Buy-sell agreements are a common succession planning tool for business owners where, upon a triggering event like the death of one owner, the surviving owners have either the option or the contractual obligation to purchase the deceased owner’s shares of the business. Traditionally, buy-sell agreements are structured either as cross-purchase agreements (where the surviving owners buy the deceased owners’ shares directly from their estate) or entity-purchase agreements (where the business itself redeems the deceased owner’s shares).
The agreements are usually funded by life insurance policies on each owner: cross-purchase agreements are owned by each owner on every other owner, and entity-purchase agreements are owned by the business on each owner. This has generally made entity-purchase agreements preferable for businesses with more than a small handful of owners, since an entity-purchase agreement only requires the purchase of one insurance policy per owner, while the number of policies needed for a cross-purchase agreement increases exponentially as more owners are added to the group.
Which makes it notable that, in a recent ruling by the U.S. Supreme Court in the case Connelly v. Internal Revenue Service, the court ruled that life insurance proceeds paid to an entity-purchase agreement increase the business’s value for the purposes of determining the taxable estate of the deceased owner, with the IRS arguing (and the court agreeing) that if a hypothetical third-party buyer were buying the shares, they would be willing to pay for them based on the full value of the company… including the life insurance proceeds.
As a result, business owners who have implemented entity-purchase agreements face the prospect of the insurance proceeds used to fund those agreements being at least partially included in their taxable estate, which, at a top Federal estate tax rate of 37%, could result in a significantly higher estate tax liability for owners whose estates either exceed the current $13.61 million estate tax threshold or for whom inclusion of the insurance proceeds would bump them over the threshold. And with the threshold scheduled to be reduced by 50% when the Tax Cuts & Jobs Act expires after 2025, many more business owners stand to be impacted by the Connelly decision in the near future.
The challenge of ‘fixing’ an entity-purchase agreement that may subject owners to higher estate tax is that it isn’t possible to simply move ownership of the business-owned insurance policies to the business owners themselves, because doing so could trigger “transfer for value” rules that make the proceeds taxable on receipt for income tax purposes. However, one exception to the transfer-for-value rules makes it possible to transfer a life insurance policy to a partnership owned by the insured person – which potentially opens the door for business owners to create a new “special-purpose buy-sell insurance LLC” that is treated as a partnership for tax purposes and assumes ownership of the insurance policies, which would serve the purpose of moving the policies off the books of the original business without running afoul of the transfer-for-value rules.
The caveat, however, is that despite having recognized such insurance LLCs as legitimate in the past, there’s no guarantee that the IRS will continue to do so – and in the wake of the Connelly ruling, they could potentially scrutinize new and existing insurance LLCs, challenging the legitimacy of ones that may lack a valid business purpose – which, if successful, could cause the LLC to be disregarded and the insurance proceeds to become taxable, either to the estate of the deceased owner for estate tax purposes and/or to all of the business owners for income tax purposes!
The key point is that while an insurance LLC may make it possible to transition away from an existing entity-purchase agreement to one that won’t create new estate tax exposure without unwinding the entire buy-sell agreement and starting from scratch, doing so does add to the complexity of the business succession plan and introduces potential risks that it won’t succeed in meeting the business owners’ goals. Which, for some owners, means it might be preferable to simply start anew with a traditional cross-purchase agreement – but for others, who are willing to accept the risks and navigate the challenges of drafting and adhering to an insurance LLC, it may still be worth it for the potential for estate tax savings and flexibility.
