IN BRIEF
As versatile as a Swiss Army Knife, buy/sell agreements can be used to solve a wide variety of tax and financial problems associated with business succession or acquisition. But these planning tools are not without downsides, and they can even create unanticipated problems among owners. This article takes a deep look at buy/sell agreements with different structures in different contexts and shows how they can be used to solve problems and how to avoid them creating problems of their own.
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Buy/sell agreements can solve a number of business problems, but they also have the potential to backfire and create unforeseen problems, most infamously in the case Connolly v. United States. The first half of this article reviews how buy/sell agreements solve problems; the second half shows how buy/sells create them and ends with advice about solving a “Connolly problem.” Although this article focuses on corporations, the issues discussed apply equally to businesses owned as partnerships and LLCs. This article builds on the September 2018 CPA Journal article “Considerations for Using Buy-Sell Agreements,” by Hugh H. Lambert and Briana K. Wright, which details buy/sell agreement valuation methods. Because the information and advice in the 2018 article are still up to date, this article merely mentions valuation issues in passing.
Part 1: The Small Business Planner’s Swiss Army Knife
The modest buy/sell agreement is a financial tool that performs surprising tax and nontax duties. At its simplest, a buy/sell agreement is a contract obligating one party to sell all or part of their ownership interest in a business to one or more parties. Its essential function is to provide a market for the owner’s business interest. Aside from identifying the parties to the agreement, the contract must also specify a time or triggering event for the sale to take place, and a price or a method to determine the price at the time of the sale. Although the sale may take place promptly after the agreement is executed, the sale will more commonly take place upon the seller’s retirement or death. Buy/sell agreements are merely contracts and normally can be modified by the parties in mutual agreement if the need arises.
A buyer or pool of buyers will be identified in advance. The agreement will generally provide a method of arriving at a sales price for the stock. Although a potential buyer can pay for corporate stock with personal funds, buy/sell agreements usually employ life insurance on the lives of the selling shareholder that would fund a sale if the buy/sell is triggered by the shareholder’s death. The insurance can be purchased by the corporation, the shareholders, or both. Although most buy/sell agreements are arranged as a “cross-purchase” among the owners, a corporate redemption is also an option. No matter which type of agreement is used, life insurance premiums are not deductible for tax purposes, and policy owners receive proceeds (payouts) tax-free.
Valuation
When a business buys back and retires a shareholder’s stock, ownership shifts to the remaining owners. Identification of a potential buyer becomes more valuable with assurances of follow-through, and a purchase price is typically set. The insurance can be paid for by the business, the owners, or both. The valuation established in the agreement may or may not satisfy tax authorities. Because of these complexities, getting advice at the outset from an experienced business lawyer and an insurance professional is beneficial. A brief review of valuation issues follows; a fuller discussion can be found in Lambert and Wright (2018).
A buy/sell agreement sets out a methodology for calculating stock price for the sale transaction. The buy-out price can be arrived at in various ways. The most accurate method is having the fair market value determined by a professional appraiser. These agreements often require a mandatory appraisal of the business. Over time, the appraisal is apt to grow stale, which triggers the need for an updated one—an expense some owners might rather avoid. An alternative would be to include a formula to determine fair market value. Such a formula attempts to arrive at or adjust the fair market value in future years without the need for a new appraisal, but it may not account for certain unique aspects of different types of businesses. The least accurate method is an agreed-upon value. In the authors’ view, this method is not advisable for anything but a very small and predictable businesses. Even an accurate fixed price would be too low over time, although it could also be too high if the value of business falls. Book value omits any goodwill. Failing to consider other possible changes in asset values can also affect a business valuation. For example, a buy/sell agreement that fails to anticipate changes in business-owned real estate may cause a serious dispute when a buy/sell agreement is triggered. A formula that relies on one or more external measures may or may not produce an accurate adjustment.
When there is actual uncertainty about the fair market value, the parties to the buy/sell agreement could agree to a contingency clause that sets a price but also provides that if the IRS later audits the transaction and determines a higher amount, the corporation is obligated to make an additional payment to the deceased’s estate to help pay any additional estate taxes.
All businesses change ownership over time. Even family-owned businesses will have different owners as members of a younger generation replace older ones. In closely-held businesses, succession planning typically has a mixture of business, tax, and family issues. Ownership changes in closely-held firms often have more dramatic consequences for individuals and families. In a closely-held business, the owners’ entire current income and wealth may be tied to the business. In some cases, owners and their families may have the bulk of their wealth in the business and lack other diversified investments. In family-owned businesses, individuals in the extended family may all follow this pattern. Accordingly, change of ownership planning may focus more on individual owners than the business entity.
