A Whole New Meaning

November 10, 2004 at 07:00 PM
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Would Your Business Owner Clients

Be Interested In A Tax-Deductible Buy-Sell?

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Most business owners know the value of having a buy-sell agreement (BSA), and many of those have realized the advantages of having their BSA funded in case of death or disability. Most often, these business owners have concluded that to fund a BSA properly, they will have to accept the fact that insurance premiums must be paid, either by the corporation or by the parties obligated to purchase the interest of a deceased business partner, and that those premiums will be paid on an after-tax basis.

Often, the structure chosen for the BSA will be a trusteed cross-purchase plan, so that the number of required policies is minimized, yet the surviving owners can receive a basis step-up in the deceased owners shares going to them.

But what if the entity could deduct the premiums being paid for the life insurance? Would that be the kind of planning your clients would be interested in considering?

Many advisors who have assisted clients in negotiating BSAs probably have not highlighted the unparalleled advantages of having the insurance premiums tax deductible to the business from day one. However, proper planning can accomplish this objective.

What we are talking about here is a properly established, properly run trust established under Internal Revenue Code Section 419A(f)(6).

Besides the tax deductibility of the premiums, several other favorable advantages arise from this type of plan. Most business owners, like real estate homeowners, have difficulty evaluating how much they should sell their business for. A typical cross purchase buy-sell via this plan allows the owners to minimize the costs and time associated of attempting to derive a "fair" consensual evaluation method and err on the side of a higher amount, which always will be appreciated by the beneficiaries.

In addition, if the business runs into financial difficulties and there is a claim on their assets, the insurance policies within the plan are not subject to creditors.

With C Corps, contributions to the plan have the additional benefit of resulting in a reduction in its taxable income. This in return would reduce the amount which would be transferred to the companys retained earnings account. A reduction in the amount going into the retained earnings indirectly helps avoid the company paying an accumulated earnings tax. The companys CFO will like the effect on the balance sheet.

Another nice administrative and less costly benefit of buy-sell agreements within the plan is the need for fewer actual policies. For example, with 5 owners, outside the plan, 20 policies need to be underwritten and purchased along with incurring the additional policy fees and costs, whereas the plan trustee needs only to purchase 5 policies. The fact that the business is paying the total premiums for the 5 owners also avoids the equity concern of younger, healthier owners having to possibly pay significantly higher premiums for a partner not as healthy and young.

Of course, while this plan has benefits, it also has the drawback of the owners not having access to the policys cash values while they are within the plan. Typically, buy-sell owners do not look to cash values as a ready source of funds. If the policies values are depleted, making them vulnerable to being lapsed, this would defeat the purpose of a properly designed agreement.

It is also impermissible to structure the buy-sell as a stock redemption and still enjoy the benefits of the plan. Note the confidentiality and privacy of the companys buy-sell terms are not lost by participating within this plan since its provisions are not embodied within the plan nor need be provided to the plan trustee or plan sponsor.

The recent publication in July 2003 of final regulations regarding these plans helps to ensure that they are properly administered as multiple employer welfare arrangements (MEWA), thereby assuring that the benefits discussed here are obtainable.

A MEWA refers to a plan whereby 10 or more employers join a trust to provide employee welfare benefits. Section 419A(f)(6) plans provide for an exception to the deduction limits that apply to other welfare benefit plans. Employer participants collectively, not individually, share both the risk and return. All of the contributed funds are commingled, with no single employer contributing greater than 10% of the aggregate of contributions. 419A(f)(6) plans may not use experience rating of any one employer to determine either the contribution or benefit amounts nor may it be a deferred compensation plan.

Congress believed no restrictive limitations were necessary on the deductible contributions to 419A(f)(6) plans since no single employer could properly influence the trust either by making excessive contributions or through experience rating. The deduction still must satisfy the "ordinary and necessary business expense" standard of Section 162.

Some plan sponsors have sought to stretch the meaning of Section 419 with single employer 419(e) Plans. These plan sponsors have contended that since single employer plans are not subject to the final regulations governing multiple employer plans, the employer would have more access to the policies and cash values. Moreover, some plan sponsors have suggested contribution formulas resulting in a sizeable income tax deduction for premiums, however, the Internal Revenue Service is free and likely to question the math of computing the deduction.

In fact, IRS scrutiny is more likely than not on single employer plans taking deductions greater than the "qualified direct cost" of the benefits each year. The qualified direct cost is defined by the IRS as the difference between the premium paid and the surrender value of the policy, and is prorated based upon how many months of the year the coverage has been in force. An amount less than the premium is deductible, and in many instances, once the policy interest credited exceeds the mortality charges, the qualified direct cost is zero.

Put simply, if an employer could have all the benefits of almost unlimited tax deductible contributions, experience rating and access to cash values under single employer 419(e) plans, then all the sharing of risk and restrictions mandated by the final regulations governing 419A(f)(6) plans would be rendered meaningless.

Section 419A(f)(6) plans managed in a conservative fashion which have been tested under audit with respected fiduciaries and support entities provide ample reason to explore taking advantage of using the company checkbook for business owners personal life insurance in a BSA.

, JD, CLU, ChFC, FLMI, is president of Friend Financial Group, PLLC. He can be reached at [email protected].


Reproduced from National Underwriter Edition, November 11, 2004. Copyright 2004 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.


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