Business Continuation Planning in depth

Transcription

1 Business Continuation Planning in depth

2 Barbara A. Bombaci Director Advanced Planning Division The Northwestern Mutual Life Insurance Co. B.A., Cardinal Stritch University, 1980 J.D., University of Minnesota Law School, 1987 C.L.U., American College, 2003 CFP, Certified Financial Planner Board of Standards, Inc., 2005 Barbara joined the Advanced Planning Division in November Barbara has been a contributor to various Northwestern Mutual schools, seminars and publications. In addition, Barbara has presented numerous seminars for estate planning councils, planned giving organizations and charitable organizations on the topics of estate planning, charitable giving, business planning and executive benefits. Before joining the Advanced Planning Division, Barbara was a shareholder of a large Midwestern law firm and worked with them for more than 15 years; her practice areas included estate planning, income, gift and estate taxation, marital property planning and probate and trust administration. Barbara is admitted to the Wisconsin and Minnesota bars. She is also admitted to practice before the U.S. Tax Court and the Federal District Courts for the Western and Eastern District of Wisconsin and the District of Minnesota. She is a member of the Wisconsin and Milwaukee Bar Associations. She is chairperson of the Professional Marketing Committee for the Planned Giving Council of Children s Hospital Foundation and past president of the Milwaukee Estate Planning Council. This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was compiled by The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education and/or promotional purposes of Northwestern Mutual Financial Network Representatives and advisors with whom they work. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions. ---To comply with Circular 230 Copyright 2007 by The Northwestern Mutual Life Insurance Company, Milwaukee, Wisconsin

3 TABLE OF CONTENTS I. INTRODUCTION...1 II. BEGINNING THE PROCESS...1 A. Can the business be transferred?...1 B. To whom should the business be transferred?...1 C. When should the business be transferred?...2 D. How should the business be transferred?...2 III. TRANSFERS DURING LIFE...2 A. Sales of Business Interests Lump Sum Sale Installment Sale Percentage of Profits Employee Stock Ownership Plan Private Annuity Self Canceling Installment Note ( SCIN )...5 B. Gifts of Business Interests Discounted Giving Sophisticated Gifting Techniques...6 a. Grantor Retained Annuity Trust ( GRAT )...6 b. Charitable Remainder Trust ( CRT )...7 c. Charitable Lead Trust ( CLT )...8 IV. TRANSFERS AT DEATH...9 A. Ownership Mix Considerations...9 B. Skill and Expertise Considerations...9 C. Estate Tax Considerations...11 V. TYPES OF BUY-SELL AGREEMENTS...12 A. Cross Purchase...12 B. Entity Purchase...12 C. Unilateral Buy-Out...12 D. Wait and See Buy-Sell...12 E. Hybrid Buy-Sell...13 F. Escrowed Buy-Sell...13 VI. FACTORS TO CONSIDER WITH BUY-SELL AGREEMENTS...14 A. Shifting Control...14 B. Basis Importance of Basis Basis of Surviving Owners with Cross Purchase Arrangement Basis of Surviving Owners with Entity Purchase Arrangement...16 a. C Corporation...16

4 b. S Corporation...16 c. Partnerships and LLCs...17 C. Tax Effects to Selling Estate Year Partnerships S Corporation Entity Purchase...20 a. Distribution from Post-1982 S Corporation...20 b. Distribution from Pre-1983 S Corporation or Prior C Corporation C Corporation Entity Purchase Attribution A Tax Trap...22 a. Family and Entity Attribution...22 i. Family...23 ii. Partnership...23 iii. Estate...23 iv. Trust...25 v. Corporation...25 b. Waiver of Family Attribution Section 303 Redemption...27 D. Funding Existing Funds Borrowed Funds Sinking Fund Cash Flow Immediate Annuity with Installment Note Insurance...29 E. Funding with Life Insurance Generally Number of Policies Needed...31 a. Entity Purchase...31 b. Cross Purchase...31 c. Escrowed Cross Purchase Premium Payment Availability of Cash Values Creditors Psychological Factors Alternative Minimum Tax ( AMT ) Surplus and Profits Transfer for Value Life Insurance Ownership Considerations...38 a. Entity and Cross Purchase Arrangements...38 b. Escrow Agreement...38 c. Trust Owned Policies...39 d. Joint Ownership...39 e Partnership Arrangement...40 f. Endorsement Split Dollar...40 ii

5 g. Personal Ownership...41 h. Profit Sharing Plan...43 i. ESOP...44 VII. VALUE OF THE BUSINESS...45 A. Three Main Approaches to Valuation Cost or Book Value Approach Income Approach Market Approach...46 B. Discounts Control Issues...47 a. Controlling Interest...47 b. Minority Interest Lack of Marketability Other Discounts...48 C. Buy-Sell Price and Estate Tax Value of Business Setting the Price Estate Tax Value...49 a. Binding Buy-Sell Price Historical...49 b. Section Impact of the Death Benefit on the Value of the Business...50 D. Professional Service Businesses...51 VIII. DISABILITY BUY-OUT...53 A. Basis and Tax Effects Upon Sale...53 B. Coordination of Agreement and Policies...55 IX. COMMUNITY PROPERTY CONSIDERATIONS...57 X. TERMINATING THE BUY-SELL PLAN...58 A. Sale by Business...58 B. Transfer from Business Transfer from Partnership or LLC Transfer from C Corporation Transfer from S Corporation...60 C. Exchanging Cross-Owned Policies...61 XI. RESTRUCTURING A BUY-SELL PLAN...63 A. Changing from Entity Purchase to Cross Purchase...63 B. Changing from Cross Purchase to Entity Purchase...64 C. Lifetime Sale...64 D. Insurance Funding Must Be Reviewed...65 E. Pitfalls...65 iii

