A technical guide to business continuation planning

Transcription

1 For the Closely Held Business Owner The Transfer of a Business Interest A technical guide to business continuation planning

2 On the Cover GUIDANCE AND DIRECTION We provide solutions to help guide your future direction

3 Table of Contents Page Business Continuation Planning: The Transfer of a Business Interest...2 Advantages of a Buy-Sell Agreement...4 Stock Redemption/Entity Buy-Sell Plan...6 Cross Purchase Buy-Sell Plan...8 Stock Redemption vs. Cross Purchase...10 The Problems of Attribution in a Stock Redemption Plan...13 The Use of a Trustee in a Buy-Sell Plan...15 Different Ways to Fund a Buy-Out...17 Self-Funding a Buy-Out...18 Borrowing the Buy-Out Price...20 Insuring the Buy-Out...22 Unforeseen Problems in an Unfunded Buy-Sell Plan...24 Other Considerations in Funding Buy-Sell Plans...25 Section 303 Redemption...27 Tax Facts in Buy-Sell Planning...28 Disability Buy-Out...31 Buy-Out Provisions for Other Life Events...32 The foregoing information regarding business and/or estate planning techniques is not intended to be tax, legal or investment advice and is provided for general educational purposes only. Neither Guardian, nor its subsidiaries, agents or employees provide tax or legal advice. You should consult with your tax and legal advisor regarding your individual situation. 1

4 Business Continuation Planning The Transfer of a Business Interest A buy-sell agreement is a contract for persons engaged in a business. Buy-sell agreements are generally entered into between shareholders of a corporation, partners of a partnership, members of a limited liability company (LLC), or among any of them (or a sole proprietor) and a key employee or acceptable outside buyer. It can also be between business owners and the business entity itself. The buy-sell agreement ensures that the business interest of either a deceased, disabled or departing owner is effectively transferred to the company or co-owner(s) in accordance with predetermined, mutually agreed upon guidelines. Moreover, it provides a guaranteed market for the sale of the owner s business interest at the time of either his death, disability or departure. By providing a means to sell the deceased owner s business interest, advisors will often refer to the buy-sell agreement as a business person s will. In the absence of a buy-sell agreement, a decedent s business interest passes at death by the terms of his or her will or by the laws of intestacy. This means the surviving owner could become a business partner of the decedent s beneficiaries -- people who may or may not be interested in the business or have the ability and experience to meaningfully contribute to the business. Alternatively, the estate or the beneficiaries could sell the decedent s interest to an outside buyer unknown or unfriendly to the other owners, to raise money to pay transfer taxes, administrative expenses and debts of the decedent. This may result in the surviving owner having unacceptable strangers as co-owners. The possibility of such a sale also assumes such a buyer may be readily found. Generally, it is not easy to find a buyer for a partial interest in a closely held business. 2

5 Business continuation plans address not only needs arising upon the death of an owner, but also resolve those concerns that ensue following an owner s disability. In this instance, a buy-sell agreement can be thought of as a business owner s disaster recovery plan. Business people know that if one of their partners were to become disabled, the effect on the business could be devastating. The healthy partner(s) would be faced with the task of running the business while deciding how long to pay the disabled partner, and from what funding source. In all likelihood, the disabled partner will want to recover the capital he or she has invested in the business. The remaining partner(s) will be challenged to come up with the money to buy the disabled partner s share while keeping the firm in business. The remaining partner(s) must also be concerned with the very real and very worrisome possibility that the disabled owner s spouse or ex-spouse or children will want to participate in running the business. The disability buy-sell agreement solves all these problems by having the disabled party s interest purchased at a predetermined price and at a time agreed to by all the parties. Business continuation plans may also provide for other circumstances, such as the retirement, bankruptcy, divorce or felony conviction of an owner, and other life events. Buy-sell arrangements take many forms. Each has its own legal, tax and financial ramifications. The key is to find the one that best fits the needs of your business and family. 3

