The LLC buy-sell is a recent innovation in business succession planning that emphasizes the advantages of standard buy-sell arrangements while mostly eliminating the hurdles. Advisors who gain an understanding of the LLC buy-sell concept will be in a better position to help their business-owner clients. It is truly a game changer in the buy-sell world. 

Buy-sell planning: the hurdles

The buy-sell planning universe contains two bedrock types: (1) Stock (entity) redemption; and (2) Cross-purchase. Nearly all variations of buy-sells, such as wait-and-see buy-sells or trusteed buy-sells, trace their roots back to these “big two.” Both types of plans have advantages, but business owners and advisors often struggle with the hurdles.

Stock (entity) redemption hurdles

  • Lack of basis increase. In other words, when stock is redeemed by a business, the remaining owners generally do not receive a stepped-up basis in their ownership interest.
  • Business owned life insurance is potentially subject to the claims of company creditors.
  • Business owned life insurance is an Alternative Minimum Tax (AMT) preference item for large C corporations. Both the accumulating cash value and death benefit may contribute to AMT exposure.
  • Transfer-for-value (TFV) rule may apply in some cases. The TFV rule, found in Internal Revenue Code Section 101(a)(2), applies when a life insurance policy is transferred for valuable consideration. For instance, if a corporation transfers an existing life insurance policy to a co-shareholder to achieve cross ownership, the transfer is most likely a transfer-for-value. It makes no difference whether the policies are term or permanent. The TFV rule is harsh. It results in a taxable death benefit. 

Cross-purchase hurdles

  • The number of policies can become unmanageable if a business has three or more owners. For example, a four-owner business would require up to 12 policies.
  • Cross-purchase life policies are personally owned and may be subject to the claims of personal creditors and/or ex-spouses.
  • Plan compliance can be an issue. Parties to a cross-purchase are relying on each other to pay premiums on time, maintain beneficiary designations, and avoid “raiding” policies of their cash values.
  • Issues of premium inequality can surface. For example, a young, healthy owner may not like the idea of paying the premium on an older, unhealthy owner.
  • Transfer-for-value may apply if a shareholder is added to an existing cross-purchase. 

Enter LLC buy-sell

It is possible to deliver the benefits of stock redemption and cross-purchase buy-sells while mostly eliminating the hurdles. The LLC buy-sell strategy combines two simple business planning techniques: a limited liability company (LLC) and a cross-purchase.

The elegance of the LLC buy-sell is in its simplicity. Here’s the four-step process: 

1 Form the LLC.

This is the entity that will oversee and administer the buy-sell agreement. The LLC must be valid under state law. The LLC is separate from the underlying business.

2. Draft a cross-purchase buy-sell.

The client’s attorney will draft a tailor-made cross-purchase agreement. The agreement will cover the underlying business and the LLC. It can be either a separate document or made part of the LLC operating agreement. The parties to the buy-sell agreement are the business owners.

3. The LLC purchases a life insurance policy on each business owner.

Cash value life insurance is preferred because of the potential to fund lifetime triggering events — retirement and disability comes to mind. 

4. The triggering event occurs.

In the case of a triggering event, such as death, the LLC receives the policy proceeds and allocates the proceeds to each LLC member. The LLC members purchase the exiting owner’s business interest in both the LLC and the underlying business. Each purchaser is generally able to increase his or her basis in the businesses based on the purchase price. 

Paying the premium

The most common funding strategy is to flow earnings through the underlying business to the LLC as capital contributions. The funds passing from the underlying business are taxable to the business owners, but the capital contributions increase each owner’s LLC basis.

In some cases, each owner contributes an existing insurance policy to the LLC as a capital contribution. This strategy is sometimes employed where an owner is no longer insurable but personally owns life insurance.

The funding method selected will depend on a variety of tax and accounting issues that are best left to a tax specialist.

Which funding vehicle?

  • Term Insurance: Provides short-term protection at the lowest possible cost. It is appropriate for short-term needs or for start-up businesses where cash flow is a concern. 
  • Universal Life Insurance: Look for a policy that offers business owners maximum flexibility and a wide range of premium choices. Universal life is a good fit for cyclical businesses or where business cash flow varies.
  • Whole Life Insurance: The best choice for business owners seeking strong guarantees and predictable cash accumulation. 
  • Disability Buy-Sell Insurance: Business owners should not overlook this critical funding vehicle.

The LLC buy-sell sizzle

The LLC buy-sell emphasizes the advantages of standard buy-sell planning while mostly eliminating the disadvantages:

  • Stepped-up basis: The LLC buy-sell is built on a cross-purchase chassis. Each purchasing owner may increase his or her cost basis by his or her share of the purchase price.
  • Simplicity: The LLC buy-sell requires only one life insurance policy per owner.
  • Transfer-for-value (TFV): Under current law, transferring a life insurance policy (or portion) to a co-owner of a LLC is an exception to the TFV rule. Adding new owners to the agreement or transferring policies among LLC members does not trigger a TFV trap.
  • No Alternative Minimum Tax (AMT): The corporate AMT does not apply to an LLC.
  • Creditor protection: LLCs provide an extra layer of protection from two types of creditors. First, creditors of the underlying business generally cannot attack LLC assets. Second, creditors of the individual owners generally cannot attack LLC owned life insurance.
  • Plan compliance: The LLC owns the insurance and pays the premiums.

Exit strategies

For a retirement buyout, the life policy is transferred to the exiting owner as part of the purchase price. Transfer of a life policy to the insured is an exception to the TFV rule. The exiting policy owner can subsequently access policy cash value in retirement. If policy cash flow is properly structured and the policy remains in force, it can be received income tax-free.

If the policy cash value is inadequate to cover the full purchase price, the shortfall is often paid in installments (most common) or with a bank loan. In some cases, the purchasers access cash value from multiple life insurance policies. This is common if the exiting owner is the majority owner and the purchase price is significant. 

After the buyout, the remaining LLC owners can either go forward with the existing LLC arrangement or the LLC can be wound up and terminated. If the LLC is terminated, the policies are distributed to each insured and should not result in any immediate taxation (assuming the LLC capital accounts were properly accounted for).

If the exit happens at death, the life insurance death benefit is paid to the LLC income tax-free. The LLC distributes the proceeds to the surviving owners, income tax-free. The LLC members then complete the purchase of both the LLC and underlying business from the exiting owner. After completion of the purchase, subject to the LLC operating agreement, the LLC may continue with the remaining owners or new owners may be added. If the LLC members decide to terminate the LLC, the existing policies are distributed to the insureds. The transfer is tax-free as a return of basis and is not considered a transfer-for-value.

Although the LLC buy-sell is a relatively recent innovation, it is already generating interest among business owners, insurance advisors, CPAs and attorneys. It emphasizes the benefits of standard buy-sell plans while mostly eliminating the hurdles. It is a business life insurance game changer.

Prior to implementing any strategy, clients should also consult with their tax and legal advisors regarding their particular situation and the potential tax and legal consequences for the buy-sell strategy chosen.