6 XII. ACCOUNTING ISSUES FAS A. Background...67 B. Buy-Sell Liability...67 C. Effect on Financial Statements...67 D. Practical Effect...69 XIII. CONCLUSION...70 iv

7 THE NORTHWESTERN MUTUAL GUIDE TO BUSINESS CONTINUATION PLANNING I. Introduction Sooner or later, all business owners exit their business. Proper planning can ensure the orderly transfer of the business consistent with the owner s objectives. Lack of planning can result in liquidation, loss of value, loss of a subchapter S election, loss of jobs and bitter personal feelings. This Guide discusses planning for business continuation, focusing on buysell agreements triggered upon death or disability. II. Beginning the Process Every business owner should begin the process of business continuation planning by asking the following questions: A. Can the business be transferred? Some businesses may not be transferable due to the nature of the business or lack of eligible transferees. For example, franchise arrangements are governed by contracts that usually contain specific rules regarding to whom the business owner s interest can be transferred or whether the interest can be transferred at all. If the business is a professional business (i.e., physicians, dentists, accountants, lawyers, architects), only a licensed professional can succeed in ownership. If the service is artistic, like a photography studio or decorating business, it may be so unique that the business cannot be continued by anyone less gifted than the business owner. In addition, the business may be subject to lending agreements that dictate who can run the business while the loan is outstanding. While this does not necessarily make the business nontransferable, the presence of such requirements may limit the options of the business owner. B. To whom should the business be transferred? The business owner s goals govern to whom the business should pass. Potential transferees include one or more of the following: co-owners, spouse, children, grandchildren, third parties, key employees or trusts for family members. When there are multiple owners, it is best to consider who should be the successor owner under different scenarios, making various assumptions regarding the order of the departure of the various owners. EXAMPLE: If a father owns 30 shares of a business, each of his two sons owns 15 shares and an unrelated person owns 40 shares, consider the following:

8 Who should own the father s shares? Right now, father and sons combined control the business. If the two sons own the father s shares, they will, as a block, control the business. Who should own the third party s shares? If father owns these shares, father will then own a majority interest, thereby increasing father s gross estate significantly (a premium-valued majority interest). This may not be a determining factor but should be considered. Who should own the sons shares? If father owns these shares, he will own a majority interest, again increasing father s gross estate. This question is often ignored because it is assumed that the younger generation will survive the older generation. If the surviving son takes the departing son s shares, father and son will still jointly control 60% of the business, but father s interest continues to be a minority one. Sometimes, there may be no appropriate buyer of the business. A sole proprietor may have no family members or employees who are qualified to take over. The sole proprietor may look at a competitor as a potential buyer, but it may be difficult to come to agreement without letting the competitor examine the business operation and review the books. C. When should the business be transferred? Business interests may be transferred during the owner s life, either upon a planned sale or retirement, or upon an unexpected disability. The entire business interest may be transferred all at once, or partial interests may be transferred over time. If not transferred during life, business interests are either liquidated or transferred at the owner s death. D. How should the business be transferred? Business interests may be transferred by gift or by sale in a variety of ways, many of which are set forth below. III. Transfers During Life Business owners may plan to sell or give their business interest away during their lifetime. Typically, owners give a business interest to family members. Sales of business interests are typically made to unrelated people. However, sales can be made to family members; this is usually done where the buyers are not immediate family members (brother, cousin, etc.). Sales can also occur when the owner wishes to pass the business interest to an immediate family member (child) but the value of the business is more than the child s share of the estate. For example, Dad s business is worth $1.5 million and Dad s total estate is $2 2

