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.
- 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.