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.
Conclusion
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.
In an effort to help educate your clients about the importance of taking action now to protect their estate, I wanted to share the following true story with you. As the title indicates, this is a case study detailing how not to provide for for heirs. I hope this story provides your clients with the incentive and a sense of urgency to plan now to protect their estates.
At the age of 10, Barbara Hutton, granddaughter of F. W. Woolworth and niece of E. F. Hutton, inherited $25 million. The money stayed in trust, managed by her stockbroker father, Frank (E. F. Hutton’s brother), until Barbara was 21. Unfortunately, 46 years and 7 husbands after she inherited her share of the Woolworth fortune, Barbara Hutton died with a mere $3,000.
By the time the money was distributed outright to Barbara Hutton in 1933, at age 21, her fortune had ballooned to $40 million, thanks in part to Frank’s astute decision to sell out early enough in 1929 to miss the crash in October. After receiving her $40 million inheritance in 1933, Barbara gave her father $5 million as a thank-you gift for his management services. Then, she embarked on the sad and what became a lonely life of a socialite, where she was both envied and exploited for her money. Keep in mind that $40 million then, would be worth approximately $500 million today.
Barbara Hutton’s inheritance made headlines around the world and potential suitors quickly lined up for the attentions of the “million-dollar baby”, even before she hit the age of 21. Ultimately, of Barbara’s 7 husbands, the only one who received no alimony was actor Cary Grant. Each of her other husbands, after living very lavishly, received a substantial portion of Barbara’s fortune in connection with her divorces. When she died in 1979, at the age of 66, her share of the Woolworth fortune, as noted above, had dwindled to a mere $3,000.
Estate Planning Pitfalls and Opportunities
1. What could F. W. Woolworth have done differently to protect his granddaughter and what could she have done differently to protect herself and her assets?
2. What lessons can we draw from Barbara Hutton’s life, (which included drug addiction and outrageous spending sprees) in order to help our clients protect their loved ones?
3. How can your clients avoid the mistakes made by F. W. Woolworth, which allowed his granddaughter to receive $40 million, in cash and securities, on the day she turned 21?
An Unsigned Will Made Barbara Hutton Rich
Shortly before his death, F. W. Woolworth had his attorney prepare a Will that would have distributed his estate among his wife, daughters, grandchildren, friends, and charities. Under the terms of the new Will, his granddaughter Barbara would have attained merely “average” wealth. However, Woolworth failed to sign his new Will. When he died, his entire fortune passed to his wife, Jennie Woolworth, who was hospitalized. When Jennie died, the money was split three ways: two-thirds to Frank and Jennie’s two surviving daughters, and one-third to Barbara, the only child of their third daughter, Edna, who had committed suicide when Barbara was four. Because Barbara was a minor at the time, her share of her grandfather’s inheritance was placed in trust. But once she turned 21, Barbara was entitled to receive her entire fortune, outright in one lump sum.
A Trust Could Have Protected Barbara Hutton. Had F. W. Woolworth designed the right kind of trust, Barbara Hutton might have led an entirely different life. The beauty of a trust is that the grantor can include specific provisions to protect their beneficiaries from both creditors and predators. Woolworth could have provided for a certain percentage of his assets to be paid out to his beneficiaries at specified intervals, such as 25% at age 30, 25% at age 35, and the balance at age 40. Or, he might have provided that a specified amount of money be paid to his granddaughter upon the occurrence of one or more specified events.
A popular trust that my clients often establish for their children and grandchildren is known as an “Incentive Trust”. A typical “Incentive Trust” may specify that a certain amount of assets from a trust be paid to the beneficiary upon attainment of certain levels of education or to match income levels earned by a beneficiary.
One of the most important estate planning goals of our clients is to create a plan that preserves their wealth and protects their loved ones from losing motivation. As an estate planning attorney, I am called upon to design trusts for my clients who want to provide financial benefits to their spouse, children, and other relatives, but also want to make certain that inheritances are protected from rapid dissipation by beneficiaries, as well as from outside assaults by predators, divorce settlements, and frivolous lawsuits.
While Barbara Hutton could have executed a prenuptial agreement before each of her marriages, to protect her fortune in the event of divorce, even without a prenuptial agreement, the right kind of trust could have insulated her inheritance from the claims of her ex-spouses.
It is impossible to know how much of Barbara Hutton’s tragic life was caused by her early inheritance, received outright in one lump sum, and how much was attributable to the dynamics of her family life. What is evident is that, over 30 years after her death, her story provides us with a roadmap detailing….”How Not to Provide for Heirs”.
At The Levin Law Firm, we work with individuals to ensure that their property distributes to whom they want, when they want, and how they want, at the lowest possible overall cost to the client and their loved ones.