6 Advantages of a Buy-Sell Agreement A buy-sell plan can provide numerous advantages to the estate of a deceased business owner, to a retiring or disabled owner, to the remaining or surviving owner(s), and to their families. Some of the important advantages are: 1. Provides continuity of management by requiring the estate or disabled owner to sell the decedent s or disabled owner s interest in the company to the remaining owner(s) of the business. There will be no unexpected or unwanted owners. The business will be operated and managed by the remaining owner(s). 2. Provides the estate of a deceased owner with needed liquidity by converting an illiquid asset to cash. The cash can be used to settle a decedent s estate and establish an income stream to the beneficiaries. In a disability situation, the cash provides a needed source of income to the disabled owner and his or her family. Generally, it is unlikely that an estate or disabled owner could sell an interest in a closely held business on the open market for a fair price. The buy-sell agreement creates a certain market for the business interest at a fair price. 3. Provides a retiring owner a method to convert his business wealth to personal financial wealth, and to fund retirement and legacy goals. 4. Provides a fair and reasonable price for the business. The purchase price, or the mechanism to determine the purchase price, is established by the parties to the agreement during life when conditions and provisions for the buy-sell agreement can be negotiated fairly and reasonably. 4

7 5. Provides a method of pegging the value of a decedent s interest for federal estate tax purposes. Generally, the IRS will accept the buy-out price as the value of the decedent s business interest for federal estate tax purposes if: The agreement is an arm s length transaction; The price is fair and reasonable at the time the agreement is entered into; and The agreement prohibits the parties from selling or giving away the business interest to anyone without first offering the co-owners and/ or business an option to purchase the business interest at a price no higher than the price at death. Note that buy-sell agreements between family members (including siblings) are also subject to the complex rules and regulations created by Chapter 14 of the Internal Revenue Code which was meant to curb perceived abuses in valuations and tax treatment of intra-family transfers of businesses. 5

8 Stock Redemption/Entity Buy-Sell Plan An entity buy-sell plan is a contract between the business and the business owners. The agreement obligates the business entity to purchase from the estate of the deceased owner, or from the retiring or disabled owner, his or her interest at an agreed upon price. Entity buy-sell agreements between corporations and their shareholders are called stock redemption plans. Buy-sell arrangements between partnerships and their partners or LLCs and their members are usually simply called entity buy-sell plans. Most stock redemption and entity buy-sell plans are funded with life insurance issued on the life of each owner. The business is the owner, beneficiary and premium payor of the policy. Premium payments are not tax deductible, but death proceeds are received income tax-free*, subject to the Alternative Minimum Tax ( AMT ) rules for certain C corporations. S corporations are not subject to corporate AMT. Stock redemption and entity buy-sell plans are also funded with disability insurance owned and paid for by the business, which receives the proceeds income tax-free. The business uses the proceeds to buy the disabled owner s or decedent s interest in the business. In the situation of a death of an owner, the estate s basis in the business interest is stepped up to its fair market value on the date of the decedent s death. Thus, if the buy-sell purchase price equals the fair market value of the business interest, no gain is realized and no income tax has to be paid. (Note: Under provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, for the year 2010 only, a full step-up in basis may not be available.) * Life insurance purchased by employers used in conjunction with redemptions and other entity buy-out arrangements must comply with the employer-owned life insurance rules of the Pension Protection Act of 2006 for the death benefit to be received income tax free. 6

9 Corporation (or Partnership, LLC, etc.) Step 1: Buy-Sell Agreement Owner A Owner B Corporation (or Partnership, LLC, etc.) Step 2: Buy Insurance on A and B Insurance Company Step 3: Insurance Proceeds Corporation (or Partnership, LLC, etc.) Step 4: Cash Departing Owner or Estate of Deceased Owner Step 5: Stock Corporation (or Partnership, LLC, etc.) 7

10 Cross Purchase Buy-Sell Plan A cross purchase buy-sell plan is a contract between the owners of a business. Unlike the entity buy-sell or stock redemption, the business itself is not a party to this agreement. The agreement obligates the remaining owner to purchase from the estate of a deceased owner, or from a retiring or disabled owner, his or her business interest at an agreed upon price. Cross purchase arrangements are generally entered into between the shareholders of a corporation, partners in a partnership, or members in an LLC. They can also be between any of these or a sole proprietor and a key employee or acceptable outsider. In the latter situation, the buy-sell agreement is sometimes known as a unilateral buy-sell plan. Life and disability insurance, used to fund a cross purchase agreement, is personally owned by the parties. Each individual is the owner, beneficiary and premium payor of the policy on the life of the co-owner(s). Upon the death, disability or departure of an owner, the remaining co-owner(s) purchases the disabled, deceased or departing owner s business interest from the owner or his or her estate. The remaining owner s basis is increased by the price paid for the business interest. Life insurance cash values may also be available to help pay for the purchase of the business interest of a disabled or retiring owner. 8

