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Solutions to these common problems often come in the form of a buy-sell arrangement. This article will review the various forms of buy-sell agreements and illustrate how you, the producer, can use buy-sells to customize planning to the business owner's individual circumstances. In discussing these arrangements, we will assume that the operating entity is a C corporation; however, the buy-sell concepts work similarly for other operating entities.
Types of Buy-Sell Arrangements
There are four primary forms of buy-sell arrangements: cross purchase, stock redemption, wait-and-see, and partnership buy-sell. Buy-sell arrangements consist of a legal agreement between multiple business owners and/or the business entity to buy and sell a proportionate share of stock upon certain events.
The plan might cover events such as death, retirement, disability, divorce, or a stockholder who wishes to sell stock. Typically, death is always a covered event, but the business owner should consider additional events. Identifying those key events, such as "take care of my family in the event of death," or "accumulate funds to supplement retirement," can give you a good indication as to the type of buy-sell arrangement needed.
Cross Purchase Arrangement
Although an attorney drafts the actual cross purchase document, you should determine the best way to plan for the events specified in the agreement. For instance, to plan for the obligation to buy stock in the event of a death, we recommend that each stockholder own a life insurance policy on the other stockholder(s). Each stockholder pays the premiums on the policy owned on the other stockholder(s) and is the beneficiary of the life insurance.
When a stockholder dies, the cross purchase arrangement requires the surviving stockholders to purchase stock directly from the stockholder's estate. The surviving stockholders usually purchase a pro rata share of the deceased stockholder's stock.
If there are more than two stockholders, the cross purchase arrangement becomes more complicated because each stockholder must own a life insurance policy on the others. For example, if there are four stockholders, they will need to buy 12 policies. If an age or health disparity exists between the stockholders, the "healthier or younger" stockholder(s) pays higher premiums on the policy that insures the "less healthy or older" stockholder(s). This is often an unattractive but unavoidable result in some cross purchase agreements.
When any event specified in the cross purchase agreement occurs, stockholders purchase stock directly from the liquidating stockholder, which creates an increased "cost basis" for income tax purposes. If the purchasing stockholders subsequently sell the stock, the increased tax basis decreases the amount subject to income taxes.
If a stockholder retires, he or she may want to take possession of the policy under which he or she is insured. For two co-owners, they simply "exchange" policies and make up any difference in the value with cash or other property. This transaction is a taxable event and any gain will be taxable.
We have had several cases in which the cross purchase arrangement was effective. An ideal case involved two business owners who were both close to retirement. The simple cross purchase was successful because there were only two stockholders, so only two policies were needed. Also, since the two co-owners would retire in about six years, there was no time to accumulate gain in the policies. Therefore, when the policies were "uncrossed," no gain needed to be recognized.
Stock Redemption Arrangement
Under a stock redemption agreement, the corporation, rather than the stockholders, owns life insurance policies on each of the stockholders. It pays the premiums and is the beneficiary. The arrangement requires the corporation to redeem the stock of a decedent stockholder.
If there are more than two stockholders, the stock redemption is more convenient than the cross purchase. The corporation owns only one policy on each stockholder. If an age or health disparity exists between the stockholders, the stockholders each bear a more equitable, proportionate (or pro rata in relation to ownership percentage) cost for the premiums paid.
If any events specified in the stock redemption agreement take place, the corporation, not the stockholders, redeems the stock. The remaining stockholders do not receive an increased "cost basis" for income tax purposes, as they do under a cross purchase arrangement. This is one of the negative aspects of stock redemption plans.
Also, a retiring stockholder may have the right to take possession of the policy under which he or she is insured as compensation or as a distribution. This transaction is a taxable event for the C-corporation. Therefore, if there is a gain in the policy, that gain will be taxable to the C-corporation. The distribution of the policy is also a taxable event to the departing stockholder.
The stock redemption arrangement usually works best when there are more than two stockholders and the business owners stress simplicity or have a short timeline to retirement.
Wait-and-See Arrangement
The wait-and-see arrangement allows the stockholders to choose either a stock redemption or cross purchase at the time an event occurs. The corporation is given an option to purchase some or all of a stockholder's stock upon the occurrence of a specified event. If the corporation exercises its option in the event of a death, the surviving stockholder(s) use the life insurance proceeds to loan cash to the corporation. Any stock remaining after the corporation has exercised its option must be purchased by the remaining stockholder(s). However, the shareholders or corporation do not avoid taxation on gain in the life insurance policy if it is transferred to a departing stockholder.