Buy/sell agreements are typically funded with life insurance policies on the lives of the owners. On an owner’s death, the policy death benefit pays for the ownership interest. Buy/sell agreements come in two general formats: redemptions and cross-purchases. In a redemption, the business could simply use corporate funds to buy the departing owner’s shares. More commonly, the corporation buys and owns a life insurance policy on each owner. When an owner dies, the policy death benefit is used to buy the deceased’s ownership interest from the owner’s heirs and the interest is extinguished, increasing the ownership interests of the surviving owners. In a cross-purchase, each shareholder owns a life insurance policy on the life of each other shareholder. The death benefits pay for the deceased owner’s ownership interest. The greater the number of owners, the greater the number of life insurance policies required. For example, a company with just five owners requires 20 policies.
Policies owned by individuals are valued at cash value plus premiums paid but unearned at the date of death. In a cross purchase, the money to purchase the shares—or pay for the life insurance that will pay for the shares—comes from the individual owners, not the corporation. But the corporation may be able to pay shareholder-employees a bonus to pay for the insurance. If the payments cannot be justified as compensation, the IRS may allege that such payments are constructive dividends that are income to recipients, but nondeductible to the payor-corporation. In a redemption format buy/sell agreement, the corporation buys and owns the life insurance policies. The business receives a death benefit, which it uses to redeem (buy) the shares from the deceased owner’s estate.
Buy/sell agreements need regular review, especially when the business changes. Besides changes in value, individual and family needs may have changed since the agreement was first drafted. Luckily, buy/sell agreements are simple contracts and can be changed if all parties agree. Although buy/sell agreements are useful tools for succession planning, they are only effective when they are up to date and state a path to determine value, notwithstanding the difficulty of stating an accurate price when drafting the agreement. In addition, the agreement should aim to minimize both income and estate taxes. This is an area where transaction form matters.
Although both a redemption (a buyout funded by the business) and a cross-purchases (a buyout funded by fellow owners) have the same essential function—facilitating the sale of shares—they have far different financial consequences. In a redemption funded by corporate-owned life insurance on the life of the deceased shareholder, the surviving shareholders’ wealth typically automatically increases because each shareholder’s ownership percentage increases when the corporation buys back and retires the deceased shareholder’s shares. In a cross-purchase by co-owners (whether life insurance funded or not), those co-owners will receive an increased income basis in their stock, which will minimize their income tax when they sell their interests.
Creating a buy/sell agreement requires devising a succession plan. This can involve difficult choices, especially when family members are involved. Because any decision is likely to result in a major disappointment or feud, family owners may avoid making choices, but procrastinating can create the same problems. Anticipating future events can be difficult, so it should not be surprising that owners avoid dealing with these issues.
Tax Issues
Besides the planning needed to deal with business and family issues triggered by the change of ownership, advisors to business owners must anticipate both income tax and estate tax issues. The form of the buy/sell transaction can have a large impact on the tax consequences to the owners, as well as the business itself. A buy/sell agreement typically does not operate until triggered by an event described in the agreement itself. Because buy/sell agreements will typically operate in the future, the parties have the opportunity to design a transaction that will provide favorable, if not ideal, tax consequences, in contrast to reporting a transaction that has already happened.
The party selling the business interest will have a taxable gain or loss. If the deceased’s heirs are selling the ownership interest, tax may be modest because the tax basis of the interest will get stepped up to fair market value at the decedent’s death. On the other hand, if the buy/sell agreement is triggered before death, possibly because of the shareholder’s disability or divorce, the seller’s income tax cost could be substantial, especially if the business has appreciated in value over a long period of time.
The buyer can also have tax consequences. If an individual or a business buys the deceased owner’s business interest, the buyer will have no income tax liability. But buying assets rather than stock can be more attractive to a buyer, because the purchase price can be allocated to tax depreciable assets rather than non-deductible stock. Accordingly, an equity acquisition can be less attractive for a buyer and thus depress the purchase price. This is of particular interest to a fellow owner thinking about buying an existing owner’s stock. When a corporation is owned solely by family members, different transaction designs may be more costly for some family members than others if the owners acquired their interests at different times. When a redemption occurs in a corporation solely owned by family members, any gain will be treated as a corporate dividend, unless the exiting shareholder has a complete termination of interest in the business [IRC § 302 (b)(3)].
In a cross-purchase, shareholders will own the life insurance policies on the lives of their fellow shareholders. If these are cash value policies, the value of the policies will be included in the taxable estate of the policy owner. Although the receipt of insurance death benefits is not subject to income tax, the cash value of life insurance policies owned by a decedent is included in their estate. This may cause unexpected estate tax problems for the family.