11 Owner A Step 1: Buy-Sell Agreement Owner B Owner A Step 2: Purchase Insurance on Each Other Insurance Company Step 3: Insurance Proceeds Owner A Step 4: Pay Buy-Out Price Owner B or his/her Family and Estate Step 5: Transfer Ownership Interest Owner A 9

12 Stock Redemption vs. Cross Purchase XYZ Corporation is owned equally by A and B. Each Shareholder contributed $50,000 to start the business. The company is currently valued at $500,000. A and B want to enter into a buy-sell agreement. They want to know the effect of a cross purchase versus a stock redemption agreement, funded with life insurance, on the company and surviving shareholder. Let s assume A dies. Stock Redemption Cross Purchase Insurance Company Insurance Company Insurance: $250,000 Insurance: $250,000 Corporation Shareholder B Cash: $250,000 Cash: $250,000 Shareholder A s Estate Shareholder A s Estate Stock Stock Corporation Shareholder B Results to Shareholder B Basis: $50,000 FMV: $500,000 Results to Shareholder A s Estate Cash: $250,000 Results to Shareholder B Basis: $300,000 FMV: $500,000 Results to Shareholder A s Estate Cash: $250,000 10

13 In the stock redemption plan, B becomes the sole shareholder of the corporation. A s redeemed shares become treasury stock. B s remaining shares are worth $500,000 the full value of the corporation. B s original basis of $50,000 in his stock has not been affected by the redemption. If B sells his stock during life for $500,000, he realizes a gain of $450,000 and must pay the appropriate tax. In the cross purchase plan, B personally acquires A s stock for $250,000. B owns his original shares of stock and A s stock. His basis in the stock purchased from A s estate is equal to the purchase price of $250,000. Thus the total basis in all of his shares has increased to $300,000. If B sells all his shares for $500,000, he realizes a gain of $200,000. The difference in taxable gain is the savings realized in a cross purchase plan over a stock redemption arrangement. A cross purchase buy-sell arrangement could result in substantial income tax savings for the surviving shareholder. Note that in a stock redemption plan, funded with life insurance, for an S corporation, or entity buy-sell arrangement for a partnership, the remaining shareholder or partner receives a basis increase because of the tax rules relating to pass-throughs of tax-exempt income such as life insurance proceeds. It is even possible that if certain accounting methods are employed, the surviving owner(s) might receive basis increases based on the full amount of the proceeds. See the section in this brochure on Tax Facts in Buy-Sell Planning. 11

14 Other benefits of the funded cross purchase include: 1. No potential attribution issues under IRC 318 (this provision provides that an individual is deemed to own the stock of his or her spouse, parents and lineal descendents, potentially creating adverse tax consequences in stock redemptions). 2. No potential corporate Alternative Minimum Tax issues. 3. Corporate creditors cannot reach the insurance (but creditors of the co-owner who personally owns the insurance may be able to do so). On the other hand, the stock redemption has benefits over the cross purchase plan, including: 1. Plan is more easily implemented and managed if there are many coowners (e.g., four or more co-owners). 2. The life insurance funding of the plan is more easily unwound without adverse tax consequences (i.e., transfer-for-value rules) if the stock redemption plan needs to be terminated as a result of the sale or termination of the business, or retirement of a co-owner. 12