9 million. Dad has two children, one working in the business and one not. Dad wants each child to receive $1 million. His estate may give $1 million of the business to the child working in the business and have that child purchase the remaining $500,000 of the business interest. Then, Dad s estate will give the $500,000 of the sale proceeds plus the remaining $500,000 of his estate to the child not working in the business. A. Sales of Business Interests Sales of business interests may be accomplished using various methods, such as lump sum sale, installment sale, sale based on a percentage of profits, sale to an employee stock ownership plan, private annuity sale or self canceling installment note. A business owner may sell the business by transferring either the entire ownership interest (i.e., stock, partnership interest, LLC interest) or just the assets of the business. 1. Lump Sum Sale If the seller receives a lump sum of cash and/or property, capital gain is generally recognized in the year of sale to the extent that the sale price exceeds basis. 1 A lump sum sale is only feasible when the buyer has funds (personally owned or through financing) readily available. Sellers of qualifying non-service businesses 2 may be entitled to tax advantages. For example, sellers of qualified small business stock held for more than five years may exclude 50% of the gain. 3 Also, sellers of qualified small business stock may defer recognition of all gain if the proceeds are reinvested in the stock of another qualifying small business within 60 days of the sale Installment Sale If the purchase price is paid in installments over time pursuant to a promissory note, the seller has an option to recognize all capital gain in the year of sale or to recognize capital gain over the time period in which payments are received. If the latter is selected, each payment will consist of return of basis, capital gain and interest on the promissory note. 5 Interest on the promissory note evidencing the installment obligation is received as ordinary income to the seller and will be imputed if an appropriate rate of interest is not stated in the note. 6 The risk with an installment sale is that the business won t generate the cash flow for the buyer to make the payments under the note. If the promissory note is secured, the collateral is usually the business; using the business to insure payments when the 1 IRC To qualify, businesses must be C corporations with gross assets under $50 million and be engaged in active businesses other than services such as law, medicine or accounting. IRC 1202(c). 3 IRC IRC IRC 453. Gain in installment sales can be accelerated if the purchaser is related to the seller and the purchaser subsequently sells the business interest for a lump sum payment. See IRC 453(e). 6 The interest rate must be set at or above the applicable federal rate to avoid income and gift tax consequences. See IRC 483 and

10 buyer is relying on the business revenues to make payments may not provide much, if any, security to the selling business owner. So, an installment sale should be used when the business is stable and will be able to generate the cash flow needed to service the installment payments. 3. Percentage of Profits Interests in certain businesses may be sold based on a percentage of profits for a period of time. Often, this is combined with a fixed purchase price for tangible assets. This strategy is often used with professional organizations where the skill and reputation of the owners constitute the primary value. The buy-sell agreement may call for a lump sum payment for tangible assets, plus installment payments for a period of time based on a percentage of revenue. A portion of each payment is taxed as a capital gain transaction (related to the tangible assets and perhaps goodwill), and a portion will result in ordinary income taxation Employee Stock Ownership Plan A buy-out may be accomplished through an employee stock ownership plan ( ESOP ). The ESOP s objective is to acquire and hold corporate stock and provide retirement benefits for the employees. A corporation adopting an ESOP may make tax deductible contributions of stock and cash to the ESOP. 8 The ESOP is the ready market for the business, purchasing stock from a selling shareholder with the pre-tax cash. A partial ESOP buy-out may be implemented if the ESOP funds are insufficient for a complete buy-out. The selling shareholder may be able to defer all gain on a sale of certain closely-held domestic C corporation stock by reinvesting the proceeds in stocks or bonds of domestic corporations. 9 An ESOP dilutes the remaining shareholders' ownership interests because all employees (not just the remaining shareholders) receive an ownership interest in stock through the ESOP. An ESOP is a sophisticated technique with many issues to consider, and experienced advice should be retained prior to implementation. 5. Private Annuity Private annuities an exchange of an asset for annuity payments made by the buyer for the seller's life have been used with sales of business interest, with the income tax consequences spread over the annuity payments. However, proposed regulations have eliminated the income tax reason for using private annuities. 10 Under the proposed regulations, the sale of an asset for annuity payments is taxed as if the seller received a lump sum of cash (with immediate taxation) and then purchased an 7 See IRC 736, 741 and 751. Also see the discussion on tax effects to the selling estate below at p See IRC 404(a) and 4975(e)(7). 9 IRC 1042; see The Northwestern Mutual Guide to Employee Stock Ownership Plans (F.O , 05/06), pp Prop. Reg (j). 4

11 annuity. The proposed regulations apply to all exchanges after April 18, 2007 (and earlier October 18, 2006 for some exchanges). 6. Self Canceling Installment Note ( SCIN ) In exchange for transferring the business interest, the buyer gives the seller an installment note. The installment note obligates the buyer to make payments to the seller until the first to occur of the end of a stated term or the death of the seller. While the stated term may not be longer than the seller s actuarial lifetime, this feature of a SCIN may protect against continued payment obligations if the seller lives beyond life expectancy. The sales price includes a risk premium to reflect the fact that payments may cease upon a premature death. Each payment received by the seller is divided into three portions for tax purposes: (a) tax-free return of basis, (b) capital gain and (c) ordinary income. 11 Upon the seller's death, all remaining gain must be reported on the income tax return of the seller s estate as income in respect of a decedent. 12 Tthis sale method works well with a business having a good cash flow. No taxable gift occurs at the time of the sale if the present value of the installment note equals the fair market value of the property at the time of transfer. The IRS will characterize any extension beyond life expectancy in generally accepted mortality tables as a disguised gift to the buyer. 13 Assuming the parties bargained for the cancellation feature and the buyer paid a premium for it, nothing should be included in the seller s estate at death. 14 B. Gifts of Business Interests Business owners may desire to keep the business in the family by giving it to family members. For gain purposes, the donee receives a carryover basis, which is the donor s basis. 15 For loss purposes, the donee s basis is the lesser of the donor s basis as of the date of the gift or the fair market value as of the date of the gift. 16 If the donor s basis is more than the fair market value of the gift, the donee will need to track two bases, one for gain purposes and one for loss purposes since gain or loss will not be known until the time of a sale by the donee. The donee s basis is increased for any gift tax paid. 17 The fair market value of a lifetime gift as of the date of the gift is subject to gift tax. 18 Gift tax is paid only if the value of the gift exceeds the donor s available annual 11 IRC 453. The buyer may be able to deduct interest paid with a SCIN. See Gen. Couns. Mem (May 7, 1986). 12 Frane Estate v. Comm r, 998 F. 2d 567 (8 th Cir. 1993). 13 Gen. Couns. Mem (May 7, 1986). 14 See Moss v. Comm r, 74 T.C (1980), acq. in result only, C.B. 2; Buckwalter Estate v. Comm r, 46 T.C. 805 (1966). 15 IRC 1015(a). 16 Id. 17 IRC 1015(d). 18 IRC

