24 Oct How to Arrange Insurance Funding of Your Buy-Sell Agreement 

Is a Special Purpose Insurance LLC the Answer? 

When planning your buy-sell agreement with your partners, how will you handle the insurance funding of your plan?   

Many companies use cross-purchase arrangements for their buy-sell planning.  But if you have three or more owners, managing all of the insurance policies for a cross-purchase plan can get unwieldy very quickly.  For example, three owners would be required to purchase six policies.  If that company adds one more owner for a total of four owners, then twelve policies would be required.  Management of all of these policies can quickly become complex.   

Buy-Sell Arrangements and Life Insurance Funding 

In cross-purchase buy-sell arrangements funded with life insurance, each owner owns a life insurance policy on all the other owners.  Cross-purchase arrangements are often beneficial because the surviving owners will get to increase their basis in their business interests due to the purchase of the deceased owner’s business interests.  

But due to the multiple life insurance policy issues with cross-purchase arrangements for businesses with multiple owners, some advisors use entity redemption arrangements.  In a redemption arrangement, the business is the owner and beneficiary of one life insurance policy per owner.  While this cuts down on the multiplicity of policies issued with cross-purchase arrangements, there are potential negative tax consequences to that arrangement.  For example, an increase in basis for the surviving owners may not be available in an entity redemption arrangement.   

Also, the Supreme Court’s recent decision in Connolly v. United States has made it important to reconsider using redemption agreements in light of the implications of that decision.  In Connolly, the Supreme Court held that the value of the life insurance proceeds received by a company upon the death of an owner increases the fair market value of the total company.  This decision makes it all the more important for your executor or trustee to get an appraisal of your company upon the death of an owner for estate tax reporting.  Depending on the size of your estate, you may face higher estate taxes due to the increase in the value of your company. 

So what are owners of closely-held companies to do when considering how to structure these arrangements going forward? 

The Buy-Sell Insurance LLC 

The Buy-Sell Insurance LLC (“Insurance LLC”) can solve many of the issues with both cross-purchase and entity redemption arrangements.   

For example, redemption arrangements may result in the loss of a basis increase for the remaining owners, the exposure of the life insurance policies to the business’s creditors, and potential income taxation on the change of ownership of the life insurance policy from the business to the insured at retirement. But the need for a lot of life insurance policies makes the cross-purchase agreement less desirable when there are many owners.  These drawbacks to the redemption and cross-purchase approaches may cause advisors to consider another option.  Enter the Insurance LLC.  

How It Works 

The owners of the business form a separate LLC (the Insurance LLC).  Instead of the business owners or their main company owning the insurance policies, the Insurance LLC owns the life insurance policies on the business owners’ lives to fund a separate buy-sell agreement amongst the business owners.  

This centralized ownership of the life insurance policies in the Insurance LLC has the following advantages: 

1. It makes the premium payments easier to administer and allocate between the business owners,  

2. It ensures all the policies are kept in force and that a business owner does not drop the policy ensuring another business owner, and  

3. It assists in paying the life insurance proceeds to a decedent’s estate for the purchase of the decedent’s ownership interest in the operating business as required by the separate buy-sell agreement. 

When an owner dies, the Insurance LLC will need to redeem the deceased’s membership interest in the Insurance LLC. Then the life insurance proceeds are allocated to the surviving members of the Insurance LLC.  This can happen by either the Insurance LLC distributing the insurance proceeds to the surviving members who then use the proceeds to purchase the deceased owner’s interest in the operating company.  An alternative way to handle the distribution is the Insurance LLC pay the proceeds directly to the deceased’s estate.   

In sum, by using the Insurance LLC, only one life insurance policy is needed per owner, the policies are centrally owned and managed by the Insurance LLC, the remaining owners will obtain an increase to their basis in their operating company interests, and the insurance proceeds distributed t the Insurance LLC members should be tax-advantaged. 

Is an Insurance LLC Right For You? 

We’ve only scratched the surface of Insurance LLCs here.  If your business has multiple owners, there are many advantages to considering this method for insurance funding.   Talk to us to find out if it works for you. Book Here