Understanding the Evolving Landscape of Buy-Sell Life Insurance and Its Impact on Estate Planning for Business Owners
In the realm of estate planning for business owners, buy-sell agreements have long been crucial tools for ensuring business continuity in the event of a partner's death or departure. These agreements typically stipulate how business interests are transferred upon specified triggering events, such as death, disability, or retirement. Central to many buy-sell agreements is life insurance, which provides the liquidity needed to facilitate a smooth transition of ownership in the event of the death of an owner.
However, the landscape of buy-sell life insurance is evolving, influenced by changing tax laws, economic conditions, and IRS regulations. Specifically, a recent IRS ruling of a Buy-Sell Agreement Life insurance policy and the effect of its proceeds on the deceased owner's estate makes it ever important to consider your options, even if you have existing plans in place.
This article will break down the various types of Buy-Sell Life insurance, how the recent Connelly vs IRS ruling affects these strategies, and possible things to consider.
Buy-Sell Agreement:
A buy-sell agreement is a legally binding contract between co-owners of a business, outlining what happens if one owner dies or leaves the business. It ensures a smooth transfer of ownership by specifying how the departing owner's interest is valued and who can purchase it.
The importance of such agreement comes from the fact that starting and growing a business is difficult. And most owners want to ensure that their hard work can benefit the people they care about without disputes with additional owners.
Types of Life Insurance Strategies to Fund Buy-Sell Agreements:
1.
A buy-sell agreement is a legally binding contract between co-owners of a business, outlining what happens if one owner dies or leaves the business. It ensures a smooth transfer of ownership by specifying how the departing owner's interest is valued and who can purchase it.
The importance of such an agreement comes from the fact that starting and growing a business is difficult. Most owners want to ensure that their hard work can benefit the people they care about without disputes with additional owners.
Types of Life Insurance Strategies to Fund Buy-Sell Agreements:
1. Cross-Purchase Plan:
- Description: In a cross-purchase plan, each business owner purchases a life insurance policy for the other owners.
- Mechanism:** When an owner dies, the surviving owners use the insurance proceeds to buy the deceased owner's share from their estate or heirs.
- Benefits: Simplifies valuation and funding, preserves step-up in basis for heirs and ensures liquidity without affecting the business's financial stability.
Downsides: Cross-purchase plans require each owner to buy a policy on each other. This is pretty simple with less than 3 owners, however, as the number of owners increases, so does the number of life insurance policies. For example, a business with 10 owners would require 90 total life insurance policies, which creates complexity if adjustments need to happen due to increasing business value or changing owners.
Connelly vs IRS and What it Means for Buy-Sell Life Insurance Going Forward
Connelly vs IRS and What it Means for Buy-Sell Life Insurance Going Forward
A recent ruling by the IRS and the Supreme Court could challenge the strategy of Entity Purchase Agreements going forward.
In summary, after the majority owner of a company (Connelly) passed away, the surviving owner (Connelly’s brother) executed the written buy-sell agreement and filed the claim for the Entity Purchase Life insurance policy. This gave the company a $3.5mm death benefit, with which $500k was going to be kept by the business and $3mm was going to pay the deceased brother's estate for the redemption of his shares, therefore giving the surviving brother 100% of the business.
The disagreement came about when the IRS determined that the deceased brother’s share of value in the business would include his shares AND the $3mm death benefit from the life insurance, thus creating an estate tax issue and costing the estate $800k+ in estate taxes.
The IRS ruled that if a 3rd party were to purchase the business, they would consider the $3mm life insurance policy as included in the value of the business. This goes against previous rulings of similar agreements in the past.
It should be noted that the brothers failed to fully follow the written agreement set in place and go with an informal valuation of the business rather than going through a formal valuation process. Although, it is not assumed that following this process would have changed the outcome in the end.
The significance of this ruling is 2 fold;
- It challenges the value and validity of entity purchase life insurance due to how the IRS ruled this case.
- With our country’s spending since the pandemic and its growing debt balance, many people are concerned about taxes being raised or other measures the government will take to claw back these funds. This, along with the pending “sunset” of our current tax laws at the end of 2025 and the estate tax threshold set to be cut in half at that moment creates a potential “perfect storm” for high-net-worth business owners and the ramifications of having additional proceeds being added to their estate.
What You Can Do?
Obviously, none of us can control what the IRS rules. But, we can control how proactive we are with our planning.
Here are some action items to consider for your own planning.
Review. Even if you have existing plans and agreements in place, this ruling shows us that things change and the more proactive we are, the better outcomes we will have.
- Step 1: Go back to your goals. What do you want to do with your business? What type of legacy would you like to create with your business?
- Step 2: Review existing agreements and meet with your appropriate legal, tax and financial councils to ensure they are still along with your goals. If you do not have agreements in place, this is a great opportunity to put them in place.
The second step would be to follow the formal processes and agreements laid out. Although it is unlikely that following a formal valuation would have actually helped with this process, it is prudent to follow a formal valuation process and formal steps. “Napkin agreements or calculations” very rarely end up working out better at the end.
The last step is to plan and adjust. Certain strategies for possible consideration;
- Special Purpose Life Insurance LLC’s have come up as a potential solution to help solve the estate tax issue brought on by this ruling. Although a strategy to consider, there is no guarantee that the IRS will consider these LLC’s as legitimate if their main purpose for existence is to simply avoid taxes. Additionally, owners should consider the additional cost to start and maintain such LLC’s.
- Cross-Purchase Plans. Another thought would be to simply switch over the insurance policies to a cross purchase plan. Some considerations for this would be the process to the policies required to make this switch or start this type of agreement as well as being aware of possible “transfer for value” rules if making a switch.
Conclusion
Laying out every possible strategy for a complex topic like Buy-Sell agreements and funding it with life insurance is beyond the scope of this post. However, what is clear is that the environment around us will continue to change, often overnight.
As mentioned previously, this makes it imperative to have a solid team of professionals in your corner that are communicating with each other and understanding what your particular goals are and what options are worth considering.
These planning topics are complex. Business owners need different strategies than most others. If you are looking for a review of your options, we offer complimentary consultations that can be scheduled via this link.
Disclosure: Intrepid Wealth Partners does not offer tax and/or legal advice and you should consult with your advisors in those areas for specific questions in those areas.
