Structuring An Effective Management Team Buy-Out

The engine that moves most buy-out arrangements to satisfactory completion is life insurance. The best way to provide a lump sum for a buy-out at death is by funding it with life insurance because the death benefits become available in cash when the need arises. Life insurance cash values may also be used to provide part or all of the needed cash for a lifetime buy-out occurring at the principal owners retirement or disability.

In a management team buy-out, a trust or partnership would own a policy on the principal owners life. Subject to a split-dollar agreement between the business and the trust or partnership, the business would pay the premiums and take back a limited collateral assignment for the cumulative premiums paid (under loan regime split-dollar) or the entire cash value (under economic benefit split-dollar where there is no equity element owned by the trust or partnership). The limited assignment, which prohibits the business from accessing the assigned cash values, would keep the proceeds out of the estate of the insured owner.

Using amounts contributed by or imputed to the management team members, the trust or partnership would pay or be charged the appropriate term costs or loan interest due under the split-dollar agreement.

The split-dollar arrangement keeps only “term” insurance in the trust or partnership, thus allowing members of the management team to change from time to time without new members having to buy out the interest of the outgoing management team members interests in the trust or partnership.

When the policys cash values, which have been assigned to the business, are needed to effect a buy-out at retirement or disability, the business can lend the money to the trust or partnership and the buy-out can be consummated. If there is not enough cash available to complete the buy-out, the cash can be used as a down payment and the rest of the buy-out can be done through an installment sale.

Once the management team owns the business, they can either pay back the business over time or the business can forgive the loan as a taxable bonus to the executives.

Avoiding Transfer-for-Value. The primary obstacle to overcome in structuring a management team buy-out is the transfer-for-value rule, which, if applicable, would cause most of the proceeds to be subject to income taxation. If a general partnership is used to own the life insurance, the business owner should own a 1% interest in the partnership. Transfers to a partnership in which the insured is a partner is one of the exceptions to the transfer-for-value rule. If a trust is used to own the policy on the life of the principal owner and effect the buy-out, the management team should form or participate in a separate partnership with the insured owner. Seeking legal guidance for the clients individual circumstances on this issue is critical.

Richard C. Baier, J.D., CLU, ChFC, FLMI, is assistant vice president–advanced sales with Jefferson Pilot Financial, Greensboro, N.C. He can be reached at [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, September 15, 2003. Copyright 2003 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.