When the dreaded alternative minimum tax went into effect in the 1980s, entity buy-sell agreements were quite common. The AMT potentially taxes the collection of a life insurance death benefit. That possible taxation prompted many tax professionals to convert entity agreements to cross-purchase agreements. However, the entity buy-sell approach has many advantages and is now making a comeback.
In addition to avoiding AMT, the advantages of a cross-purchase include creditor protection and a step-up in basis when the decedent/retiree is bought out. However, the entity advantages are its:
o lower policy count;
o financial strength;
o efficient rollout at retirement; and
o equitable sharing of premium commitments.
A real-life example
Consider twins Jim and John Blackford, 50/50 owners of Blackford Mechanical, LLC, a heating and cooling contractor. They started the business 10 years ago. They worked hard, were frugal and put money back into the business.
The company is now worth $3 million with 30 employees. Jim and John want to grow the business and remain co-CEOs, but they want to hire professional management. They are looking for a CFO, a COO and a comptroller.
Beyond that, they have capable teenagers who want to get involved in the family business. Because the local business climate is good, Jim and John believe the company could easily handle the additional management personnel, add more construction personnel and grow quickly. They expect the operation to be worth $10 million in 10 years.
Jim and John know they will have to allow more owners. The professional managers will want to become owners and so will Jim’s and John’s children. The business could have seven or more owners. Eventually, Jim and John want to retire, so while they’re contemplating expansion, they also need exit strategies.
Jim and John created a cross-purchase buy-sell when they started the company. They funded it with permanent life insurance. Currently, each of their cross-owned $500,000 policies has $100,000 of cash value with premiums paid of $75,000. Current re-proposals indicate that in 10 years total premiums will be $150,000 and cash value will be $250,000.
Benefit of an Entity Agreement
An entity agreement benefits Jim and John, first, by cutting the policy count. A cross-purchase agreement can require each owner to have a policy on the life of every other owner. For seven owners, 42 policies would be needed.
Accompanying the policy count would be the necessary changes every time an owner joins or leaves. Blackford Mechanical has an advantage in that it is an LLC, so it fits into the partnership exemptions in the transfer-for-value rules.
However, if the firm were a corporation, it would find no transfer-for-value exemption for co-shareholders. An entity structure would cut the policy count to seven and would dramatically simplify entries to and exits from ownership.
Blackford Mechanical regularly borrows to take advantage of purchase discounts and it needs bonding capacity to take on jobs. Both the bank and the bonding company want to see strong financial statements.
Funding the life insurance for a cross-purchase agreement requires taking money out of the company, reducing income and permanent capital. With an entity agreement, the money for the premiums would stay in the company.
Funds would move from the “cash in bank” asset account to the “cash surrender value of life insurance” asset account. Within a few years, the life insurance actually could become an income-producing asset.
Beyond strengthening the financial statements, the bank and bonding companies would be happy to see that asset on the balance sheet. Subjectively, the asset would demonstrate Blackford Mechanical’s owners are planning for problems that might arise.
On a practical level, the bank and bonding companies see that cash value as a ready source of emergency capital or collateral. If there’s a cash flow crunch, a fresh influx of cash is a phone call away.