Business Planning By Robert W. Finnegan, J.D., CLU Advanced Planning Attorney

Without proper planning many small businesses fail! 20 September 2018 Buy-Sell Strategies Without proper planning many small businesses fail! Presentation Title

Buy-Sell Review A contractual agreement between business owners 20 September 2018 A contractual agreement between business owners Based on certain triggers, a party agrees to sell his or her interest in the business and another party agrees to buy it. Defines the price, terms of the purchase, trigger events Death Disability Retirement Presentation Title

Buy-Sell Agreements - Review Benefits of a Buy-Sell Agreement Structuring the Buy-Sell Funding the Buy-Sell

1. Benefits of the Buy-Sell Ensure Continuity/Smooth Transition (Keyperson also important!) Prevent the failure of the business Create a market for closely held stock Ensure a fair price Note: Partners don’t know who will be a buyer and who will be a seller! Control who survivors are in business with Not with a surviving spouse Not with children who are not in the business With child who is involved in the business Fix the value of the decedent’s interest for estate tax purposes Provide funds to the surviving spouse and/or children Prevent a lot of stress

2. Structuring the Buy-Sell Frequently (but not always), the family business is transferred to heirs through the estate plan rather than with a buy-sell agreement. For other situations, consider a buy-sell agreement (today’s focus). Basic forms: Stock (or Entity) Redemption Cross Purchase

2. Structuring the Buy-Sell Stock (or Entity) Redemption Pros Simpler One policy per shareholder (regardless of # of shareholders) No Transfer-for-Value following death of a shareholder Cons Reduced stepped up basis for survivors AMT exposure on life insurance owned by ‘C’ corporations only Cross Purchase Stepped up basis for survivors No AMT exposure Multiple policies – n x (n-1) Transfer of decedent’s policies following death (transfer-for-value) Special Case Redemption: ‘S’, LLC or PS that is a Cash Basis Tax Payer

2. Structuring – Wait and See Buy-Sell Situation Parties want flexibility to use business or personal funds. Address transfer-for-value in multiple shareholder setting Wait and See Buy-Sell Structure Business option to redeem Individual option to purchase balance Business obligation to redeem Funding Individual policy ownership Use business funds to redeem shortfall Business can purchase policies from decedent’s estate

3. Funding the Buy-Sell What is the business worth? What are the ways to fund? No Planning (it’s the survivors’ problem!) Use available business cash flow Business borrows funds Planning Installment Sale Sinking Fund Life Insurance Note: Policy ownership must match the buy-sell agreement!

3. Funding the Buy-Sell Life Insurance Term (many buy-sell agreements) Permanent Shelf (UL, UL G, VUL, IUL) COLI (VUL) Note: Ensure that policy ownership matches buy-sell type!

4. Special Cases – Basis of Surviving Shareholders Policy owned by the entity. In an entity agreement, policy death proceeds increase the shareholder’s basis pro-rata (to retain income tax free character). With a ‘C’ corporation, conventional redemption and for accrual basis taxpayers, basis allocated to the decedent’s shares is wasted because those shares get a stepped-up basis in the estate. Entity Redemption Example: Two 50/50 shareholders, $5M business, $2.5M of coverage on each. A dies, $2.5M proceeds paid to company, used to redeem A’s shares. $1.25M basis allocated to A & B’s shares. $1.25M basis allocated to decedent’s (A) shares wasted since they also received a stepped up basis in the estate to $2.5M.

4. Special Cases – ‘S’ Cash Basis Redemption If Business Entity is an ‘S’, LLC or PS that is a Cash Basis Taxpayer, then it is possible to structure the redemption so the surviving owner receives a full step up in basis. Note: Does not work with Accrual Basis taxpayer (ever). Upon the death of a shareholder: Entity redeems the decedent’s interest with a promissory note. Entity closes the tax year (i.e. creates a partial tax year). In the new tax year, 100% of the basis is allocated to the one shareholder.

4. Special Cases – Underfunded Agreement Corporate Buy-sell with greater than 2 shareholders Following the first death, the agreement is underfunded Example: 3 Shareholders, $3M Business ($1M each) A owns $500,000 on B & C and so on A Dies, B & C purchase A’s interest in business B & C own Business worth $3M ($1.5M each) $1M insurance on each A’s estate owns $500,000 on B & C

4. Special Cases – Underfunded Agreement If surviving shareholders purchase policies owned by A’s estate For example B purchases A’s policy insuring C C purchases A’s policy insuring B On its face this purchase violates the transfer-for-value rule!

