Question

Case #1: Arlene and Gerry are business partners in a stock corporation that sells institutional furniture to colleges, hospitals and prisons. They each own 50% of the stock in the company and they are considering putting in a stock redemption plan to keep the business going forward in case one of the owners passes away. They have engaged you to explain how a stock redemption plan would work, touching upon liquidity, funding the plan and taxes. You need to describe the pros and cons of such an agreement.

Case #2: Phil, Tony, Steve, Peter and Mike are all partners in a business that helps distribute music for various artists. They each own 1/5 of the partnership and they made an appointment with an attorney to make amendments to the partnership agreement to designate what happens in the case of one of the partners dies. They have engaged you to explain how a cross-purchase agreement would work, touching upon liquidity, funding the plan (how many insurance policies are needed) and taxes. You need to describe the pros and cons of such an agreement; and what happens to the funding mechanisms after one of the partners dies.

Answer 1

Case#1

What is Stock Redemption Plan:

A stock redemption is an agreement that is implemented by the owner’s of a business to facilitate the orderly transition of a business interest in the event of the death, disability or retirement of a business owner. With a stock redemption plan, the company agrees to purchase the interest of a business owner in the event his or her business interest becomes available due to death, disability or retirement.

The entity agreement outlines the terms of the sale and establishes a formula for determining the actual sales price of the stock based on the company’s valuation. It also obligates the company to purchase the departing owner’s shares while at the same time mandating that the departing owner or her heirs sell their business interest back to the company.

How the Stock redemption Plan Work:

Life insurance is the most convenient, effective and economical tool for funding a buy-sell plan. In a stock redemption plan funded by life insurance, each business owner is party to an agreement where the business purchases a life policy on the life of each business owner in an amount equaling their respective business interests.

The company is the premium payer, policy owner and beneficiary of each of the policies. In the event an owner dies, the company receives the proceeds of the life insurance policy and uses the proceeds to purchase the deceased owner’s business interest at a previously agreed upon price.

The deceased owner’s family receives instant liquidity at a fair market value for their business interest.

Taxation Related:

1. Life insurance policy premiums are not tax deductible to the business. Hence this is not considered as expenses for tax purpose.
2. Any death benefit proceeds received by the business are generally received income tax free.
3. If the business is properly valued, the value defined in the buy-sell may likely be binding when calculating the estate tax value for income and estate tax purposes.
4. Once a deceased owner’s shares are purchased, the remaining owner’s do not receive an increase in their cost basis for tax purposes.

Pros

1. Creates a binding plan for the efficient transition of a business in the event of an unforeseen death.
2. Easy to implement and cost effective.
3. Creates an instant market for the business at a pre-arranged fair market value.
4. Policy cash values can be listed as an asset on the company’s balance sheet.
5. Cash values may be accessed by the company for other business uses.
6. It may establish a useable fair market value for the business for estate tax purposes.
7. Only one life insurance policy is required for each business owner.
8. Business owners are not responsible for premium payments.
9. Provides liquidity for the deceased owner’s estate.

Cons:

1. There is no step-up in basis. If a business owner dies, each owner’s business interest increases but their basis remains the same.
2. Life insurance may be the alternative minimum tax.
3. Policy premiums are not deductible.
4. Policy cash values are subject to the creditors of the business.

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Case#2:

What is a Cross Purchase Agreement:

A cross-purchase agreement is a document that allows a company's partners or other shareholders to purchase the interest or shares of a partner who dies, becomes incapacitated or retires. The mechanism often relies on a life insurance policy in the event of a death to facilitate that exchange of value. A cross-purchase agreement is usually used in "business continuation planning", where the document outlines how the shares can be divided or purchased by the remaining partners, such as a proportional distribution according to each partner's stake in the company.

The Basics of a Cross-Purchase Agreement

1. A cross-purchase agreement is put in place in the event that shares become unexpectedly available. As a contingency plan for a partner's death, a partner will likely take out term life insurance policies on the other partners and list himself as the beneficiary. If one of the partners dies, the funds from the life insurance policy can be used to buy the deceased's interest.
2. Due to the structure of life insurance, this transfer of wealth will not be subject to income tax. In addition to being tax-free, life insurance proceeds from a cross-purchase agreement are not subject to creditors’ claims, because the owners of the business are the owners of the policies. Similarly, to prepare for possible incapacitation, a partner would purchase disability insurance.
3. The third major trigger for a cross-purchase agreement is the retirement of a partner or personal bankruptcy situations. Some cross-purchase agreements have a predetermined buyout price, which needs to be updated periodically. While others use a valuation formula or stipulate the hiring of an independent appraiser.

Pros

1. Creates a binding plan for the efficient transition of a business in the event of an unforeseen death.
2. Easy to implement and cost effective.
3. Creates an instant market for the business at a pre-arranged fair market value.
4. Policy cash values can be listed as an asset on the company’s balance sheet.
5. Cash values may be accessed by the company for other business uses.
6. It may establish a useable fair market value for the business for estate tax purposes.
7. Only one life insurance policy is required for each business owner.
8. Business owners are not responsible for premium payments.
9. Provides liquidity for the deceased owner’s estate.

Cons:

1. There is no step-up in basis. If a business owner dies, each owner’s business interest increases but their basis remains the same.
2. Life insurance may be the alternative minimum tax.
3. Policy premiums are not deductible.
4. Policy cash values are subject to the creditors of the business.

Funding Mechanism when one Partner Dies:

As discussed above the the main source of funding is from the life insurance plan which is being taken for this purpose. If one of the partners dies, the funds from the life insurance policy can be used to buy the deceased's interest. Due to the structure of life insurance, this transfer of wealth will not be subject to income tax.

In addition to being tax-free, life insurance proceeds from a cross-purchase agreement are not subject to creditors’ claims, because the owners of the business are the owners of the policies.