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Funding Buy-Sell Plans Using an LLC Structure

by Phil Levin, Esq. on July 15th, 2010

Developments in Buy-Sell Planning: Overview

For most business owners, the business itself provides the primary source of income for their family, both during working years and in retirement. Therefore, having an up-to-date, funded buy-sell plan is critical, not only in the event of disability or death, but also to provide a retiring business owner with an adequate source of income during retirement.

Unfortunately, the two traditional types of buy-sell legal agreements, (i.e., entity purchase and cross-purchase agreements) have significant limitations and disadvantages that often prevent our business owner clients from adequately solving their business succession issues.

Stock Redemption or Entity Purchase Plan

With an Entity Purchase or Stock Redemption arrangement, the business entity owns the life insurance purchased to fund the plan and the terms of the agreement require your client’s business to redeem the interest of an owner upon the disability, retirement, or death of an owner. Each owner also agrees that his or her estate will transfer the interest in the entity back to the business for a price agreed upon while all owners were alive.

Advantages of Entity Purchase structure include –

1. Simplicity of requiring only one life insurance policy per owner;

2. Each owner allocates all premium costs according to their percentage ownership in the entity; and

3. Assurance that an infusion of cash will be available, precisely when needed, to fund all obligations under the terms of the buy-sell plan upon one of multiple triggering events, including the disability, retirement, or death of a business owner.

Disadvantages of Entity-Purchase arrangements include –

1. There is no change to the surviving shareholders’ basis at the owner’s death so the surviving shareholders will incur larger capital gain tax upon a lifetime disposition;

2. The insurance policies are subject to attachment by creditors of the business;

3. If the corporation is a C corporation, the death proceeds may also be subject to the alternative minimum tax (AMT);

4. If corporate-owned buy-sell policies are over-funded, to provide non-qualified retirement benefits to owners, the benefits are generally subject to income tax; and

5. Potential taxation on redemption of the stock to the extent of earnings and profits where the attribution rules of IRC Sec. 318 apply.

Practical Pointer: While Stock Redemption arrangements require only one life insurance policy per shareholder to fund the arrangement, and may cost less to implement, in practice, these type of business disposition agreements have significant disadvantages, as compared to cross-purchase arrangements.

Cross Purchase Plan

Under a Cross-Purchase arrangement, each business owner, or shareholder, personally owns a disability and life insurance policy on every other owner, and each party agrees to buy an owner’s interest in the business in the event of the disability, retirement, or death of a departing owner.

Advantages of Cross Purchase structure include –

1. In the event of the death of an owner, the surviving business owners receive income tax-free life insurance proceeds needed to buy the stock owned by the deceased owner directly from the decedent’s estate;

2. The surviving owners increase their average basis in the stock, since the cost basis in the stock acquired from the deceased owner’s estate is increased to current market value, resulting in the surviving owners incurring a smaller capital gains tax upon a lifetime sale;

3. Use of a “Wait and See Plan” allows surviving owners to keep the life insurance proceeds for themselves, so long as retained corporate earnings are available to effectuate a redemption; and

4. The proceeds of all life insurance policies are protected from the claims of business creditors since the life insurance is personally owned.

Disadvantages of Cross-Purchase arrangements are –

1. The number of policies required to accomplish proper funding often becomes unwieldy, as the number of shareholders increase, since each owner must own a life insurance policy on each other owner;

2. The cash value of the life insurance policies are subject to attachment by the owner’s creditors;

3. If an owner fails to pay premiums, or refuse to pay death benefits pursuant to the buy-sell agreement, the integrity of the plan may be compromised;

4. The premium burden is allocated based upon the cost of insurance of each other owner, which may be burdensome to one or more younger business owners; and

5. Application of the transfer-for-value rule, when surviving owners purchase the life insurance policies from the deceased owner’s estate (which the deceased owner personally owned on the other owners) or need to buy new insurance to cover increased business values.

Practical Pointer: While Stock Redemption arrangements require only one life insurance policy per shareholder to fund the arrangement, and may cost less to implement, in practice, these type of business disposition agreements have significant disadvantages, as compared to Cross-Purchase arrangements.

Use of an LLC to Structure and Fund Buy-Sell Agreements

Using an LLC structure to own life insurance required for business disposition is a strategy that has advantages of both Cross-Purchase and Entity-Redemption agreements, but without the disadvantages of either. By using an LLC structure, shareholders execute a Cross-Purchase agreement and form an LLC to own the life insurance, which is taxed as a partnership. The Cross-Purchase agreement and LLC Operating Agreement which we draft for our business owner clients include specific provisions that reference each other.

Special provisions of the LLC Operating Agreement include –

1. The LLC manager is a corporate trustee, and any replacement must also be a corporate trustee;

2. Members cannot vote on life insurance matters;

3. The LLC manager must use life insurance proceeds as required under the terms of the buy-sell agreement; and

4. The LLC must maintain a capital account for each member, with special allocations of premiums and insurance proceeds.

Upon examination of this structure, the IRS has ruled that life insurance death proceeds would not be includible in the estate of the deceased LLC member. Thus, this structure contains the advantage of traditional buy-sell structures without the disadvantages.

Practical Pointer: Using an LLC business entity to own life insurance for funding a business disposition plan accomplishes the objectives of a buy-sell plan, without causing many adverse income tax consequences, without triggering estate tax inclusion of the insurance death proceeds, and avoids the other disadvantages of both Cross-Purchase and stock-redemption agreements. Further, this structure requires only one policy per owner, making it a much more attractive structure for our businesses owner clients.


A properly drafted and adequately funded buy-sell plan is critical to ensuring the succession of your clients’ businesses. Business disposition plans provide our clients, and their families, with financial assurance and peace of mind in the event of the disability, retirement, or death of a business owner.

While Summer has clearly arrived, unfortunately, many of your clients spend more time each year planning their vacation than they do planning for the succession of their business. In the vast majority of cases, business owners defer creating and implementing a succession plan because of either the expense or tax disadvantages of establishing traditional buy-sell structures.

Use of an LLC to own life insurance is an excellent strategy for funding buy-sell arrangements, since the LLC structure eliminates both of these very common client objections, while providing a much more attractive solution to accomplish the business succession goals of your clients.

The Levin Law Firm Prepares Buy-Sell Agreements

The Levin Law Firm regularly works with business owners and their financial advisors to prepare comprehensive Buy-Sell Agreements. As a member of the advisory team, The Levin Law Firm can work with you to create a cost effective plan designed to help clients achieve their retirement planning and business succession goals. Please call our office to arrange a Complimentary Consultation at (610) 977-2443.

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