12 exclusions, deductions and gift tax exemption. 19 There are several techniques that can be used in appropriate situations to reduce the gift tax value. 1. Discounted Giving Business owners may give away minority interests (50% ownership or less) in any business interest. Because the person who receives the minority interest generally has limited ability to control the business, force distribution of profits, or transfer his ownership interest, a minority discount may be applied to the value of the gift. 20 In addition, there is not usually a ready market for the sale of family-owned businesses; thus, a discount for lack of marketability may also be used Sophisticated Gifting Techniques There are a variety of sophisticated gifting techniques that may result in a discounted gift, but these require the advice of a competent advisor. a. Grantor Retained Annuity Trust ( GRAT ) By using a GRAT, a business owner can transfer a business interest to family members at a reduced gift tax value. The owner transfers the business interest to an irrevocable trust and retains the right to receive annuity payments for a fixed number of years. The annuity amount is a fixed dollar amount or fixed percentage of the initial value of the trust assets. After the trust term expires, the remaining trust property passes to the trust beneficiaries, typically family members. When the trust is created and property is transferred to it, the owner makes a gift to the trust beneficiaries. The value of the gift is the fair market value of the property transferred to the trust less the present value of the retained annuity interest. 22 An IRS-specified rate (the 7520 rate) is used to calculate the present value of the annuity interest. If the grantor dies during the trust term, the amount needed to produce the annuity for the remaining trust term is included in the grantor s gross estate. 23 However, if the grantor survives the trust term, the trust assets are removed from the gross estate. Post-gift appreciation of the business interest escapes gift and estate taxation as well. In this event, the gift tax leverage occurs when the actual investment rate exceeds the 7520 rate used to calculate the payments that must be paid to the grantor. 19 IRC 2503 and See, e.g., Knight v. Comm r, 115 T.C. 506 (2000); Kerr v. Comm r, 113 T.C. 449 (1999). 21 See the discussion on discounts below at p IRC Prop. Reg ; see Notice of Proposed Rulemaking, REG , 72 F.R (June 7, 2007). 6

13 One potential disadvantage exists if the trust assets (the business and any other trust assets) do not generate enough income to make the annuity payments. In that case, a portion of the business may be returned to the business owner as part of the annuity payment. So, it is best to use this strategy with a business with a good cash flow. Pass-through entities fit this description because they are in the habit of making cash distributions to owners, usually to enable them to pay their income tax on the pass-through income. Because the business owner retains an annuity interest in the trust, he is generally treated as the owner for income tax purposes under the grantor trust rules. 24 The grantor is then taxed on all items of income of the trust even if income exceeds the annuity amount paid. Having the grantor pay all income tax on trust income allows the grantor to pass the trust property to the trust beneficiaries without dilution for the payment of income taxes. The grantor s payment of such income taxes is not considered a gift. 25 In addition, a GRAT that is a grantor trust is a permissible holder of S corporation stock as long as the grantor is alive. 26 b. Charitable Remainder Trust ( CRT ) An owner may contribute a business to a CRT, and the trust may then sell the business to a third party. The CRT does not pay tax on the capital gain when the CRT sells the business. The business owner receives annual payments from the CRT for life or for a term of years, after which the assets remaining in the CRT pass to designated charities. Although the CRT is exempt from income taxes, each payment received by the income beneficiary of the CRT may consist of four parts. The first tier is treated as a distribution of current and accumulated ordinary income. 27 If the amount of the payment exceeds this ordinary income, the second tier is the trust s capital gain. The third tier is tax exempt income, followed by the fourth tier of return of basis. So, each distribution may be partially taxable to the income beneficiary as capital gain and/or ordinary income. 28 The transfer to a CRT actually creates two interests. The first interest is retained by the business owner. The second interest is the ultimate distribution of the trust assets to the designated charities. This latter interest qualifies for a charitable deduction, which can be taken on the business owner s income and gift tax returns for the year of the gift. 29 The amount of the deduction is calculated actuarially, based on the value of the contribution to the CRT, the length of the term for the annual payments and the 7520 interest rate. 24 IRC Rev. Rul , I.R.B. 7 (Jul. 6, 2004). 26 IRC 1361(c). 27 Due to the maximum 15% rate applied to qualified dividends, the first tier actually consists of two subtiers: the first is ordinary income and the second is qualified dividends. The 15% rate on qualified dividends is set to expire in IRC 664(b). Think of the tiers as starting from the worst character (ordinary income) to the best character (return of basis). 29 IRC 170 and