The wait-and-see arrangement allows the stockholders to determine if an increase in cost basis for income tax purposes is attractive. If it is, the owners can do a direct cross purchase type transaction instead of a stock redemption.
On the other hand, they may prefer to do a stock redemption to reduce the undistributed earnings and profits in the corporation, which are subject to dividend treatment when distributed. The stock redemption, rather than a direct cross purchase, will reduce the departing stockholder's pro rata share of earnings and profits, and therefore also reduce future dividend income.
Partnership Buy-Sell Arrangement
The partnership buy-sell arrangement combines the advantages of both the cross purchase and stock redemption. It retains the wait-and-see option and the ability to avoid a disparate premium burden on certain stockholders. Additionally, the partnership buy-sell arrangement can avoid the income tax recognition upon distribution of the life insurance policy, which is a disadvantage for the previously discussed buy-sell arrangements.
We encountered a situation in which there were more than two owners, good cash flow, and nonqualified benefit plans in place for the key non-owner executives. The owners needed planning for buy-sell events but also wanted to supplement their current retirement planning. This was an opportunity to "kill two birds with one stone."
In conjunction with taking care of the buy-sell objectives, the permanent life insurance was used as an accumulation vehicle for retirement. The policies were strongly funded to maximize the tax deferred growth in the life insurance. The stockholders had at least 10 years until retirement, so there was time to let the tax deferral work.
A powerful selling point for the partnership buy-sell arrangement is that it allows the tax deferral to continue at retirement when the policy is distributed to the departing stockholder. The partnership taxation rules allow for the partner to take the income tax basis that is attributed to the partnership upon the distribution of "property." After the distribution, the stockholder can then take tax-preferred withdrawals and loans from the life insurance to supplement retirement income.
The partnership buy-sell arrangement requires both a partnership agreement and a buy-sell agreement. The partnership must comply with the requirement that a "business purpose" exists so that the partnership is valid. The stockholders of the C corporation are also partners in the buy-sell partnership. The stockholders' ownership percentage of the partnership usually mirrors the same ownership interest of the C corporation. However, the partnership ownership percentage may deviate if necessary.
The buy-sell agreement, which may be incorporated into the partnership agreement, controls the transfer of shares of the corporation upon the occurrence of a buy-sell event. The parties to the agreement are the corporation itself and each shareholder. The agreement restricts the transfer of stock in the corporation and requires a restrictive legend on the share certificates.
The partnership owns life insurance on each stockholder or partner, which avoids the use of multiple policies for each stockholder. It pays the premiums and is the beneficiary. Permanent life insurance must be used to support the profit and business motive. When an owner dies, the partnership receives the death benefit and incorporates the advantageous "wait-and-see" option described earlier. The surviving stockholders or partners retain the option to purchase stock directly from the deceased stockholder's estate or make a contribution or a loan to the corporation and have the corporation redeem the stock.
If the stockholders have a short time to retirement or modest cash flow, a stock redemption, cross purchase, or wait-and-see may be a better choice for simplicity. If three or more stockholders are involved, however, and each has more than 10 years to retirement, and the life insurance can be strongly funded, the partnership buy-sell arrangement may give the business owners the most comprehensive and beneficial approach.
Buy-sell agreements take many forms and give business owners many choices for structuring a well-planned transition in ownership. Such transitions are inevitable, but the failure to plan doesn't have to be. Financial professionals have an arsenal of products and techniques to help business owners and generate great sales results. Ryan Matiyak is an adviser with Omni Financial Services in Tampa, Fla. He works in the business continuation and executive compensation markets. Mr. Matiyak has worked in the insurance and financial planning industry for six years and is currently working on his ChFC designation.
Michael Orecchio also is an adviser with Omni Financial Services in Tampa. He works exclusively in business markets. Mr. Orecchio graduated from the University of Florida and has worked in the insurance and financial planning industry for six years.
William Stark, JD, LLM, CLU, is senior advanced marketing counsel at Securian Financial Group in St. Paul, Minn. He has worked in the insurance industry for 10 years. Prior to joining Securian, Mr. Stark worked for Lincoln Financial Advisors as the regional director of financial planning. He received his LLM in Taxation and his JD from William Mitchell College of Law.
