantage in that it is an LLC, so it fits into the partnership exemptions in the transfer-for-value rules.

However, if the firm were a corporation, it would find no transfer-for-value exemption for co-shareholders. An entity structure would cut the policy count to 7 and would dramatically simplify entries to and exits from ownership.

Blackford Mechanical regularly borrows to take advantage of purchase discounts; and it needs bonding capacity to take on jobs. Both the bank and the bonding company want to see strong financial statements.

Funding the life insurance for a cross-purchase agreement requires taking money out of the company, reducing income and permanent capital. With an entity agreement, the money for the premiums would stay in the company.

Funds would move from the "cash in bank" asset account to the "cash surrender value of life insurance" asset account. Within a few years, the life insurance could actually become an income-producing asset.

Beyond strengthening the financial statements, the bank and bonding company would be happy to see that asset on the balance sheet. Subjectively, the asset would demonstrate that Blackford Mechanical's owners are planning for problems that might arise.

On a practical level, the bank and bonding company see that cash value as a ready source of emergency capital or collateral. If there's a cash flow crunch, a fresh influx of cash is just a phone call away.

Having the life insurance on the company balance sheet will increase the value of the company, but this is a two-edged sword. When someone retires, the asset will be more expensive to buy out the retiree. However, financial strength is more important for growth and long-term financial stability than making it cheaper to buy out a retiree.

Their retirement

When it comes time to retire, the entity structure really shines. Each buy/sell structure requires the retiree to sell out at retirement. That will be a gain transaction, which is no different than selling the stock of a publicly traded company.

Financing is another issue. In a cross-purchase agreement, when Jim or John retire they must be paid full price for their interests. In an entity plan, the company will still have to pay full price, but it will have the life insurance policy to use as part of the down payment.

There is a drawback to that transfer. In 10 years, when the company transfers the policy to the retiree, it will have to recognize the $100,000 gain in the policy as additional taxable income.

Dealing with the life insurance at retirement in a cross-purchase agreement adds a problem. In the cross-purchase, the first thing Jim and John will want to do is trade life insurance policies. There will be no need for the cross insurance; and each will want a life insurance policy on himself.

Unfortunately, those trades will be taxable barter transactions. Looking 10 years into the future, the policy Jim owns will be worth $250,000 and will have a basis of $150,000. Therefore, when Jim sells it to John, he will realize a $100,000 gain.

The same goes for the policy that John owns on Jim. Two taxable $100,000 gains!

The gains will still be there even if each brother strips out the $100,000 of gain inside the policy with a $100,000 partial surrender. That will simply reduce each policy basis to $50,000, and leave the policy with a $150,000 fair market value-and the $100,000 gain will remain.

The situation described above covers only a two-owner, cross-purchase agreement. Things really get confusing if there are three or more owners.

Triggering the AMT

The AMT can be triggered in a C corporation when it receives a life insurance death benefit. However, it's not as big a problem as it might appear. The AMT paid can be carried forward, where it may be used as a tax credit.

C corporations (which are far less common now) with average revenues of less than $7.5 million are exempt from AMT. A life insurance death benefit will not trigger AMT to the owners of S corporations, LLCs or partnerships.

Although it doesn't apply to Jim and John now, disparities in age and ownership percentages will create differing premiums as younger owners are admitted. In a cross-purchase arrangement, the premium demand for the life insurance on Jim and John would disproportionately fall on the younger owners. In an entity structure, since it's the business's obligation, the burden would be shared more equitably.

Cross-purchase has an advantage when it comes to creditors' claims. If the business owns the life insurance, there would be no protection from business creditors. Personally owned life insurance has better creditor protection.

However, in a cross insured situation==where you own the policy on your partner's life, not your own life==there might be less enthusiasm about keeping the policy.

The step-up in basis when a retiree/decedent's interest is bought by a remaining owner is a highly promoted advantage to the cross-purchase structure. And that is true with a C corporation.

However, many businesses elect pass-through taxation in the form of an S election; or they elect to have a limited liability company (LLC) treated as a partnership. In both cases, the collection of a policy death benefit increases the owners' bases in ownership interests. That fact, to a degree, mitigates the step-up in basis feature of the cross-purchase structure.

The cross-purchase structure is common and well understood. An entity plan, however, has many features and benefits to recommend it. It should be considered in any buy/sell situation, especially when there are, or may be, three or more owners.

David K. Smucker, CPA, CLU, CFP, ChFC serves as advanced sales consultant for Nationwide Financial in Columbus, Ohio. He may be reached at [email protected].

…the entity buy/sell approach has many advantages and is now making a comeback.

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