14 To accomplish these favorable tax results, the owner must not arrange a sale of the business before establishing the CRT. If there is a prearranged sale, the owner will be taxed as if she had sold the business (triggering capital gain to her) and then contributed the sale proceeds to the CRT. 30 Also, a CRT is not an eligible S corporation shareholder; as a result, contributing S corporation stock to a CRT will terminate the S election. 31 The owner who uses a CRT in his planning is usually charitably inclined. Since the CRT usually sells the business, there is still a need to have a buyer with the funds to buy it. The CRT strategy is simply a wrapper designed to convert the business to a stream of income while deferring capital gain. c. Charitable Lead Trust ( CLT ) By using a CLT, a business owner can transfer business interests to desired beneficiaries at a reduced gift tax value, while benefiting one or more charities along the way. 32 The CLT is appealing to a charitably-minded donor with no need for immediate income from the business. The owner creates a trust and transfers the business interest to the trust for a fixed term of years. During the trust term, an income stream is paid to the charitable organization(s). At the end of the trust term, the remaining trust property passes to the named family members. At the owner s death, the property in the CLT, including any appreciation, is excluded from the owner s estate. When the trust is created and property is transferred to it, the grantor makes two gifts: one to the charity and one to the ultimate beneficiaries of the trust. The value of the charitable interest is the present value of the payments to the charity using the 7520 rate as the discount rate. The value of the charitable interest qualifies as a gift tax charitable deduction. The value of the gift to the ultimate beneficiaries is the fair market value of the property transferred to the trust less the present value of the charitable interest. 33 If the CLT is a grantor trust, 34 the grantor is entitled to a charitable income tax deduction upon the creation of the trust equal to the present value of the income stream going to charity. 35 In that case, the grantor is taxed on all income generated by the trust property and is not entitled to an income tax charitable 30 See Grove v. Comm r, 490 F. 2d 241 (2d Cir. 1973); Palmer v. Comm r, 62 T.C. 684 (1974), aff d on another issue, 523 F.2d 1308 (8th Cir. 1975); Rev. Rul , C.B See IRC 1361(c) and 1361(e)(1)(B)(iii). See also Rev. Rul , C.B The private foundation rule relating to excess business holdings applies to CLTs in certain circumstances. IRC This may limit the trust s ability to own closely-held stock. 33 IRC 2522(c). 34 IRC If the business is an S corporation, the CLT must be a grantor trust in order to be a permissible shareholder of S corporation stock. See Priv. Ltr. Ruls (Sept. 13, 1999) and (Mar. 1, 1999). 35 IRC 170(f). 8

15 deduction each year for amounts paid to charity. However, if the CLT is set up as a nongrantor trust, all income is taxed to the trust itself. Also, in contrast to a grantor trust, the grantor is not entitled to an income tax charitable deduction upon the creation of the nongrantor CLT, but the trust is generally entitled to an unlimited income tax charitable deduction each year as amounts are paid to charity. 36 The CLT must make annual payments to charity. If the only asset transferred to the trust is an interest in a business, the business must generate income to the trust (i.e., dividend or distribution) in sufficient amounts to make the annual payments. If not, portions of the business interest itself must be distributed to charity. If business interests are distributed, the amount of the business ultimately distributed to the remainder beneficiaries will be reduced. IV. Transfers at Death Regardless of any goals to transfer a business during life, business owners should plan for the possibility of death. A business owner may, either by intention or by default, simply pass a business interest to family members by means of a will, trust or intestacy. This may create difficult issues, some of which are set forth below and may be resolved through the implementation of a buy-sell agreement. A. Ownership Mix Considerations Will the surviving owners appreciate being in business with the family members of the deceased owner, particularly if those family members have not been involved in the business? Most business owners do not relish becoming business owners with a deceased owner s spouse and children. The family could become active in the business, asserting their rights and demanding a role in management whether or not they possess management skills. Absent any transfer restrictions, the family members could transfer the business interest to anyone they choose. These are just examples of the potential problems, which are compounded if the family members are majority owners. B. Skill and Expertise Considerations If the business passes to family members, do they have the skill and expertise to run the business? A business owner may have some children involved in the business and some who are not involved, yet may desire to treat all of the children equally. Or perhaps the owner wishes to treat his children not equally, but fairly, giving the involved children slightly more (usually in terms of the business interest) as an acknowledgment of their contributions to the business. If the noninvolved children receive business interests, 36 IRC 642(c). 9