15 The Problems of Attribution in a Stock Redemption Plan One of the primary benefits of a stock redemption plan, when implemented at death, is that the decedent s estate receives the buy-out price for the decedent s share of stock, income tax-free. At death, the value of the decedent s stock is stepped up * to equal the fair market value. The buy-out price determined by the stock redemption should also be the fair market value. Hence, the gain on the sale should be zero. This favorable result would only occur if the redemption qualifies for capital gain treatment as an exchange defined by Section 302(b) of the Internal Revenue Code. In a buy-sell arrangement, the stock redemption is generally designed to qualify as an exchange where (1) there is a complete redemption of all of the stock of the corporation owned by the shareholder; or (2) there is a substantially disproportionate redemption (generally defined as a reduction of 80% or more of the shareholder s equity ownership and voting power). Failure to qualify the redemption as an exchange would result in the redemption being treated as a corporate dividend distribution, not deductible by the corporation, and taxed as ordinary income to the selling shareholder or shareholder s estate. Unfortunately, the favorable tax treatment of a stock redemption plan could be lost, particularly in a family corporation, because of what is known as the attribution rules. The attribution rules are provided for under Section 318 of the Internal Revenue Code. These rules create a fictitious concept that attributes ownership of stock to the seller, even though the stock may be owned by others. Attribution typically occurs by virtue of the relationship between the seller and his or her close family members (i.e., spouse, children, grandchildren and parents), or if the seller is an estate, between the estate and the decedent s beneficiaries. This constructive ownership will prevent the estate from being deemed to be selling all of its stock, since it cannot sell stock it does not actually own, thus failing the complete redemption test that allows the transfer to be treated as a sale. The other shareholders maintain legal ownership of the shares. The attributed stock may also cause the redemption to fail the substantially disproportionate redemption test for similar reasons. * Note that in 2010, for that year only, the federal estate tax is scheduled to be repealed, together with the step-up in basis tax provision. 13

16 Fortunately, there are several ways to avoid attribution problems: Where possible, make sure no beneficiary of the estate is a shareholder in the corporation. Where possible, make sure no spouse, child, grandchild, or parent of the decedent is a shareholder in the corporation. Have the family member file a waiver agreement with the Internal Revenue Service, where permitted. Use a cross purchase buy-sell arrangement. Use a Section 303 Redemption (partial redemption to pay estate taxes and administrative expenses). The attribution rules are extremely complicated tax rules requiring expert advice. They should be carefully analyzed in any stock redemption plan particularly where family members are shareholders. In some situations, attribution can be avoided. In others, it cannot, thereby requiring other plans to be used. 14

17 The Use of a Trustee in a Buy-Sell Plan When a buy-sell agreement is triggered by the death, disability or departure of one of the business owners, the terms of the agreement become enforceable. One way to ensure that the terms of a buy-sell contract will be carried out is to use a trustee. A trustee is an independent party who will act as an intermediary between the disabled or departing owner or deceased owner s estate and the remaining owner(s) and business. The trustee will be the owner and the beneficiary of the life and disability insurance used to fund the agreement, and hold stock or other property in escrow. Upon the death, disability or departure of an owner, the trustee collects the funds to be used in the buy-out. The Trustee pays the disabled or departing owner or deceased owner s estate the purchase price, and transfers the stock or ownership interest to the remaining owner(s) or the business depending upon whether the plan is a cross purchase or stock redemption. The trustee protects the interests of the departing owner or the deceased owner s estate, and the surviving owners. He or she oversees and implements the plan for the benefit of each party to ensure that what was promised in the buy-sell agreement is actually delivered. A trusteed buy-sell arrangement can be used for an entity buy-out but it is most often used when a cross purchase arrangement is desirable but there are many owners and the number of insurance policies required to fund the arrangement makes the cross purchase too complex. This arrangement, however, does not avoid the usual consequences, including taxation of the premiums to the policy owners if the policies are not personally funded, and the inability of the business to book the insurance policies as assets. 15

18 A trustee can be a financial institution or individual but is typically a trusted neutral employee, accountant or attorney. Financial institutions, lawyers, accountants or other individuals may charge fees for their services as trustee. Insurance Company Insurance: $250,000 Trustee Cash: $250,000 Departing Owner or Estate of Deceased Owner Business Interest Business OR Surviving Owner Trustee 16

