N—Entity Purchase Agreement

The entity purchase agreement is another means of providing for the complete disposition of a business interest. Under such an arrangement the contract is with the business rather than with the other owners.

DURING LIFETIME. To illustrate how it works, assume that we have a corporation that is owned equally by A and B. They would each enter into an agreement with the business for the purchase and sale of their respective interests. Typically, this agreement is binding, in that it obligates both A and B, and their estates, to sell, and the business to buy, upon the death, disability or retirement of either one of them.

Rather than relying on its ability to accumulate or borrow sufficient funds to meet its obligations to purchase these interests, the business obtains separate life insurance contracts insuring A and B. The business pays the premiums and is owner and beneficiary of the contracts. In this manner, the business pre-funds its obligations with life insurance. With the use of life insurance to fund an entity purchase agreement the business is in effect amortizing the cost of the purchase over the lifetime of the insured.

Connelly v. United States, No. 21-3683 (8th Cir. 2023) is a troubling case for entity buy-sell arrangements funded with life insurance. Contrary to what most planning professionals thought was well-established law, the IRS and court included the value of business owned life insurance used to fund the buy-sell obligation in the value of the business which resulted in a substantial underpayment of estate taxes. In 2024, the U.S. Supreme Court ruled that life insurance proceeds purchased on the life of a shareholder did increase the corporation’s value for estate tax purposes (Connelly v. United States, No. 23-246, 602 U.S. ___ (June 6, 2024). Many businesses may wish to reevaluate their agreements and even consider cross-purchase agreements and alternative funding solutions.

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UPON DEATH. Should A die first, his stock interest passes to his family or estate. At the same time, the insurance company pays a potentially tax-free death benefit to the business as beneficiary of the contract insuring A’s life.

Pursuant to the agreement, in return for cash, A’s family, or estate, will then transfer A’s entire interest to the business. In this way a fully funded agreement guarantees that the surviving family will receive a fair price for A’s interest. If A’s estate is subject to estate taxes, the agreement can also serve to help “peg,” or establish, the value of the stock for estate tax purposes, thereby avoiding the extensive negotiations and potential litigation with the Internal Revenue Service that may occur when valuation is left to chance.

The biggest draw-back of an entity purchase agreement is that the cost basis in B’s interest is not increased by the purchase price paid by the business. Given the importance of income tax planning; the cross-purchase arrangement discussed in the following sections is usually more tax efficient.