Conventional wisdom in business succession planning needs a change

When a business has multiple owners and none of the owners plan to pass their share to children who are actively engaged in that business and its management, a cross-purchase buy-sell agreement, as we all know, carries certain benefits over a redemption (entity purchase) agreement.

In a redemption, the business owns life insurance on both owners.  When one dies, the business retires his or her shares into treasury, leaving the remaining owner with his or her original shares and original basis.  This is true for all C-Corporation and for S-Corporations, as well as and LLCs that use accrual accounting.  S-Corporations and LLCs that use cash basis accounting can still benefit from a step-up in cost basis.

In a cross purchase agreement, the life insurance on “A” is owned by “B: and vice versa.  When one dies, the other owner buys the deceased owner’s shares and therefore benefits from a step-up in cost basis regardless of the form of business enterprise.

The deceased owner’s estate benefits from a step-up in cost basis regardless of whether a redemption or a cross-purchase agreement is used.

However, 50 percent of the value of the business is included in the estate of the first owner to die and 100 percent of the value of the business is included in the estate of the surviving owner.  Estate taxes (federal, maybe, and/or state) may not be due until the death of the owner’s surviving spouse.  But, the government still gets to tax 150 percent of the value of the business—or more!

More?  That’s right.  If 50 percent is valued at $500,000, then 100 percent could be valued at $1,500,000 instead of only $1,000,000.  Why?  Because the IRS recognizes discounts for minority (interests without voting control) interests and 50 percent is not voting control.  If we use a discount of one-third, for example, for lack of marketability and lack of voting control, then a business valued at $1,500,000 for 100 percent would result in a value of $500,000 (not $750,000) for 50 percent.

If there are three equal stockholders, then the 150 percent (or more), above, becomes 183.33 percent of the value of the business subject to estate taxes.

  • 33.33 percent in the estate of the first owner to die
  • 50 percent in the estate of the second owner to die
  • 100 percent (or more) in the estate of the surviving owner

With four equal owners, that becomes 208.33 percent and so on. Using irrevocable trusts in business succession

Each owner should have an irrevocable life insurance trust to hold his or her personal life insurance as part of his or her personal estate planning.  That same trust, or a separate business irrevocable trust, can also own life insurance on the life of his or her business partners (insurable interest is established when the buy/sell agreement is signed).

So, in our 50/50 ownership case, instead of “A” owning insurance on the life of “B”, “A”’s irrevocable trust owns insurance on the life of “B” and vice versa.  Upon the death of the first owner to die, the surviving owner’s trust buys the deceased owner’s 50 percent.  When the surviving partner dies, only 50 percent is included in his estate.

In this instance, 100 percent—not 150 percent—is subject to estate taxes,

But, what if the business is valued at $1,500,000 and each owner wants his or her family to receive $750,000 instead of only $500,000?  Then, recognizing that the selling (or deceased) owner is also a retiring (or deceased) key employee, the business can fund an additional $250,000 of life insurance to be owned by his or her personal irrevocable trust, as follows:

 

 

Trust for “A”

Trust for “B”

 

 

Insurance on “A”

$250,000

$500,000

 

 

Insurance on “B”

$500,000

$250,000

 

 

 

buy/sell

personal

 

So, how much more does that cost to create all of this?

Assuming that each owner has an irrevocable trust for his or her own personal estate planning, and that each needs to have a cross-purchase created anyway, there is no additional cost to have stepped-up cost basis and estate tax savings.

But, I frequently hear the concern as soon as you have more than two owners, “cross-purchase has too many policies!” 

If the discounted value of a one-third ownership is $500,000, then:

 

Owned by “A” or Trust for “A”

Owned by “B” or Trust for “B”

Owned by “C” or Trust for “C”

Insurance on “A”

 

$250,000

$250,000

Insurance on “B”

$250,000

 

$250,000

Insurance on “C”

$250,000

$250,000

 

That’s six policies instead of three.

Alternatively, you can use a “trusteed” cross-purchase and have the trustee, or escrow agent, hold three separate $500,000 life insurance policies.  The irrevocable trusts can be the beneficiaries of the cross-purchase trust. Or you can form an LLC to hold the three policies.  The irrevocable trusts can be the members of the LLC. 

There are concerns regarding transfer-for-value (TFV) rule when the policies are owned by individuals or by trusts, but not by an LLC (one of the TFV exceptions).  However, frequently today, we find that the business (or practice) is already an LLC. Or if the business is a corporation, there is often a separate LLC in place to hold the business real estate and/or equipment.  But TFV issues must be addressed.

For quick review, generally, life insurance is received free of income taxes by the beneficiary, unless a transfer-for-value occurred during lifetime.  There are five exceptions to the TFV rules, where a lifetime transfer still results in tax-free death benefits:

  1. If the policy is transferred to the insured (e.g., owner “A” owned insurance on the life of owner “B” and then transfers that policy to the insured, owner “B”)
  2. If the policy is transferred as a gift (e.g., from the insured to an irrevocable trust)
  3. If the policy is transferred to a corporation where the insured is an owner or officer
  4. If the policy is transferred to a partnership (of LLC) where the insured is a partner (or member)
  5. If the policy is transferred to a partner of the insured (or member of the an LLC where the insured is also a member)