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Life Health > Running Your Business

One-way buy-sell agreements: the mechanics and benefits

By William R. Buslee, Stephen O. Kroeger

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The closely held business is often underserved when it comes to succession planning. This can be due to the lack of a clear successor, not understanding available options or the possible consequences of doing nothing.

Is there a plan that can be both financially attractive as well as potentially flexible enough to motivate action: a planning solution that not only can assist with providing the required funding regardless of when the succession need is triggered but also help with the intrinsic idiosyncratic challenges?

The one-way buy-sell is such a tool. Depending on the owner’s goals, it can be structured to maximize tax efficiency or to maintain total long-term control and can even allow for estate planning considerations. Broadly, there are two basic types of one-way buy-sell: the bonus structure features a current tax deduction and endorsement split-dollar provides the owner long-term control. Most importantly, each encourages participation because it provides tangible financial incentives to all parties.

Related: Retirement planning for small business owners

The bonus structure is the most straightforward of the one-way buy-sell strategies and most readily employed in family situations where a member or members of the next generation are going to eventually assume control of the business. Premiums are advanced to the family member employee(s) as tax-deductible compensation to purchase life insurance coverage on the business owner.

The business can “gross up” the extra compensation to account for all taxes, making the transaction income tax neutral to the recipient(s), while being fully tax deductible to business. In addition, an indemnity-style long term care (LTC) rider, can be added so tax-free funds can be available for executing the agreement regardless if the buy-out is triggered by the business owner’s death or disability. Moreover, the equity in the life insurance contract can serve as a tax favored sinking fund that can provide the down payment on a lifetime sale.

The income tax-free death benefit that will be used to buy out either the deceased owner’s spouse or the deceased owner’s estate, establishes the new owner’s basis in the business. This essentially uses tax-free dollars to create what will be the tax-free return of basis portion of the proceeds from any future sale of the business.

Further, since not all closely held businesses are small businesses and may be large enough to create an estate tax challenge, this structure provides liquidity outside the deceased owner’s taxable estate that can be used by heirs to pay estate taxes. This effectively leverages business dollars to create funds for the heirs from life insurance held outside the estate in a tax-deductible manner, while preserving traditional estate planning techniques.

Related: SMB owners rethinking retirement benefits to retain, recruit

If the owner decides to dispose of the business during his or her lifetime, the employee typically has the right of first refusal under a buy-sell agreement’s terms and conditions. (Photo: Thinkstock)

Related: Business succession planning: The day after disaster strikes

The bonus one-way buy-sell can accomplish a great deal while cementing the legacy between generations in a family business; however, it is obviously geared toward those circumstances where all participants have an inherent, vested interest due to their lineage.

Alternatively, what if more control is desired by the business owner over the ultimate funds used to execute the agreement? If the situation involves a key employee from outside the family who will likely take over, the business may consider funding the buyout plan with an endorsement split-dollar.

When “control” becomes more important than “tax deduction,” the business owner can personally own the life insurance policy and endorse a portion of the death benefit to the key employee. The key employee will have to recognize the economic benefit associated with the amount of tax-free death benefit to which he or she is entitled.

This is measured by either annual term rates published in IRS Table 2001 or the issuing carrier’s alternative rates (if available) times the share of the death benefit (DB) due to the key employee. This is akin to rent, and is paid to the policy owner who recognizes it as income.

To provide detail to this discussion, we will now focus on specific samples illustrating the practical application of these concepts.

The situation

Ron Brown, age 50, is the sole owner of Custom Car Concepts, LLC (CCC) – a 10-year-old company that repairs, restores, and maintains high-end luxury cars. The business is very profitable. CCC has six full-time employees, including Greg Brown, age 38, who is Ron’s nephew and most dependable worker.

Lately, Ron has been thinking about what would happen to the business if he were no longer involved. He realizes that Mary, his wife, could not sustain the company for very long. He also feels that it would be difficult for Mary to sell the business for its full value.

Ron believes this because from time to time, he has floated “trial balloons” about his business being “on the block” and got no takers. He and Mary have no children, and there are no immediate family members that could immediately step into his shoes to keep the business afloat. Ron’s CPA believes the business is worth $1 million based on the business’ generated annual income.

Of all Ron’s employees, Ron believes that Greg is the candidate most likely to successfully operate and actually own the business. Ron realizes that Greg’s current financial situation is such that he neither has enough savings nor the ability to borrow the money needed to purchase the business outright. Ron needs some help.

Related: Millennial small biz owners: More prepared in 4 key areas

The bonus structure is the most straightforward of the one-way buy-sell strategies and most readily employed in family situations where a member or members of the next generation are going to eventually assume control of the business. (Source: Crump Life Insurance Services)

Related: A case study in life insurance as a succession planning tool

A one-way buy-sell agreement, which Ron and Greg decide to execute, typically includes the following terms and conditions:

  • The owner’s spouse or estate agrees, in the event of the owner’s death, to sell the entire interest in the business to the employee (who is often a family member).

  • The employee agrees to purchase the business subject to the terms and conditions of the agreement, using the funding provided by the life insurance, whether it is triggered by death, disability (the rider) or retirement (the policy’s cash value).

  • The owner agrees that he or she will not sell, assign, convey, encumber or otherwise dispose of the business or of any asset of business, except as allowed in the agreement.

  • If the owner decides to dispose of the business during his or her lifetime, the employee has the right of first refusal.

