As a business owner, you’ve worked hard to build and grow your company, and ensuring its continuity and stability in the face of unexpected events is crucial. One key component to achieving this is a well-structured buy-sell agreement funded by life insurance. While there are several ways to set up a buy-sell agreement, I often suggest the entity purchase agreement (or stock redemption agreement) funded with life insurance owned by the business itself. Here’s why this approach can be an effective solution for many businesses, including yours.
Why Choose an Entity Purchase Agreement?
An entity purchase agreement allows the business itself to purchase life insurance policies on each owner. The business is both the owner and beneficiary of these policies, and it pays the premiums. Upon the death of an owner, the business receives the life insurance proceeds, which are then used to buy out the deceased owner’s share from their estate. This agreement provides several advantages:
- Simplified Administration: With an entity purchase agreement, the business only needs to maintain one life insurance policy per owner. This is far more manageable than a cross-purchase agreement, where each owner must buy a policy on every other owner. For businesses with multiple owners, this streamlined approach can save both time and money.
- Centralized Premium Payments: The business pays all premiums, reducing the financial burden on individual owners. This can also simplify cash flow management, as premiums are a consistent, predictable expense for the business.
- Consistency in Valuation: The agreement helps establish a clear and consistent valuation method for the business. The life insurance proceeds provide the liquidity needed to buy out a deceased owner’s interest, ensuring that heirs are compensated fairly without forcing the surviving owners to scramble for funds or resort to selling off assets.
- Minimized Conflicts Among Owners: Since the business itself handles the purchase of shares, this approach helps prevent potential disputes among surviving owners regarding the buyout process, valuation, or funding.
Impact of the US Supreme Court Case: Connelly (2024)
The recent U.S. Supreme Court decision in Connelly (2024) has significant implications for buy-sell agreements funded by life insurance. In this case, the Court ruled that life insurance proceeds received by a business under an entity purchase agreement are generally considered exempt from federal income tax. However, the ruling emphasized the need for proper documentation and adherence to specific formalities to ensure that the transaction is viewed as a legitimate buy-sell arrangement rather than a disguised dividend or compensation.
Key Takeaways from Connelly (2024):
- Clarified Tax Treatment: The decision reaffirmed that life insurance proceeds paid to a business under a properly structured buy-sell agreement are not subject to federal income tax. This provides reassurance that, when structured correctly, these proceeds will be available to fund the purchase of a deceased owner’s shares without an additional tax burden.
- Importance of Formalities: The ruling highlighted the importance of adhering to strict formalities and maintaining accurate records to substantiate the agreement's purpose. Businesses must ensure that the buy-sell agreement clearly documents the valuation method, payment terms, and other relevant details to withstand potential scrutiny.
- Focus on Reasonable Valuation: The Court stressed that the valuation method used in the agreement must be reasonable and consistent with the fair market value of the business. If the agreement is found to be undervaluing or overvaluing shares to manipulate tax outcomes, the IRS may challenge the tax-exempt status of the proceeds.
Recommendation:
If your buy-sell agreement was established before the Connelly decision, I strongly recommend a legal review of your agreement to ensure compliance with the new guidance.
This review can help confirm that your agreement meets the required formalities and avoids any potential tax pitfalls under the recent ruling. A review can provide peace of mind and ensure that your business is protected under the latest legal standards.
Tax Considerations with an Entity Purchase Agreement
While there are many benefits to using an entity purchase agreement, it is important to be aware of the potential tax implications:
- Non-Deductibility of Premiums: The premiums paid by the business for the life insurance policies are generally not tax-deductible. This means the business must pay these expenses with after-tax dollars, which could impact its cash flow.
- Tax-Free Insurance Proceeds: The life insurance proceeds received by the business upon an owner’s death are generally income tax-free, as clarified in Connelly (2024). However, for C corporations, the proceeds may affect earnings and profits, potentially impacting dividend distributions or other financial considerations.
- Estate Tax Implications: The increase in the value of the surviving owners' shares after the business buys back the deceased owner’s shares could lead to higher estate taxes for the surviving owners. It is important to consider how the increased ownership value will affect the surviving owners' personal estates.
- Creditor Risk: Because the business owns the life insurance policies, the proceeds may be accessible to the business’s creditors in the event of insolvency or financial difficulties. Proper planning and structuring are essential to mitigate this risk.
Other Buy-Sell Agreement Options
There are alternative buy-sell structures, such as cross-purchase agreements and hybrid agreements. In a cross-purchase agreement, each owner buys life insurance policies on the other owners. This approach can be beneficial when there are only two or three owners and when they want to directly control their ownership interests.
Hybrid agreements combine elements of both entity purchase and cross-purchase agreements. This method can be appropriate in situations where owners want flexibility in who buys the shares or when a combination of business-owned and individually-owned policies makes financial sense.
Using Irrevocable Life Insurance Trusts (ILITs) for Additional Protection
For business owners concerned about estate taxes or creditor protection, an Irrevocable Life Insurance Trust (ILIT) can provide additional benefits. An ILIT is a trust specifically designed to own life insurance policies outside of the insured’s estate. Here’s how an ILIT can complement an entity purchase agreement:
- Ownership of Policies: When using an ILIT, the policies are typically not owned by the business but by the trust itself. This arrangement means that the policies are personally owned through the trust, which may require a different structuring approach.
- Potential Need for Cross-Purchase Agreements: If an ILIT is used, each owner may need to establish a separate trust to own life insurance policies on the other owners. This can resemble a cross-purchase agreement, where multiple policies are needed. Each owner’s ILIT would hold the policies on the other owners’ lives, and the trust would receive the proceeds to fund the buyout.
- Increased Complexity and Costs: Using ILITs with a cross-purchase approach can lead to increased administrative complexity and costs, especially when there are multiple owners. Each owner would need to set up their own ILIT, purchase policies on the others, and ensure proper funding for the premiums.
While ILITs can provide estate tax benefits and creditor protection, they often involve more complexity and may be more appropriate when there are a limited number of owners or when significant estate tax or creditor protection concerns exist.
Why I Prefer the Entity Purchase Agreement and Entity Insurance
Ultimately, I often recommend the entity purchase agreement for its ability to centralize the process, simplify administration, and create a predictable and fair outcome for all parties involved. It allows the business to handle all aspects of the buyout, reducing the risk of conflict and confusion among surviving owners. Furthermore, by using life insurance owned by the entity, the business can ensure that it has the necessary funds to carry out the buyout, providing peace of mind for both owners and their families.
If you’re considering how to best protect your business and your legacy, I’d be happy to discuss your unique situation and help you determine the most effective buy-sell strategy to meet your goals.
Feel free to reach out to me directly to explore this and other options tailored specifically for your business.
Jeana Goosmann,
CEO & Managing Attorney
Goosmann Law Firm PLC