Many factors go into the decision of what approach a business owner takes in developing a buy-sell plan. But each type of plan–a stock redemption plan or a cross purchase plan–has both advantages and disadvantages.

First, lets discuss the drawbacks of each type of buy-sell plan, then well explore what elements should go into the “perfect” buy-sell plan and how to structure it.

The pitfalls of stock redemption plans. When working with the owners of a C-corporation, there are significant disadvantages associated with stock redemption plans. Perhaps the two most significant drawbacks are the absence of a proportionate increase in the cost basis of shareholders for stock redeemed by the corporation, and the potential exposure of corporate-owned policy cash values and death proceeds to alternative minimum tax (AMT).

In addition, state law may subject policy values and proceeds to the claims of corporate creditors or restrict the corporations ability to redeem shares. Also, the transfer of corporate-owned policies to shareholders can have undesirable income tax consequences, and the “attribution” rules relating to stock ownership can create difficult planning issues.

The downside of a cross-purchase plan. Unfortunately, a cross-purchase plan among the shareholders is not without its disadvantages as well. If the shareholders own policies and the corporation pays premiums, there are potential issues relating to “reasonable compensation” and/or “constructive dividends.” These issues can be minimized with a split-dollar arrangement, but the actions of the IRS in 2002 have created uncertainty and confusion regarding this planning technique.

Because policies are owned by the shareholders, the corporation will have no control over them, and policy values will not be a balance sheet asset.

Finally, if there are numerous shareholders, the number of policies and administrative complexity of the agreement will be increased significantly.

Develop the “perfect” plan. Under perfect conditions, a buy-sell plan for a C-corporation with numerous shareholders would have all the following characteristics:

1. The purchase of shares would result in a full increase in cost basis to shareholders;

2. Elimination of the alternative minimum tax;

3. Protection of policy values and proceeds from business creditors;

4. Only one policy per shareholder would be required;

5. Business control over policies would be maintained;

6. The possibility of an income tax-free transfer of policies to the insured-shareholders would be created; and,

7. All potential “transfer-for-value” and “stock attribution” issues would be eliminated.

Does such a plan exist? Consider the use of a general partnership to administer and fund a cross-purchase buy-sell agreement among the shareholders of a C-corporation.

Heres how it works. The shareholders form a general partnership, and each of the shareholders becomes a general partner. The shareholder-partners implement a cross-purchase buy-sell agreement, and coordinate the terms of the buy-sell agreement with the partnership agreement. The partnership is the owner and beneficiary of one insurance policy on each shareholder-partner.

If a shareholder-partner dies, the partnership receives the proceeds and distributes them to the surviving shareholder-partners who use the funds to complete the purchase of the deceaseds shares. If a shareholder-partner retires or withdraws from the business, the partnership can assign the policy to the insured-shareholder or access policy cash values as partial payment of the purchase price.

In order to fully appreciate the advantages of this type of arrangement, one needs to understand a few basic principles. First, as a general rule, partnership income, basis, capital, etc., will be allocated among the partners in proportion to their respective ownership interests. However, Section 704 of the Internal Revenue Code permits a partnership agreement to make “special allocations” among the partners provided such allocations have “substantial economic effect” other than tax avoidance.

Second, life insurance death benefits paid to a partnership generally will increase the partners cost basis pro-rata, and the distribution of those proceeds to the partners will decrease their cost basis.

Heres an example to illustrate how these principles can be applied to achieve favorable tax results:

Assume a corporation has 5 shareholders and each shareholders stock is worth $1 million. The shareholders form a general partnership, and each partner acquires a $1 million life insurance policy and transfers it to the partnership as a capital contribution. A shareholder-partner dies, and the partnership receives $1 million death proceeds income tax-free. Ordinarily, the cost basis of each shareholder-partner (including the deceased) would be increased by $200,000, but the partnership agreement specifies that the increase in cost basis will be allocated entirely to the surviving partners.

Why? Because the deceaseds cost basis has already been increased to fair market value on the date of death (at least until 2009), so the deceased doesnt need an increased cost basis. Therefore, the cost basis of the surviving shareholder-partners is increased by $250,000, the death proceeds received by the partnership are paid to the surviving partners income tax-free, thereby reducing their cost basis by $250,000, and the surviving partners use the proceeds to purchase the stock of the deceased.

What if a shareholder-partner retires or withdraws from the partnership during lifetime? If the partnership agreement has allocated the policy on his life to his capital account, then the partnership can transfer the policy to him income tax-free as liquidation of his capital account, and thereafter he can access policy cash values income tax-free with withdrawals or loans.

Assumedly, if the value of his stock in the corporation exceeds the cash value of the policy, the buy-sell agreement would specify the terms of payment for the balance of the purchase price. The partnership could take income tax-free policy loans from some or all of the policies on the remaining partners, distribute the funds to them income tax-free, and they could use the funds received to purchase some or all of the retiring shareholders stock.

This is just one example of how this type of arrangement might work–the “special allocation” rules permit a great deal of flexibility in allocating various financial items among the partners to achieve the shareholders objectives.

Although the partnership-administered buy-sell agreement will be most advantageous when the underlying business entity is a C-corporation (due to the cost basis and AMT issues), it can be used with any type of business entity (S-corporation, limited partnership, LLC, etc.) to implement an effective, tax-advantaged buy-sell agreement among the business owners.

David A. Scott, J.D., CLU, is assistant vice president, advanced sales for Penn Mutual Life Insurance Company, Horsham, Pa. David may be reached via e-mail at Scott.David@

pennmutual.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 23, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.