19 Different Ways to Fund a Buy Out Once the owners of a business agree on the need for a buy-sell agreement, they should explore the different ways to fund the plan. Most businesses fund a buy-sell plan in one of four ways. First, a business can set aside cash from earnings and create its own savings plan, called a sinking fund. This plan is viable if the business owner lives a reasonably long time, or stays with the company long enough for the company to accumulate the purchase price, assuming it can afford to make the contributions. If, however, the sinking fund is diverted for research, development and other business growth activities -- typically desirable business activities -- that will defeat the buy-sell funding. Hence, this is rarely used as the primary source of buy-sell funding. A second way to fund a buy-sell plan is to borrow the money. This approach depends upon the interest rate to be charged, the ability of the business to borrow and its ability to repay the loan. Repayment of the loan will be a drag on business cash flow and credit availability may be further restricted as a result of the death or departure of an owner. A third way is for the business to pay the purchase price over an installment period, starting when the buy-out is triggered. This plan is similar to borrowing the purchase price, except that the departing owner or estate of the deceased owner is acting as the lender. This delays the receipt and enjoyment of the buy-out price by the departing owner or the deceased owner s estate. The departing owner or the deceased owner s estate is now also subject to the abilities of the remaining owners to maintain and grow revenue and profits, and the increased risks to the success and viability of the business created by time and unforeseen events. The last way to fund the buy-out is through life and disability insurance. This technique requires the purchase of life and disability insurance on the lives of the owners. Generally, this funding provides the cash at the exact time when it is needed, when a business owner dies or becomes disabled. If permanent life insurance is used, the cash values may also be accessed for other purposes, including funding a buy-out due to the disability or retirement of an owner. A comparison of these various plans is shown on the next several pages. 17

20 Self-Funding a Buy Out To accumulate money for a buy out, a business can create its own savings plan, called a sinking fund. Cash from earnings can be set aside each year and earmarked for a sinking fund. The chart below demonstrates the true cost of a sinking fund. Let s assume a business owner s interest in a business is worth $500,000 today and will grow modestly as shown in Column 2. Column 3 shows the annual contributions that must be made after taxes to accumulate the buy-out price, assuming 8% interest after-tax can be earned on the funds. For example, if the buy-out price is $580,484 and will occur in 15 years, starting today the company must annually contribute $19,796 after-tax to its sinking fund. Column 4 is the cumulative total of the annual sinking fund contributions. Column 5 shows the amount the business must earn to make the contribution to the sinking fund if it is in a 34% income tax bracket. Column 6 is the cumulative total of the earnings required to have made all of the contributions to the sinking fund (before taxes) Business Value Annual A/T Contrib. Cumulative Contrib. Annual Earnings Required Cumulative Earnings Today $500,000 $500,000 $500,000 $757,576 $757,576 5 Years 525,505 82, , , , Years 552,311 35, ,020 53, , Years 580,484 19, ,940 29, , Years 610,095 12, ,900 18, , Years 641,216 8, ,050 12, ,652 18

21 Starting today, could the business or business owners afford to make these contributions every year? Are the business or business owners disciplined enough to consistently save the required amount? Are the business or business owners disciplined enough to not withdraw from the sinking fund for other business purposes? What happens if an owner dies tomorrow, or in 5 years? There will not be enough time to save the money through relatively small annual deposits. 19

22 Borrowing the Buy-Out Price Instead of creating a sinking fund to accumulate funds for a buy-out, a business can borrow money from a bank or other lending institution. The chart below shows the cost of borrowing the buy-out price. Let s assume a business owner s interest in the company is worth $500,000 today and will grow modestly as shown in Column 2. Column 3 is the repayment schedule when the buy-out price is borrowed and repaid over a 10-year installment period at 7% interest Repayment Schedule* Date of Price of Buy Out Buy Out Monthly Yearly Total Today $500,000 $5,805 $71,188 $711,887 5 Years 525,505 6,101 74, , Years 552,311 6,413 78, , Years 580,484 6,739 82, , Years 610,095 7,084 86, , Years 641,216 7,445 91, ,947 * Deduction for the interest paid on the loan not shown. 20

23 Even if the business has the credit to borrow the purchase price, could it afford to make the payments? What guarantee is there that the business (or surviving business owners) can get a loan? What will the cost of the loan be - 4% interest, 8%, 12%? Technically, an installment sale of the business comes under the topic of borrowing. The only difference is that rather than borrowing from a bank or third party the seller is financing the purchase price. Payments to be paid to the seller would be contingent upon the ability of the business or business owners to continue making the required payments plus interest. The installment method is usually the choice of last resort for the business or business owners who do not adequately plan. 21