4. Special Cases – Transfer-for-Value General rule: life insurance proceeds are received income tax free. Any sale or exchange of a policy for valuable consideration violates the transfer-for-value (TforV) rule, unless it is within one of the exceptions. If TforV violated, death benefit in excess of purchaser’s basis is taxable. Exceptions: Gift of policy (basis) Transfer to the insured (including a defective grantor trust) Transfer to a partner of the insured (applies to partnership or LLC) Transfer to a corporation in which the insured is an officer or a shareholder As long as the last transfer in a series of transfers is within an exception, the proceeds will be income tax free.

4. Underfunded Agreement & Transfer-for-Value Continuing our example where surviving shareholders purchase policies owned by A’s estate: B purchases A’s policy insuring C C purchases A’s policy insuring B Those purchases are within an exception to TforV rule (Transfer to a partner of the insured) if The business is an LLC or partnership Corporate shareholders are also partners in a partnership or LLC If corporate shareholders are not partners in a PS or LLC Have corporation purchase the policies from A’s estate in conjunction with a wait-and-see buy-sell agreement. (Transfer to a company in which the insured is an officer or shareholder.) What if shareholders own interests in the same publicly traded partnership?

4. Underfunded Agreement & Transfer-for-Value Corporation purchase the policies from A’s estate In conjunction with a wait-and-see buy-sell agreement Over time converting cross purchase buy-sell into a stock redemption

4. Special Cases – Basis – One-Way Buy-Sell Situation No children in the business Owner would like to sell to key person (not related) Key person does not have means to purchase Owner will be funding One-Way Buy-Sell Give key employee a small amount of stock Structure as redemption - Owner retains control of the policy Loss of full stepped up basis to employee tradeoff for maintaining control Also consider ESOP (benefit all employees)

5. Advanced Structuring of the Buy-Sell Stock (or Entity) Redemption Cross Purchase Wait-and-See (Combo of redemption & cross purchase) Trusteed Cross Purchase (reduce # of policies, but transfer-for- value?) Partnership Redemption (reduce # of policies, no transfer-for-value) Cross Endorsement ESOP (Special case – lifetime exit strategy – beyond this presentation) Note: The optimal structure depends upon the facts and circumstances of each case including the client’s goals & objectives.

5. Advanced Structuring – Trusteed Cross Purchase “Trustee” owns policies and executes terms of the agreement on behalf of the individual shareholders. It is a cross purchase agreement “Trustee” is an escrow agent or agent of the individual shareholders Not a true trust arrangement “Trustee” stands in the shoes of each individual shareholder All of the benefits of a cross purchase buy-sell Stepped up basis for surviving shareholder No AMT exposure Same limitations following the first death Potential transfer-for value violation Multiple policies Typically client’s CPA, attorney or other trusted professional serves as the trustee. May be costs involved

5. Advanced Structuring – Trusteed Cross Purchase Uses Where shareholders don’t trust each other or parties simply want to ensure that the buy-sell agreement will be executed according to its terms. Keeps executor of the estate out-of-the-mix. For multiple business owner situations Can have one policy per owner. Must address transfer-for-value following first death. Structuring “Trustee” is the owner and beneficiary of all of the policies. Best practice is for “trustee” to hold the business interests Stock, PS or LLC interests Especially if owners don’t trust each other!

5. Advanced Structuring – Partnership Cross Purchase Overcomes the limitations of the trusteed cross purchase Partnership (or LLC) owns the policies Partners manage partnership (not a separate trustee) Policies are the sole assets of the partnership Partnership is a cash basis taxpayer Upon death of a shareholder Policy proceeds paid to the partnership Split the tax year so that basis increase allocated to surviving partners Each partner uses proceeds to purchase decedent’s Interest in the business Interest in the policies on the surviving partners (part of formula clause) An existing trusteed cross purchase can be converted to a partnership agreement.

6. Endorsement Buy-Sell Permanent life insurance design provides flexible options.

6. Endorsement Buy-Sell The Basics: Endorsement Cross Purchase Each insured Owns policy insuring his or her own life Endorses death benefit to non-insured partner Non-insured partner pays one-year term cost If large discrepancy in premiums (due to age or health), can equalize premiums through bonus plan

6. Endorsement Buy-Sell Design provides flexibility Each insured can select Best policy type Different type of policy Additional death benefit for personal needs Use Option 2, proceeds = CV + initial death benefit Insured beneficiary receives DB = CV Non-Insured beneficiary receives DB = Total DB - CV Insured takes over ownership of policy on own life if If business sold, If insured retires If non-insured partner dies Can then use policy for personal planning

6. Endorsement Buy-Sell Design provides flexibility Each insured can select Best policy type Different type of policy Additional death benefit for personal needs Use Option 2, proceeds = CV + initial death benefit Insured beneficiary receives DB = CV Non-Insured beneficiary receives DB = Total DB - CV Insured takes over ownership of policy on own life if If business sold, If insured retires If non-insured partner dies Can then use policy for personal planning

6. Endorsement Buy-Sell – Example 1 Example 1 - $5M Business Two 50/50 shareholders Business value $5M ($2.5M each) Cross Purchase Buy-Sell Additional Needs A would like additional $1M of insurance to provide for her family B is married without children, but would like to use policy CV to provide income.