16 conflict may result. If the noninvolved children receive only non-business assets, the division may not be equitable if the business comprises the majority of the estate. To resolve this dilemma, the business owner can create two classes of stock and transfer voting stock to the children involved in the business and nonvoting stock to the children not involved in the business. (The same may be accomplished with general and limited partnership interests in a limited partnership.) Keep in mind that the involved children are able to take earnings out of the company as compensation but that the noninvolved children are only able to receive earnings as business distributions. If the business has typically reinvested its profits, there may not be any business distributions. The noninvolved children may be better off with non-business assets. The business interest may pass to a spouse. Upon the surviving spouse s subsequent death, the business interest may be transferred to a second spouse or to children from another marriage, which may not be consistent with the objectives of the business owner. To resolve the concerns about a second spouse or children from another marriage, a business interest may pass to a qualified terminable interest property (QTIP) trust on the owner s death. 37 EXAMPLE: Herman wants his son, Eddie, to manage the family business on Herman s death but also knows that his second wife, Lilly, will need the income from the business. Herman can provide that a portion or even all of the business interest pass to a QTIP trust on his death. Lilly will receive income from the trust. Herman also provides that, upon Lilly s death, the trust assets pass to Eddie. There are several resulting advantages - the business interests qualify for the marital deduction, Lilly receives an income stream and Herman directs that Eddie ultimately will receive the business. Alternatively (or in addition), Herman can fund an irrevocable trust with life insurance ( ILIT ). When the ILIT receives the life insurance proceeds at Herman s death, the ILIT buys the business interest from Herman s estate. The estate now has cash to pay taxes and expenses and for Lilly (either outright or in trust, such as a QTIP trust). Also, the ILIT can provide that any income produced by the ILIT (i.e., by the business and any other assets in the ILIT) be distributed to the trust beneficiaries. Unlike the QTIP trust, the ILIT income beneficiaries could include Eddie. Like the QTIP trust, Herman provides that Eddie ultimately receive the trust assets at Lilly s death. This alternative gives Lilly an income stream through the estate and through the ILIT. It allows Herman to direct the disposition of the business and to include Eddie as an income beneficiary. 37 If the business is an S corporation, the QTIP trust must be a qualified subchapter S trust ( QSST ) in order to continue the S election. IRC 1361(c)(2) and (d). The fact that a surviving spouse can cause QTIP assets to be sold needs to be considered, particularly if the business is a C corporation where family attribution rules may come into play; see discussion on family attribution below at p

17 In addition, if structured properly, the insurance proceeds are not included in Herman s estate. Alternatively, and perhaps less prone to conflict, the children involved in the business may purchase the business interest from the estate. For example, the business owner could provide in her will that the involved children have the option to purchase the business interest from the estate. The involved children may own life insurance on their parent s life so they have the funds to buy the business. Perhaps the best solution would be for the business owner to leave the business interest to the involved children and use life insurance to pass an equitable amount of assets to the noninvolved children. Using life insurance with an irrevocable life insurance trust also provides the opportunity to shelter the life insurance proceeds from estate taxes. A further issue arises if children are minors upon death of the owner. As minors, it may be unclear whether the children want to be involved in the business when they grow up, or whether they have the aptitude required. There should be discussion about who should manage the business on behalf of the children until they reach majority. One possibility is for the business owner to create an irrevocable trust funded with a life insurance policy on the owner s life. At the owner s death, the trust can purchase the business interest from the owner s estate, which leaves the business intact; the estate can use the cash from the sale to pay any estate taxes and other expenses. The trust can then hold the business interest for the benefit of the children. The trustee can be given the discretion to make distributions to the children who have an interest and aptitude for the business. If the trust is funded with other assets, the trustee can make equalizing distributions of other assets to children who are not involved in the business. C. Estate Tax Considerations Business interests owned at death are included in the owner s estate. If the business is transferred to a spouse, a marital deduction should be available. If the business is transferred to children, however, estate tax may be due if the value of the business exceeds the estate tax exemption amount. Planning should consider the availability of liquid resources for the payment of any estate taxes and the impact to heirs of a reduced estate, especially if the owner wants to equalize inheritance among children If eligible, payment of estate taxes may be paid from cash in the business by means of a 303 redemption (see discussion below at p. 27) or postponed under IRC

18 V. Types of Buy-Sell Agreements A. Cross Purchase Upon a triggering event (death, disability or retirement of a business owner), the surviving owners will purchase the departing owner s business interest. To provide funds for the purchase upon an owner s death, each owner generally buys a life insurance policy on the other owners. Each owner also may buy a disability buy-out policy on the other owners to assist with the purchase upon an owner s disability. If cash value policies are used for a buy-out upon death, an owner may access the cash value of the policy he owns to help with a purchase upon a co-owner s disability or retirement. B. Entity Purchase Upon a triggering event, the business purchases the departing owner s business interest. The business generally buys life insurance policies or disability buy-out policies on each owner. The entity purchase arrangement consolidates and centralizes buy-sell duties in the business. C. Unilateral Buy-Out Upon the death, disability or retirement of a sole business owner, an individual purchases the business. The potential buyer may be a key employee, family member or competitor. The intended buyer generally buys a life insurance policy or a disability buy-out policy insuring the business owner. This is the typical arrangement used with a sole proprietorship since there is no co-owner to purchase the business. However, this arrangement may be used if there are co-owners but not all co-owners are required to sell their business interest. D. Wait and See Buy-Sell Upon a triggering event, there are three tiers of possible buyers. First, the business has an option to buy all or a portion of the departing owner s business interest. Second, after the business has had the opportunity to buy, the surviving owners have the option to buy any remaining ownership interest. Finally, any interest not purchased by the remaining owners must then be purchased by the business. 39 Insurance or disability buy-out policies can be maintained by either the owners or the business. If the policies are owned by the owners personally and the business chooses to purchase the business interests, the owners can transfer the policies or the life insurance proceeds to the business as either a loan or capital contribution. If the policies are owned by the business and the surviving owners 39 The final obligation to purchase should rest with the corporation to avoid a "deemed" dividend. Rev. Rul , C.B. 42,