Please do not hesitate to call The Levin Law Firm concerning specific client situations and to arrange a Complimentary Consultation with your selected clients to help them achieve their estate planning goals.
A limited liability company (LLC) may be the best choice of entity for your business owner clients. LLCs can protect your client’s personal assets and takes advantage of valuable tax benefits.
The most favorable choice of business entity depends upon a number of factors, including the number of owners, the tax situation, and whether or not the business owner has employees. LLCs are often a good choice because this entity provides flexibility, low administrative costs, favorable tax treatment, and most importantly, limited liability protection to insulate your client’s personal assets.
A properly structured LLC combines some of the best aspects of partnerships and corporations into one entity. For example, partnerships and sole proprietorships do not insulate business owners from personal liability. However, by statute, a member of an LLC has limited liability and no personal responsibility for the debts or liabilities of the entity or other members of the LLC.
LLCs often work well for family businesses that may have exposure to potential liabilities, including real estate enterprises, and service companies.
If you provide advice to clients who own or operate a business, contact The Levin Law Firm to discuss the specific benefits of an LLC, along with other forms of business ownership. We can help you and your clients select and create the proper entity which is right for their business.
While laws regulating LLCs vary from state to state, following is a list of general LLC issues to consider:
Creating an LLC
Formation: It is fairly easy to create an LLC. First, Articles of Organization are created and filed with the state, along with the payment of the applicable fee. Second, an Operating Agreement is established among the members. This document establishes members’ rights, the percentage of ownership each member has in the enterprise, and the share of profits. Owners can include corporations, partnerships, other LLCs, as well as trusts. The Operating Agreement should also contain specific provisions detailing the management structure and relevant financial details.
Management: In nearly every state, clients can form an LLC with just one person, but there is no limit on the number of members. In theory, all members can participate in managing the company. However, smooth operation of a business depends upon centralized management to ensure good communication and the ability to reach consensus. In practice, we see many clients designate one or more owners (or even an outsider) in their Operating Agreement to take on daily management responsibilities.
Operations –
Limited Liability: LLC members are not personally liable for the company’s debts or obligations. However, LLC members do not enjoy complete blanket protection. More specifically, members may still be liable for debts of the business if they personally guarantee them. In addition, LLC members are also liable for their own professional malpractice if they personally injure someone, do not deposit taxes withheld from employees’ wages, or use the company to conduct personal business. Beyond that, members are liable only up to the amount of their capital contributions and the amount they agree to contribute to the firm’s capital.
Business Continuity: Depending upon state law, an LLC can provide that the business terminate upon retirement, bankruptcy, resignation, death, or expulsion of a member. Upon the departure of an LLC member, all remaining members of an LLC would be required to reallocate the business interest of a departing member and distribute assets in accordance with the terms of the Operating Agreement. In order to ensure that a departing business owner, or surviving family members of a deceased LLC member, receives fair value for their interest in the LLC, the Operating Agreement should include a “buy-sell” provision, which provides clear and consistent guidelines for all LLC members in the event that a member is no longer involved in the business.
Tax Treatment –
Federal and State Taxes: LLCs avoid double taxation. Like an S corp or a partnership, an LLC is a “pass-through” structure for income tax purposes. LLCs file a federal tax return, but pass through all of its profits or losses, to its members, who then pay tax on their personal income tax returns. In contrast, when a business is structured as a C corporation, your client’s company pays income tax on its earnings, and then again if the company’s post-tax earnings are distributed to the business owner as dividends.
Employment Taxes: LLCs, like S corps and partnerships, distribute income to their members but the income distributions are not considered wages by the IRS. Therefore, there are no employment taxes. However, a member who is active in the business and treated like a partner must pay self-employment taxes. Of course, the business owner must also pay employment taxes for any employees on the payroll.
An LLC’s tax advantages, combined with insulation for the members from personal liability, along with business succession benefits, make an LLC a very attractive and cost-effective choice of entity compared to other business models.
We invite you to call The Levin Law Firm to schedule a Complimentary Consultation to discuss your clients business objectives and estate planning concerns. We can help your clients to create the business entity which achieves their goals and estate planning objectives.
A recent article in OnWallStreet.com reported that more boomers are thinking about Long Term Care Insurance – for their parents. Is this a trend that you’ve seen too?
Featured in the article, Norm Mindel, a principal at Forum Financial Management in Lombard, Ill., is increasingly seeing his 40 to 50 year-old clients asking about Long-Term Care insurance for their parents. Often, this is to protect not only their parents’ estates, but their own financial future as well.