Example 1 - Endorsement Cross Purchase Perm LI on A A Pays One-Year Term Cost on $2.5M Coverage on B’s Life Parties Cross Endorse $2.5M DB For Buy-Sell B B Pays One-Year Term Cost on $2.5M Coverage on B’s Life Perm LI on B Review Slide Content

Example 1 - Endorsement Cross Purchase - Flexibility A Dies 1st - $3.5M DB: B will receive $2.5M for B-S A’s Family $1M + $2.5M B-S $3.5M UL G on A Extra $1M fbo Family Parties Cross Endorse $2.5M For Buy-Sell B $2.5M VUL on B Opt II Review Slide Content B Dies 1st - Opt II increasing DB: A will receive $2.5M for B-S B’s Spouse will receive DB = CV + $2.5M B-S Policy Emphasizes Accumulation

Example 1 - Sell the Business UL G on A Opt II $3.5M UL G fbo Family + Sale Proceeds A’s Family Parties Tear Up Endorsements Now Personally Owned LI No Transfer! No Transfer-for-Value! B & Spouse B $2.5M VUL for Income + Sale Proceeds $2.5M VUL on B Opt II Review Slide Content

6. Endorsement Buy-Sell – Example 2 Example 2 - $50M Business 50/50 shareholders, $50M Business ($25M each), Cross Purchase Additional Needs Parties plan to sell the business in the next 5-10 years After sale, keep life insurance out of insured’s estate Provide coverage for estate needs until sell the business Higher initial face ($35M), after sale decrease face $10M Additional Term

Example 2 - Endorsement Cross Purchase with Trust A Gifts Premiums UL on A Opt II ILIT fbo A’s Family Parties ILITs’ Cross Endorse $25M B Review Slide Content B Gifts Premiums UL on B Opt II ILIT fbo B’s Family

Example 2 - Endorsement Cross Purchase with Trust A Gifts Premiums UL on A Opt II ILIT fbo A’s Family Tear up Endorsement B Review Slide Content B Gifts Premiums UL on B Opt II ILIT fbo B’s Family

6. Endorsement Buy-Sell – Example 3 Example 3 - $50M Business Two 50/50 shareholders, $50M Business ($25M each), Cross Purchase Additional Needs Keep additional stock out of surviving shareholder’s estate Pass control to surviving shareholder Recapitalize stock into voting and non-voting Non-voting sold to survivor’s ILIT Voting sold to surviving shareholder After sale, keep life insurance out of insured’s estate Provide coverage for estate needs until sell the business Higher initial face ($35M), after sale decrease face $10M Additional Term

Example 3 - Endorsement Cross Purchase with Trust A Gifts Premiums UL on A Opt II ILIT fbo A’s Family Parties ILITs’ Cross Endorse NAAR B Review Slide Content B Gifts Premiums UL on B Opt II ILIT fbo B’s Family

6. Endorsement Buy-Sell – Premium Fairness If a death occurs while the buy-sell is in place, there is an inherent unfairness built into the endorsement buy-sell structure. Consider: A pays the permanent premiums for coverage on her life A is the first to die Proceeds paid to B (cost: one-year term cost) B has 100% of company and insurance on his life. Note: This is always an issue with any cross purchase. It is just that with our trust planning, the stakes are higher.

6. Endorsement Buy-Sell – Premium Fairness Typical buy-sell ($5M business): A owns policy on B and vice versa. A dies. B receives $2.5M proceeds. B buys A’s stock. B now has $5M stock. A’s estate owns policy on B A’s estate maintains policy and equalization upon B’s death. B purchases policy, Family ends up with $5M stock & $2.5M

6. Endorsement Buy-Sell – Premium Fairness Solutions: Do nothing – survivor wins Stock purchase price includes reimbursement for premiums paid plus specified interest. Each party has term insurance and uses reimbursement to fund conversion. Purchase price paid with death proceeds and policy on survivor’s life 1st to die’s family made whole at second death

Buy-Sell Consulting Basic Fact Finding How is company organized (‘C’, ‘S’, LLC, Partnership)? Cash or accrual basis taxpayer? Owners, their relationship and ownership percentages Single owner Children in business or not Key employees (non-owners) Estimated Value of business Plans to sell business, keep in the family, uncertain at this time?