19 choose to purchase the business interests, the policies or the life insurance proceeds may be transferred to these owners as a loan, distribution or compensation. 40 E. Hybrid Buy-Sell Upon a triggering event, part of the ownership interest is purchased by the business, and part is purchased by the other owner(s). This may be designed from the outset, or may result from circumstances arising upon the triggering event. For example, three shareholders have a hybrid agreement, which calls for a cross purchase when the first shareholder dies and for an entity purchase when another shareholder dies. When the first shareholder dies, the two remaining shareholders receive the insurance proceeds and use them to buy the deceased shareholder s stock. The deceased shareholder s estate owns policies on the two surviving shareholders. The estate sells these policies to the corporation, which is an exception to the transfer for value rule. When the second shareholder dies, the surviving shareholder receives insurance proceeds and buys a portion of the stock. In addition, the corporation receives insurance proceeds and buys the balance of the deceased shareholder s stock. F. Escrowed Buy-Sell An escrowed buy-sell is also referred to as a "trusteed buy-sell. However, trusteed implies incorrectly a higher fiduciary duty on behalf of the beneficiaries. The term escrowed buy-sell is preferred because the escrow agent is a stakeholder who holds property and delivers it as ordered by the principals when certain conditions are met. For all intents and purposes, an escrowed buy-sell arrangement is a cross purchase arrangement, with the advantage of only requiring one policy on each business owner. The business owners agree to buy and sell their respective business interests under a cross purchase arrangement. The business owners also agree (under either an independent agreement or as part of the cross purchase agreement) to appoint an administrator (escrowee or escrow agent) to perform the centralized function of overseeing and performing any buy-sell duties on behalf of the business owners. The escrow agent is the owner and beneficiary of one policy on the life of each owner. The agent credits each business owner with a pro rata interest in the policies covering the other owners. To avoid inclusion of the death proceeds in an insured's estate, the agreement should specify that an insured will not be credited with any ownership interest in a policy insuring his or her life See discussion on the tax consequences of getting life insurance policies into and out of businesses below at pp. 29 and See Priv. Ltr. Rul (Mar. 20, 1996). 13

20 The owners are responsible for paying the premiums, which can be accomplished by the owners directly paying the insurer, the owners giving funds to the escrow agent to pay the premiums or the business directly paying the payments through a bonus plan. Upon the death or disability of an owner, the escrow agent distributes the collected insurance proceeds to the surviving business owners for their use in personally purchasing the decedent s business interest. The escrow agent may, but need not, hold the business interests. If so, the agent credits each business owner with her own business interest; upon receipt of insurance proceeds, the escrow agent allocates them to the accounts of the surviving owners, which are then used to buy the business interest of the departing owner. The account of each surviving owner is credited with a pro rata share of the purchased business interest. The beauty of this plan is marred only by one bump in the road. If a business owner dies, generally the decedent s escrowed interest in the policies insuring the survivors are reallocated to the surviving owners. This reallocation is a transfer for value, which can be resolved through the existence or creation of a partnership. 42 VI. Factors to Consider with Buy-Sell Agreements As mentioned, there are a variety of pros and cons associated with each type of buy-sell agreement; each needs to be weighed to make the appropriate choice. A. Shifting Control In a cross purchase arrangement, the buyers usually buy the number of shares that maintains their existing proportionate interests in the business. As a result, unintentional control shifts are not an issue with a cross purchase arrangement. Nevertheless, it is possible that only one owner must buy a departing owner s interest or that the remaining owners buy disproportionate interests. This is usually not a problem because these purchases are thought out in advance and are specifically provided for in the agreement; as a result, there is no surprise at the ultimate ownership. A cross purchase plan is used in these situations. Shifting control is an issue with an entity purchase, regardless of the type of business entity; however, it is an issue easily dealt with simply look at how the ownership would line up upon each death. An entity purchase arrangement can cause the percentage of ownership to change among the remaining owners, and unintended shifts in control may result. 42 See the discussion on transfer for value below at p