The bonus solution — After establishing and ratifying the buy-sell agreement, several things take place. Greg purchases a life insurance policy on Ron’s life with a $1 million death benefit (the amount equal to the value of CCC as set forth in the agreement). CCC establishes a bonus plan for Greg wherein CCC agrees to pay the premiums for the life insurance policy on Ron’s life. The premiums are deductible to CCC because they will appear on Greg’s annual tax notice as additional compensation.

Since it is not Ron’s intention to create an additional tax burden for Greg, CCC agrees to use a “double” or “gross-up” bonus for Greg: CCC pays Greg an additional bonus equal to all of the income taxes associated with the bonus of the premium. Doing so creates a larger deduction for CCC and makes the transaction income tax neutral to Greg.

What happens if Greg leaves CCC? What if Greg becomes disabled or dies before Ron? What if Ron decides to terminate Greg?

Greg, as owner of the policy (or his executor), could sell the policy for its fair market value to either Ron (the insured), or to CCC (of which Ron is the 100 percent owner). Either transfer qualifies as an exception to the transfer for value rules under IRC Sec. 101(a)(2)(B), thus preserving the income tax-exempt status of the policy’s death benefit.

Greg could also gift the policy to Ron. In doing so, and assuming the policy is worth more than $5,000, he may be required to have the policy appraised by a third party. Greg will also have to complete a gift tax return to report the value of the policy for the tax year when the gift occurred.

Related: Succession Planning: Just be SMART

If a key employee from outside the family will likely take over, the business may consider funding the buyout plan with an endorsement split-dollar buy-sell agreement.  (Source: Crump Life Insurance Services)

Related: The COLI market is making a comeback

Selling or gifting the policy to Ron will cause the policy proceeds to be includible in Ron’s estate for federal estate/state death tax purposes. Ron can avoid the inclusion by establishing an ILIT. Greg or his executor/trix could then sell the policy to the trustee of the ILIT based on its fair market value.

Prior to the transfer, Ron has gifted enough money to the ILIT to purchase the policy. Since a grantor trust is disregarded for income tax purposes, it is the same as transferring the policy to the insured (Ron). Consequently, this sale will also qualify as an exception to the transfer for value rules.

If Greg were unable to fulfill the terms of the buy-sell agreement, preserving the life insurance policy through the sale to either Ron or the ILIT assures that Ron’s heirs will be taken care of regardless of disposition of the business. At Ron’s death, Mary will have the benefit of tax-free policy proceeds to protect her future livelihood whether it’s pursuant to the buy-sell agreement or as a result of being a beneficiary of the ILIT.

On the other hand, what if Greg is not a family member but is his most reliable and capable key employee? An endorsement split-dollar-funded life insurance policy can be an ideal solution for the business owner who wishes to sell the business to a key employee who has shown the commitment to the future of the enterprise but lacks the strong family ties. Depending on the estate planning needs of the business owner, the required life insurance policy can be owned in one of two different ways.

Split-dollar solution one — The business owner owns the policy (using an endorsement split-dollar agreement). Ron enters into the previously described buy-sell agreement with Greg in which, upon Ron’s death, Ron’s spouse or estate is obligated to sell CCC, and Greg is obligated to buy it.

Ron, as the owner of CCC, applies for and owns a $1.5 million permanent life insurance policy on his own life to fund the agreement informally. Under the agreement, Ron is the owner of the policy and retains the policy’s cash values. He endorses $1 million of the death benefit over to Greg, and Greg agrees to pay “rent” to Ron for the death benefit. The rent that Ron receives each year is taxable income.

Related: Business owners don’t plan to retire

Under version two of the split-dollar arrnagement, the owner’s trust owns the life insurance policy, thereby keeping policy proceeds out of the estate. (Source: Crump Life Insurance Services)

Related: Exit planning: All questions answered

This arrangement is also subject to the split-dollar economic benefit taxation regime. Consequently, Greg’s annual “rent” is based on cost of the current life insurance protection, and calculated using table 2001 rates. Greg’s employer (CCC) can double bonus the economic benefit cost to Greg’s compensation and offset the expense of the additional income taxes associated with the bonus of the annual economic benefit. Additionally, the remaining death benefit remains part of Ron’s taxable estate.

If Ron’s estate will be subject to estate taxes so that the non-inclusion of the policy’s death benefit is important, but Ron wants to maintain control of the endorsement structure, he can establish an ILIT and have the trust own the life insurance policy. In turn, the trust could endorse a portion of the death benefit over to Greg.

Again, Greg’s annual rent will be equal to the economic benefit calculated using the either table 2001 rates, or, if available, the carriers’ alternative term rates.

Split-dollar solution two  — The owner’s trust owns the policy (using an endorsement split-dollar agreement). Under this structure, due to the grantor trust rules, trust income is taxable to Ron but because the trust is revocable, the policy is outside his estate. Following these steps should prevent inclusion of the proceeds in Ron’s estate.

Bottom Line

Life insurance preserves the business’ fair-market value for heirs. Succession planning for a closely held business presents a unique set of challenges not seen in businesses with multiple owners.

The true beauty of the one-way buy-sell is that it provides the owner flexibility to retain control of the business and income from it right through to the end of his or her life even if gradually turning the day-to-day operations over to the key employee or family member.

The buy-sell can be a very tax-efficient method of funding succession planning or a tool for maintaining long-term control. The key employee or family member becomes even more tied to the business with the amplified interest in its success, encouraging all parties to consummate the arrangement.

Related:

Opportunities aplenty: Helping business owners to retire

Best practices for working with family members

Cerulli: Significant Percentage of Advisors Haven’t Designated a Successor

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