Funding buyouts
While there is a real cost to using life
insurance, the alternatives may be more costly. Funding a purchase in the
absence of insurance can cash-strap your company or force it to take on
major debt.
When a buyout is triggered by an event
other than death, installment payments may be advisable. This allows the
buyer to secure financing or fund the buyout through company earnings.
Typical triggering events besides death are
disability and employment termination, but others also may be included in
the agreement. For example, an act that discredits the company and may
result in felony conviction, such as embezzlement or fraud, may be a
triggering event. In fact, some buy-sell agreements have "bad
boy" clauses which, when triggered, establish a low buyout price.
For buyouts triggered by death, there are
two basic types of buy-sell agreements: the stock-redemption agreement and
the cross-purchase agreement. Variations and mixes of these arrangements
may be necessary to accomplish shareholder objectives.
Redemption agreements
In a typical stock redemption arrangement,
the business owns insurance policies on the lives of each shareholder, and
the shareholders enter into an agreement with the business. For example,
Lee, Pat and Chris – equal shareholders in LPC, Inc. – entered into
the following agreement with the company: On Lee’s death, LPC collects
life insurance proceeds and uses them to buy Lee’s stock from his
estate. Lee’s estate now has liquidity, and Pat and Chris each owns 50%
of LPC. Here are some important considerations:
- One policy is generally needed for each
shareholder (first-to-die policies are available to insure two or more
lives).
- The business owns, pays for and controls
the policies.
- The policies are subject to the claims
of the business’s creditors.
- Because the business is the purchaser of
the decedent’s shares, the remaining shareholders do not get a
step-up in their tax basis as a result of the purchase.
- Dividend treatment can result from stock
redemption in a family business because of family attribution rules,
unless specific conditions are met.
- Alternative minimum tax may apply for
other than a "small business" corporation.
Cross purchase agreements
In a typical cross-purchase agreement, the
business is not directly involved. Each shareholder buys a policy on the
life of every other shareholder, and all shareholders enter into a
purchase agreement.
Using the same example as before, Lee would
own one policy on Pat and one on Chris. Pat would own one policy on Lee
and one on Chris. And Chris would own one policy on Lee and one on Pat. On
Lee’s death, Pat and Chris would use the proceeds from their policies on
Lee to each buy 50% of Lee’s stock from Lee’s estate. Again, the
estate now has liquidity, and Pat and Chris each owns 50% of LPC. Again,
here are some important considerations:
- Multiple policies are needed. The total
number needed is equal to n(n-1), where n
equals the number of shareholders (e.g., six separate policies are
needed for Lee, Pat and Chris).
- The shareholders own, pay for and
control the policies.
- The policies are subject to the claims
of the owning shareholders’ creditors.
- Each purchasing shareholder receives a
step-up in basis for the acquired shares.
- No dividend is issued on the sale
because family attribution rules do not apply.
- No alternative minimum tax is incurred
because life insurance proceeds are not paid to the corporation.
Whether you should use a stock-redemption
or a cross-purchase agreement depends on many factors, including overall
premium expense, sources of funds to pay premiums, enforcement of the
agreement, the importance of step-up in basis, perceived simplicity, and
the shareholders’ primary objectives. Another consideration, at least in
connection with a redemption arrangement, is whether the life insurance
should be reflected in the purchase price of the stock. In most cases, the
cash value of the policies, not the death proceeds, are considered part of
the business’s assets.
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