21 EXAMPLE: Barney owns 50 shares, Fred owns 30 shares and Slater owns 20 shares. Upon Barney s death, the business redeems his 50 shares. Fred still owns 30 shares and Slater continues to own 20 shares. However, the outstanding shares total 50. Fred now owns a 60% controlling interest in the business. Similarly, Slater s 20 shares now represent 40% of the business. If this control result is not acceptable, some form of a cross purchase arrangement needs to be used. B. Basis EXAMPLE: Same facts as above except Slater buys 10 shares from Barney s estate (cross purchase), and the business buys the remaining 40 shares from Barney s estate. Fred and Slater now own 30 shares each, or 50%. 1. Importance of Basis When a buyer purchases an asset, the purchase price is her tax basis in the asset. There may be subsequent adjustments to the buyer s basis. Basis becomes important when this buyer later becomes a seller. On the other hand, if the buyer does not ever intend to become a seller and holds onto the asset until her death, basis is not important to that owner. When selling a capital asset, the seller pays a tax on the capital gain, which is the sale price less basis. So, the higher the basis, the less capital gain tax to be paid by the seller. A business owner who may later sell the business during life is interested in obtaining as much basis in the business as possible. When considering the structure of a buy-sell plan, it is vital to know how that plan affects a business owner s basis. 2. Basis of Surviving Owners with Cross Purchase Arrangement A surviving business owner who may later sell the business during life should consider structuring the buy-sell plan as a cross purchase arrangement. In a cross purchase arrangement (including an escrowed cross purchase arrangement), a surviving owner s basis in the business is increased by the amount she paid for the newly acquired business interest. 43 When the surviving owner subsequently sells her business interest, the potential taxable gain will be reduced. For a surviving owner who may sell the business during life, the basis increase factor may be enough of an advantage to tip the scales in favor of a cross purchase arrangement. 43 IRC

22 3. Basis of Surviving Owners with Entity Purchase Arrangement With an entity purchase arrangement, the basis of the surviving owners may or may not increase, depending on the type of entity. a. C Corporation The basis of a surviving shareholder s stock is not increased when the entity receives the death benefit and purchases the departing owner s stock. If it s unlikely that the surviving owner will sell the business during life, concern with the basis factor becomes negligible. b. S Corporation Surviving shareholders in an S corporation do receive an increase in basis - and possibly even a full increase in basis - if the corporation funds the buy-sell plan with life insurance. When the S corporation receives insurance proceeds, the stock basis of each of its shareholders is increased by a proportionate amount of the insurance proceeds. 44 The basis is increased because the life insurance death benefit is tax-exempt income, not because it s life insurance. EXAMPLE: an S corporation with three equal shareholders (A, B and C) is valued at $3 million. Upon A s death, the company receives $1,000,000 of life insurance proceeds. Upon receipt of the proceeds, each of the three shareholders (A s estate, B and C) receives a basis increase in the amount of $333,333. However, the $333,333 allocated to the stock owned by A s estate is wasted because the estate already receives an adjustment in basis to fair market value as of A s death (usually, an increase in basis, commonly referred to as a stepped-up basis), and the estate s basis cannot exceed the date of death value. 45 To make matters worse, B and C are deprived of any use of this wasted basis increase allocated to the stock in A s estate. This wasted basis can be avoided if the corporation uses cash basis accounting. To do so, a cash basis corporation redeems the stock in one tax year and receives the insurance proceeds in a subsequent tax year. Here are the steps to follow in this order: 44 IRC 1366(a)(1)(A) and 1367(a)(1)(A). 45 IRC

23 i. The corporation purchases the shares from A s estate with a promissory note. ii. In a later tax year, the corporation claims the life insurance proceeds, resulting in each of B and C (the only shareholders at the time of receipt) receiving a basis increase of $500,000. iii. The corporation uses the life insurance proceeds to pay off the promissory note. Since S corporation distributions generally are received tax-free up to basis, a side benefit to this additional basis will allow tax-free corporate distributions. However, if the S corporation was previously a C corporation, distributions may carry out taxable C corporation retained earnings. 46 Perhaps the above order of transactions is not workable because a shareholder died early in the year and the estate is unwilling or unable to wait until a later tax year for cash payment or the buy-sell agreement requires an immediate cash payment. In this case, the parties can make a 1377 election. 47 By making this election, the corporation treats its taxable year as two taxable years. In our example, the first taxable year ends when the corporation purchases the shares from A s estate, and a new taxable year begins in the following month with only two shareholders, B and C. In an accrual basis corporation, actual receipt is unimportant for tax purposes. As a result, neither the delaying tactic nor the 1377 election will work since the corporation s books show receipt of the death benefit immediately upon the insured s death when the estate is still a shareholder. 48 c. Partnerships and LLCs Survivors in a partnership that owns life insurance to fund an entity purchase plan obtain an increase in basis because the receipt of these tax-exempt proceeds increases the partners bases pro rata. 49 As with an S corporation, it is the receipt of tax-exempt life insurance proceeds, not the partnership s purchase of partnership units from the estate, which increases the partners bases in their partnership interests. Similarly, part of the basis increase is generally wasted because it is allocated to the deceased partner s interest, which receives an adjustment in basis upon death anyway. Since there is no election available to partnerships like a 1377 election, the delaying tactic mentioned above with S corporations only works with partnerships if the business interest can be purchased in one year and the insurance proceeds received in a later tax year. 46 See discussion on distributions from prior C corporation below at p IRC 1377(a)(2). The election requires the consent of the shareholders. The corporation makes this election by filing it with its tax return for the year. The consent of the shareholders must accompany it. The estate may make the election for a deceased shareholder. Treas. Reg Priv. Ltr. Rul (February 27, 2004). 49 IRC 705(a)(1)(B). 17