Buy-sell planning is the new estate planning

When Congress passed the American Tax Relief Act of 2012, the estate and gift tax exemptions were raised from $1 million to $5 million for individuals and $10 million for married couples. Additionally, the estate and gift exemptions will be indexed for inflation each year. In 2013, the exemptions are $5.25 million for individuals and twice that for married couples. Both exemptions are permanently extended for estates and gifts after Dec. 31, 2012. The top tax rate rose from 35 percent to 40 percent, and portability of unused credit for surviving spouses also was made permanent.

The business consequence of the American Tax Relief Act for advisors is that the clear need for life insurance in estate tax planning will not be as prevalent. Therefore, advisors will be interested in replacing much of their evaporated estate tax planning market with other opportunities and sources of revenue. The business planning market is a logical choice. This article delves into basic buy-sell arrangements and how advisors might educate clients about the advantages of creating buy-sell arrangements funded with life insurance.

Motivating the business owner

Start a conversation with the business owner about buy-sell planning with a thorough fact-gathering process. Basic facts include number of owners, ages, ownership percentages, type of business and the fair market value of the business. This process provides an excellent opportunity to showcase your expertise and motivate the client to take action.

Ask the business owner to consider different scenarios regarding business continuation. Typical questions to ask include:

If one of your owners died, would you like to be in business with the deceased owner's family?
If you died, would you want the wellbeing of your family to be dependent on your surviving owners' continued success in the business?

Most of the time, the answers to these questions will be an emphatic "No." A good follow-up question is, "Would you like to see how we could solve these issues with a funded buy-sell agreement?" The next step is outlining the business owners' options and organizing the information so an informed decision can be readily made.

Basic buy-sell arrangements

There are two basic forms of buy-sell arrangements: the cross-purchase and the stock/entity redemption. Both are legal agreements between the business owners or the business itself. The agreement specifies all material provisions of a buyout and, most importantly, obligates the deceased owner's estate to sell its business interest to the other owners or business.

The buy-sell arrangement should cover events such as death, retirement, disability, divorce or a lifetime sale of stock.

Any buy-sell agreement should be coordinated with all of the owners' estate planning documents and vice versa. The impact of estate taxes should also be considered regarding the ownership of any life insurance policies. This analysis is easier and less likely to affect clients because of the higher estate and gift tax exemption amounts.

Cross-purchase arrangements

A cross-purchase arrangement is an agreement among the owners. Each agrees to buy a deceased owner's share of the business upon a certain event, such as death. The deceased owner's estate agrees to sell that share of the business to the other owners. The purchase of the deceased owner's business interest raises the surviving owners' income-tax basis in the business. Therefore, if the business is sold after the buy-sell transaction is complete, the selling owner will pay less in capital gains taxes.

The cross-purchase arrangement is easy to fund with two owners. Each owns a life insurance policy on the other. If they are of similar age and health status, the premiums are also similar. If one of the owners is older, smokes or is in bad health, the premiums the healthy owner would pay could be substantially higher. This may be a point of resistance and a signal to explore a stock or entity redemption arrangement, covered later in this article.

If there are more than two owners, funding the arrangement becomes more complicated. Because each owner funds policies on the others, the number of policies could increase exponentially, which can be a disadvantage. For example, if there are four owners, a total of 12 policies will need to be purchased.

If an owner retires, he or she will want to have the right to take possession of the policy under which he or she is insured. For two owners, they would simply exchange the policies and make up any difference in the value with cash or other property. Any financial gain from this transaction is taxable.

Stock/entity redemption arrangements

A stock/entity redemption is an agreement between the business itself and each of the owners. The business agrees to redeem or buy a deceased owner's share of the business, and the deceased owner's estate agrees to sell that share of the business to the business. Under this arrangement, the purchasing owners' income-tax basis in the business is not increased. This is an important difference from the cross-purchase arrangement.

Funding the stock/entity redemption arrangement is also different. The business owns — and is the beneficiary of — life insurance policies on each of the owners. If there are more than two owners, this type of arrangement may be more attractive because it doesn't require as many life insurance policies. If there are four owners, only four life insurance policies need to be purchased.

If an owner retires, he or she will want to have the right to take possession of the policy under which he or she is insured. This transaction is a taxable event, and any gain is recognized by the entity or flows through to the owners. For a C-corporation, the distribution of the policy is also a taxable event for the departing shareholder. It is important to realize that, for a C-corporation, the corporate alternative minimum tax may apply to any cash value accumulation and to any death benefit paid into the corporation.

In this type of arrangement, it is critical to comply with Internal Revenue Code Section 101(j), which requires a written and signed notice and consent form for employer-owned life insurance. This code section does not apply to a cross-purchase arrangement.

With the estate and gift tax exemptions at all-time highs, the volume of estate tax planning cases has decreased. Advisors will want to expand and supplement their practices with planning for business owners. The buy-sell strategy is a great technique to start with and may lead to other sales, such as key person insurance, executive compensation and personal planning for the business owners.

For more on business planning, see:

Exit planning: All questions answered

Talking buy-sell reviews

Business Continuation Planning: Simple Solutions Sell