Phyllis Shelton, president of LTC Consultants, is seeing more of this new trend too. “What I hear now more than ever is that 20 years ago the objection was either, ‘I wont need it,’ or ‘My kids will take care of me.’ Today the boomer says, ‘I don’t ever want to put this on my kids,'” Shelton said. “It’s the most inhumane thing to saddle your children with long-term care, and today that’s why people are buying long-term care insurance.”
New Long-Term Care Trend: Boomers Insuring Their Parents
By: Stacy Schultz, March 10, 2010
Many advisors have been touting the benefits of long-term care insurance to their baby boomer clients for decades. While the recent recession has arguably helped clients listen to these benefits more than ever, they certainly aren’t new. What is new, though, is who boomer clients have begun buying such insurance for — their parents. Norm Mindel, a principal at Forum Financial Management in Lombard, Ill., is increasingly seeing his 40 to 50 year-old clients asking about long-term care insurance for their less well-off parents. Often, this is to protect not only their parents’ estate, but their own future as well.
“Many of them have just had a relative go through being in a nursing home, and they see the devastation and the stress it causes,” Mindel said. “They’re concerned about mom and dad, and if their parents don’t have a lot of means they want to buy insurance for them.”
Phyllis Shelton, president of LTC Consultants, said that she is also seeing more and more children buying long-term care insurance for their parents. Oftentimes several siblings will split the cost of the premium, she said, though the burden of care typically falls on only one sibling, most likely the daughter.
“The parent needs to understand that if they don’t buy this insurance the child is the one that suffers, because it can rob the boomer of a career, particularly women,” Shelton said. She recommended advisors find out if Long-Term Care insurance is in the mix for their clients’ parents.
Advisors can also emphasize this focus to shine light on the importance of boomers insuring themselves for their future care.
“What I hear now more than ever is that 20 years ago the objection was either, ‘I wont need it,’ or ‘My kids will take care of me.’ Today the boomer says, ‘I don’t ever want to put this on my kids,'” Shelton said. “It’s the most inhumane thing to saddle your children with long-term care, and today that’s why people are buying long-term care insurance.”
Special Needs Trusts are a critical component of estate plans for clients who want to provide supplemental benefits for a disabled loved one today, as well as when they are no longer able to provide financial benefits and care for a child, grandchild, or other individual with special needs.
The Levin Law Firm is experienced in establishing Special Needs Trusts for individuals with special needs. We can help your clients establish a Special Needs Trust so that government benefit eligibility is preserved, while simultaneously providing an additional source of assets to meet the supplemental needs of individuals with a disability….needs that go beyond the basic necessities of food, shelter, and clothing.
If you have clients who provide care for a child or loved one with special needs, it is important to put in place a plan of action to continue a similar level of care and services when the client is no longer able to provide for a loved one with special needs.
While clients can include specific provisions in their Will that allow a special needs individual to receive assets, such a bequest may prevent a special needs relative from qualifying for essential benefits under Supplemental Security Income (SSI) and Medicaid programs.
Unfortunately, in most states, public monetary benefits provide only for the bare necessities such as food, housing and clothing. As you can imagine, these limited benefits will not provide loved ones with the resources that would allow them to enjoy a richer quality of life.
But when clients leave assets outright to a special needs child who is receiving public benefits, parents run a high risk of disqualifying their child from receiving both federal and state government benefits. Fortunately, the government has established rules allowing assets to be held in trust, called a Special Needs Trust, for a recipient of SSI and Medicaid, as long as certain legal requirements are met.
Special Needs Trusts can be used for a variety of life-enhancing expenditures, (without compromising a loved ones eligibility for public programs), such as:
-
Upkeep and repairs of a residence
-
Medical check-ups and dental care, at facilities not covered by Medicaid
-
Attendance at religious services
-
Supplemental education and tutoring
-
Out-of-pocket medical and dental expenses
-
Transportation, including a wheelchair accessible van
-
Purchase and maintenance of a vehicle
-
Purchase of materials for hobbies and recreation activities
-
Funds for trips or vacations
-
Funds for entertainment such as movies, shows, and ball games
-
Purchase of goods and services that add pleasure and quality to the life of a loved one, including computers, videos, furniture, and electronics
-
Athletic training and fees for entrance of competitions
-
Special dietary needs
-
Personal care attendant
With a Special Needs Trust, a loved one can maintain eligibility for public benefits to cover their basic needs of food, clothing, shelter, and medical care, while funds in the trust can be used to provide for supplemental needs not covered by government benefits, which taken together, can make a significant difference in an individual’s quality of life.
To learn more about how a Special Needs Trust can make a significant difference in the life of a loved one with a disability, please contact The Levin Law Firm to arrange a Complimentary Consultation at (610) 977-2443.
