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

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

4. 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

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

6. 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

7. 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

8. 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

9. 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

10. 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!

11. 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!

12. 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.

13. 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.

14. 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

15. 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!

16. 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.

17. 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?

18. 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

19. 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)

20. 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.

21. 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

22. 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!

23. 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.

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

25. 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

26. 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

27. 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

28. 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.

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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.

38. 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

39. 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

40. 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?