insurance and the business owner – the buy-sell...

Insurance and the Business Owner – The Buy-Sell Agreement Dan M. Smolnik, JD, MBA

Disclaimer

The information in this presentation and associated discussion is for illustration of general legal principles only and may not be relied on as legal or tax advice. You should see a qualified professional to discuss your specific circumstances before taking any action.

The Market

Connecticut has about 1,468,291 people who either work for or own a small business.

This means that 1 in every 2.4 people you meet works for or owns a small business

Connecticut small business payroll is a bit over $78 Billion dollars a year

The Need

Business Owners Typically Place in Excess of 100% of their assets into the business

The Extraction of those Assets is almost invariably delayed

Owners Reduce Risk by Adding Investors/Partners/Shareholders

All this really accomplishes is a Risk Shift

Small Business Owner

Compared with the overall population, the small business owner is more likely to: Be married and have children Be college educated Income > $75k Live in a high value home Donate to environmental and

political causes

Adding Value With Insurance As a financial professional, you are

in a unique position to provide your clients with a durable and scalable framework

If you can lower Risk, you increase value:

Risk=Threat X Vulnerability X Cost

Risk Equation

The Risk Equation can be restated as:

Value at Risk = Pevent X Cost event

We cannot reduce the risk of the Events, but we can reduce their Cost

The Buy-Sell Agreement

When there is more than one equity owner of the business The owners often bring different

values to the business – sales—technical-capital

The loss of that value (death, disability, retirement) can be catastrophic

Typical Situation

Enterprise formed by two or three stakeholders, one brings some intellectual property, one brings cash and another brings sales and marketing skills

One dies, the widow of the deceased partner now becomes the owner of his share

The Buy-Sell Agreement

What Does it Do? Assures Liquidity by providing a

market for a decedent’s business interest

Provides a roadmap for orderly business succession. The risk of intractable family dispute is overwhelming

Establish an Estate Tax Value for a Decedent’s Interest in a Closely Held Business

The Family Owned Business

Valuation Issues are not Symmetrically Perceived

“Value” often includes non-economic factors

Family disputes are not subject to objective resolution

Objections

When you mention a Buy-Sell Agreement to a business owner, particularly in a family business, the owner immediately contemplates objections: Cost Complexity Loss of Casual Informality of Business

Relationships

3 Types of Buy-Sell

Redemption Agreement between the business

owner and the entity Sets terms and prices

Fixed Dollar Value Fixed Formula Valuations must comply with IRS Rev. Rul. 59-

60

3 Types of Buy-Sell cont’d

Cross Purchase Agreement Agreement among the business

owners The Business Entity Itself is not a

party to the agreement Any equity holders who do not come

up with the cash to buy their shares can find themselves at a voting disadvantage

3 Types of Buy-Sell cont’d

Hybrid Agreement Between and among the owners and

the entity Two varieties of Hybrid Agreement

RFR to entity then to other owners Assigned proportions to entity and other

owners

Tax Issues For Corporations

Deductibility of Premiums for Life Insurance to Fund the Agreement (generally not deductible)

Taxation of Life Insurance proceeds Accumulated Earnings Tax Recognition of Gain or Loss by the

corporation on purchase of its own shares

Tax Issues for Corporations, cont’d

The corporation’s basis in stock it purchases from a shareholder

The effect of the purchase of its shares on corporate earnings and profits

The effect of a purchase of shares on corporate NOL carryovers

Tax Issues for Shareholders

Treatment of the redemption as a sale or exchange (capital gain) rather than as a distribution of E&P (ordinary income) to the extent there are earnings and profits if it meets any one of five tests:

Five Tests for Sale Treatment 1. Distribution is not “essentially

equivalent to a dividend.” Facts and circumstances test. N.B. partial redemption in family owned business is always equivalent to a dividend Family Hostility Exception is generally

not available There will be family hostility, you just

need to plan for it

Typical Resolution of a Family Business Dispute

Five Tests, cont’d

2. Distributions that are “substantially disproportionate” under Sec. 302(b)(2) – must meet all these tests after the redemption: Retain less than 80% of prior shares

by Vote and Value Own less than 50% of total vote of all

shares and Not part of a plan to disguise a

distribution as a sale

Five Tests, cont’d

3. Distributions that completely terminate the shareholder’s interest under Sec. 302(b)(3) N.B. family attribution rules under

Section 318(a)(1) A s/h is deemed to own the shares of

stock owned by or for the s/h spouse, children, grandchildren and parents

Hence, in a family owned corp., it is difficult to completely terminate one’s interest

Five Tests, cont’d

4. Distribution in partial liquidation of the redeeming corporation under Sec. 302(b)(4) Cessation of a business that has been

conducted for at least 5 years and that was not acquired in a taxable transaction. Rev. Rul. 90-13

Five Tests, cont’d

5. Distribution made after the stockholder's death in order to pay death taxes and administrative expenses Estate qualifies only if the stock

comprises at least 35% of the adjusted gross estate

This exemption is rarely used

Funding the Buy-Sell

By far, the most common way to fund these agreements is with Life Insurance Most people do not know how to do

this Transfer for Value Rules Deductibility of Premiums

Transfer for Value Rule

Rule: The proceeds of a life insurance policy are includable in the beneficiary’s gross taxable income if the policy is acquired in a transfer for valuable consideration

Five Exceptions – Very Important

Example

A and B each own 50% of AB, Inc. Buy-Sell Agreement provides survivor will buy the shares of the first to die for $1 million. AB, Inc. owns the life policies on each of them. Each buys the policy on the other’s life from the company for the $20k surrender value. Each pays another $15k in premiums. When A dies, what happens?

The Result

Survivor receives $1M - $20k - $15k in ordinary income. If this gets taxed at a combined 40% rate, that takes $386k in tax This leaves $614,000 to pay a $1M debt

Use an Exclusion

1. Basis with Reference to Transferor’s Basis a. Sec. 368(a)(1)(A) reorg b. Gift

2. Transfer to the Insured 3. Transfer to a partner of the insured 4. Transfer to a partnership in which the insured

is a partner 5. Transfer to a corporation in which the insured

is a shareholder The last three exclusions are most common

One Way to Solve the AB Problem

Each situation is different, consult legal counsel

AB, Inc. Purchases Policies

on Lives of A and B

A

B

A and B Form a Partnership

AB, Inc. sells the policies to the AB partnership

Keep in Mind

The corporate by laws, certificate of incorporation and other documents can all be examined by the IRS to determine the rights of the shareholders. The Buy-Sell Agreement can cover disability, resignation and retirement, but the life policy cannot. Use cash value build up

The Message

Small and Medium Sized Business Owners represent a large and unmet need for life insurance The risk of not having it far exceeds to cost of having it The insurance professional is typically the first to see the client’s need and introduce the client to the solution

The Buy-Sell Agreement

Dan M. Smolnik Attorney at Law 500 West Putnam Avenue Suite 400 Greenwich, Connecticut 06830 203.542.7266 fax 203.306.3124