24 Insuring the Buy-Out The most efficient way for a business to accumulate funds for a buy-out is through life and disability insurance. By insuring the life of the owner(s), the business will have funds available to be used toward purchasing a decedent s or disabled owner s share. While the insured is alive, the increasing cash value of the permanent life insurance policy can be used as a special sinking fund to help fund a buy-out of a retiring owner. The chart below shows the cost of insuring a death-time buy-out on a 40 year old male business owner in preferred health. The value of his stock is worth $500,000 today and will grow modestly as shown in Column 2. The annual premium for the policy is approximately $9,500.* The increasing tax-deferred growth of the cash value is shown in Column 4. Column 5 is the death benefit payable income tax-free to the business. Date of Buy Out Price of Buy Out Total Premiums Paid Total Cash Value* Death Benefits Total* 1 Year $500,000 $9,500 $1,500 $505,000 5 Years 525,505 47,500 31, , Years 552,311 95,000 95, , Years 580, , , , Years 610, , , , Years 641, , , ,000 *This example is hypothetical and for illustrative purposes only. It does not project the actual performance of any life insurance product. Premiums will vary depending upon the insurance carrier, age, medical history, health, and other underwriting factors. 22

25 For the annual premium of $9,500, the business or business owners will have funds available to be used toward the purchase of a decedent s business interest. More importantly, the required funds for the purchase price will be available immediately. There is no time period necessary to accumulate the funds for a death or disability buy-out, as in a savings plan. There is also no uncertainty about being able to obtain a loan from a lender. The increasing cash value of the permanent life insurance policy also provides a source of funds to effect a lifetime buy-out. 23

26 Problems in Installment Plans and Unfunded Buy-Sell Plans By not fully funding the purchase price in a buy-sell agreement, the remaining owner usually is only able to pay the purchase price over an installment period. This delay could cause the remaining owner and the departing owner or deceased owner s estate unanticipated legal and financial problems. Some of these problems are: The death or departure of a business owner and the cost of his or her replacement may affect earnings, making it impossible for the company or remaining owner to borrow the purchase price or pay the installment obligation. If the company becomes insolvent before the purchase price is paid, the departing owner or the estate of the deceased owner becomes merely a creditor of the company. If the remaining owner dies before the installment purchase price is paid, his or her estate may be liable for the balance of the payments. The departing owner or the estate of the deceased owner may need money faster than the company or remaining owner is obligated to pay under the installment obligation. There is a contractual legal obligation created by the buy-sell agreement that cannot be fulfilled, potentially leading to litigation. The estate of the deceased owner may not have sufficient liquidity to pay estate taxes owed. A disabled or retiring owner, and his or her family, may have insufficient financial resources to fulfill their needs and to continue living in a reasonable lifestyle. 24

27 Other Considerations in Funding Buy-Sell Plans 1. Ability of the business to accumulate money in a sinking fund The premature death, disability or departure of a business owner may not give the business enough time to accumulate the purchase price. Will the sinking fund be needed for other business uses? Can the business continuously make the required contributions in light of possible future economic conditions? Will interest rates or investment results meet projections or will additional contributions be required? 2. Ability of the business to borrow money Will a bank or other lending institution lend the business all or part of the buy out price? What will the interest rate be in the future - 4%, 8%, 12%, or higher? Can the business make monthly payments of interest and principal after one of the owners is gone? Will the business have to hire a replacement for the owner, and at what cost? 3. Disability of an owner If an owner is disabled, the business or remaining business owners may not be able to continue making the necessary contributions to the sinking fund or to borrow from a bank. 25

28 4. Life and disability insurance The business will have death benefit proceeds and disability buy-out proceeds readily available that will be used to purchase a deceased or disabled owner s business interest at the appropriate time. Premium payments are level. Premium payments may be waived if the insured becomes disabled and if waiver of premium is purchased at additional cost. Life insurance cash values may be used to complete a lifetime sale (although, lifetime use of cash values will reduce the available amount of death benefits). Growth is tax deferred. Death benefits are generally income tax-free (subject to the AMT rules if the policy is owned by certain C corporations, and the employer-owned life insurance rules of the Pension Protection Act of 2006). 26

29 Section 303 Redemption A Section 303 Redemption is a special buy-out plan where the corporation may purchase from the estate of a deceased shareholder an amount of stock equal to the sum of all death taxes (federal and state) and the cost of funeral and administrative expenses. This is particularly useful in effecting partial redemptions or redemptions in a family owned corporation. The purpose of the Section 303 Redemption is to enable an estate to treat the transfer of stock to the corporation as the sale or exchange of a capital asset, resulting in a capital gain, as opposed to a taxable, non-deductible dividend Business Decedent s Estate $$$ No gain should be realized by the estate on the sale because the basis of the stock is stepped up to the value on the date of the decedent s death. (Note: Under provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, for the year 2010 only, a full step-up in basis may not be available.) The proceeds from the sale are intended to be used, but need not be used, for the liquidity needs of the estate. A Section 303 Redemption can enable a family to continue in control of a closely held business because only a portion of the stock is sold back to the corporation, while using corporate dollars to pay estate taxes and expenses. Business Stock* *Stock: Equal in value to the sum of: (a) federal and state death taxes; and (b) funeral and administrative expenses A Section 303 Redemption is only available to an estate possessing a closely held business interest that constitutes more than 35% of the value of the adjusted gross estate. Usually, the most efficient way to guarantee the corporation will have cash to pay for the redeemed stock is through the purchase of life insurance. Generally, the corporation is the owner and beneficiary of a policy on the shareholder s life. Upon death, the corporation receives the proceeds of the policy income tax-free and uses the funds to purchase the stock. 27

30 Tax Facts in Buy-Sell Planning 1. A corporation, shareholder, partnership, partner or employee who is the owner and beneficiary of a life insurance policy used to fund a buy-sell agreement receives the death proceeds of the insurance policy income tax-free. IRC 101(a)(1). The AMT rules may apply to policies owned by and payable to a C corporation, and in any entity buy-out, the rules for employer-owned life insurance must be followed (generally even if the owner is not also an employee). 2. Life insurance premium payments made by a business or individual on a policy used to fund a buy-sell agreement are not deductible. IRC 264(a)(1). 3. The basis of property acquired from a decedent is generally the fair market value of the asset on the date of the decedent s death. IRC (Note: Under provisions of the Economic Growth and Tax Reconciliation Act of 2001, for the year 2010 only, a full step-up in basis may not be available.) 4. A stock redemption is treated as a sale of a capital asset if all of the shares of stock of the selling shareholder are redeemed. IRC 302(b)(3). In a buy-sell agreement implemented at death, an estate may have constructive ownership of the shares of stock owned by a beneficiary of the estate or by the spouse, parents, child or grandchild of the beneficiary. IRC 318(a). The constructive ownership rules are called attribution rules and are extremely complicated. Any stock redemption plan within a family-owned corporation must be carefully planned. A violation of the attribution rules could cause the redemption to be treated as a dividend taxable to the estate. 5. The transfer of a corporate-owned life insurance policy on the life of a shareholder to a co-shareholder of the insured to directly or indirectly fund a buy-sell agreement may subject all or part of the death proceeds of the policy to income tax pursuant to the transfer-for-value rules. IRC 101(a)(2). 28

31 6. A corporation may accumulate funds for a reasonable business purpose without regard to the accumulated earnings tax. IRC 537(a). Case law suggests that the use of life insurance to fund a stock purchase agreement is a legitimate business purpose. Emeloid Co. v. Comm., 189 F.2d 230 (3d Cir. 1951); Mountain State Steel Foundries, Inc. v. Comm., 284 F.2d 737 (4th Cir. 1960); and Sanders v. Fox, 253 F.2d 855 (10th Cir. 1958). 7. S corporations are not subject to corporate AMT. In addition, although stock redemptions, as a result of death, generally do not result in an increase in basis for remaining shareholders, tax-exempt proceeds received by a pass-through entity such as an S Corporation or a partnership, give each co-owner a pro rata increase in basis. Since life insurance proceeds are tax exempt, the receipt of the death benefit would give each shareholder a proportionate increase in basis. For example: if an S corporation has 3 equal shareholders and receives a $3 million death benefit, each would receive a $1 million basis increase. But, in the situation involving the death of a shareholder, since the estate of the deceased shareholder gets a step-up under the normal rule for inherited property, his or her share of the passthrough would be wasted. Some practitioners suggest that the full $3 million could be a basis increase for only the surviving S corporation shareholders if the corporation uses the cash basis accounting method, which most do, and the corporation chooses to elect an accounting technique referred to as terminating the tax year. This is also sometimes referred to as a short tax year or books and records redemption plan. This concept, which should not be acted upon without the advice of counsel, works as follows: Upon the death of a shareholder, the corporation issues a short-term promissory note to the shareholder s estate and then the S corporation elects to close its tax year pursuant to IRC 1377(a)(2), before the insurance is received. The proceeds from the life insurance are then received and booked in the new tax accounting year, when the surviving shareholder(s) are the only shareholders, so their proportionate shares are stepped up by $1.5 million each. 29

32 8. The increasing cash value of a permanent life insurance policy is not subject to income tax until the policy is surrendered and gain is realized. IRC 72(e). 9. A buy-sell agreement may peg the value of stock for federal estate tax purposes if the agreement is an arm s length transaction, fixes a price that is adequate and fair at the time that the agreement is entered into, and prohibits the shareholder from selling the stock during life or at death to anyone other than the contracting parties at the specified price. Reg (h). Buy-sell agreements between family members (including siblings) should thus be very wary of this rule. 10. The Pension Protection Act of 2006 enacted rules relating to life insurance policies owned by businesses on the lives of employees (defined very broadly in the law), that are issued after August 17, For life insurance death benefits to be income tax-free to the business, the employer-owned life insurance rules of IRC 101(j) and 6039I must be met. There are four general requirements: (1) notice must be given to the insured, and his or her consent obtained; (2) either the insured must fit into certain categories, or the proceeds must be used for certain purposes (e.g., business continuation planning); (3) there must be record-keeping; and (4) reporting to the IRS concerning these policies. IRS reporting is done on IRS Form

33 Disability Buy-Out If your buy-sell agreement does not address a buy-out in the event of the disability of an owner, a long-term disability could spell financial ruin for you and your business. In such a case there would be no provision for the purchase of a disabled owner s interest, or for maximum salary continuation payments. A disability buy-out provision can help guarantee: the purchase of a disabled owner s interest; continued payment of his or her salary; and management continuity through the remaining owner s control. The absence of a disability buy-out provision in a buy-sell agreement could mean: that it was overlooked by business planners; or there was an unfamiliarity with the concept of the disability buy-out; or the owners felt that the cash required would not be available when needed to fund the agreement. A complete buy-sell agreement should include a disability buy-out provision and provide for its funding through Disability Buy-Out insurance. Provisions in the buy-sell agreement concerning the definition of disability should be carefully coordinated with the disability buy-out insurance that will fund the agreement. Consideration should also be given to business overhead insurance should an owner/employee become disabled. 31

34 Buy-Out Provisions for Other Life Events Most buy-sell agreements provide for a buy-out upon the death or permanent disability of an owner. However, these are not the only life events that should be considered in a buy-sell agreement. Other events that may trigger a buy-out include: voluntary retirement of an owner personal bankruptcy of an owner felony conviction of an owner force-out of an owner for cause divorce of an owner loss of professional license So, although it is important to address the possibility of the death or disability of an owner, you must consider the impact of other circumstances. Any of these other life events can just as easily and adversely impact the future of the business as a death or disability. 32

35 About Guardian Our company serves individuals, businesses, and their employees through our products and services, expert advice and vision. The financial solutions we provide are backed by our company s solid reputation and focus on the long term. When choosing a financial provider, it s important to look to the history and core values that form a company s foundation. Since 1860, Guardian has been committed to protecting clients so they can enjoy the freedom from worry and uncertainty, and capitalize on the freedom to live life to its fullest. The relationships we forge are guided by the values that govern all the decisions we make: we do the right thing, people count, and we hold ourselves to very high standards. At Guardian, we take great pride in providing solutions to help businesses and individuals build their financial security and protect what they value most. It is our privilege to serve you. Image 2009 The Vigeland Museum/ Artists Rights Society (ARS), New York/BONO, Oslo

36 Pub 3666 (03/09) The Guardian Life Insurance Company of America 7 Hanover Square New York, NY