Although redemption format and cross-purchase format buy/sell agreements both fulfill the same purpose—creating a market for the seller’s stock—the income tax effects are quite different because of the transactions’ impact on stock basis. When a corporation uses corporate funds to redeem the stock owned by a deceased owner, the transaction does not increase the basis of the stock held by the remaining owners. In contrast, stock acquired in a cross-purchase transaction will result in a basis equal to the purchase price. Compare the two examples below.
The form of the buy/sell transaction can have a large impact on the tax consequences to the owners, as well as the business itself.
Example 1, stock redemption format: A & B each invested $100,000 in Alpha Bravo Inc. The current business value is $1,000,000.
Owner A dies. A’s 50% stock interest has a fair market value of $500,000 at the date of death. Alpha Bravo Inc. redeems A’s stock for $500,000, and it becomes treasury stock. Owner B, the other original 50% owner, ends up owning 100% of the remaining outstanding stock. The stock redemption format doesn’t increase B’s basis. B’s basis remains the original 50% investment of $100,000. If B subsequently sells 100% of the shares for $1,000,000, the capital gain would be $900,000.
Example 2, cross-purchase format: A & B each invested $100,000 in Alpha Bravo Inc. The current business value is $1,000,000.
Owner A dies. A’s 50% stock interest has a fair market value of $500,000 at the date of death. Under a cross-purchase, Owner B would pay $500,000 for Owner A’s 50% interest, resulting in a step-up in basis of $500,000 plus B’s original $100,000, for a total stock basis of $600,000. A subsequent sale by B for $1,000,000 generates a capital gain of $400,000—a significant savings over the tax result under the redemption format. The result would have been similar if in the first example the corporation had purchased a $500,000 life insurance policy to fund the redemption and, in the second example, B, rather than the corporation, purchased a $500,000 life insurance policy to buy A’s shares.
This basis difference would make the cross-purchase choice preferable for a corporation when the shareholders anticipate selling the business to an outsider rather than keeping ownership in family hands. Generally, any stockholders in a business with assets far in excess of the shareholders’ stock basis will benefit from a transaction that increases their basis. It is fair to conclude that, in a cross-purchase, the tax savings all go to the surviving shareholders, whereas, in a redemption, both the deceased shareholders’ estate and the surviving shareholders typically get the economic benefit from the life insurance. If the surviving shareholders hold the shares until their death, the surviving shareholders’ benefit may itself be subject to estate tax when they die. Changing the format of a buy/sell to a cross-purchase may merely postpone payment of tax.
Entering into a new buy/sell agreement can trigger unanticipated tax issues. For example, a shareholder’s estate plan may anticipate relying on deferred payments of federal estate tax for their heirs under IRC § 6166, which requires the business to comprise at least 35% of the estate. A new buy/sell agreement may inadvertently upset this planning.
Tax planning needs to consider both income and transfer taxes. Transactions can sometimes control not only the amount of tax, but also which individuals bear the burden. It is not unusual for a transaction to generate more tax to members of one generation than another. In a cross-purchase, shareholders will own the life insurance policies on the lives of their fellow shareholders. If these are cash value policies, the value of the policies will be included in the taxable estate of the policy owner. Although the receipt of insurance death benefits is not subject to income tax, the cash value of the policies owned by the deceased is included in the decedent’s estate. This may cause unexpected tax problems for the family.
The tax issues involved in closely-held and family-owned business successions can be more complicated. There are additional transfer tax valuation rules when the transaction occurs between family members. Restrictions will not be taken into account for the valuation, unless they meet three tests designed to differentiate legitimate sales and partial gifts. A buy/sell agreement must be a “bona fide” business arrangement; it must also “not be a device” to transfer property to family members at lower than fair market value, and the terms must be “similar to an arm’slength agreement” (See IRC § 2703 for more details).
When a buy/sell agreement occurs within one family, the wealth may be subject to estate tax twice. For example, when an individual dies owning a substantial stock position in a successful business, and that stock is transferred within the family, the same stock may be subject to estate tax a second time when the buyer dies.
Part 2: Plans that Backfire
Professional advisors agree that having a buy/sell agreement is better than not. Although some owners who lack a written agreement can agree on a mutually acceptable division of a business, a written agreement provides certainty. Nevertheless, there are a number of reasons why an agreement may actually backfire and create problems.
Missing terms. Buy/sell agreements do not need to be complex to be enforceable. A small partnership may not require a detailed agreement. Problems may arise as a business grows in size and complexity. For example, the simple agreement may lack specific rules concerning adding new partners/owners, mandatory retirement age, notice periods for voluntary departures, phased retirement options, noncompete and client transitions, or dispute resolution procedures.
Disputes can be triggered because procedures are not set out in the agreement. Although a buy/sell agreement can be quite lengthy, it may fail to anticipate every eventuality. Buy/sell agreements typically provide for a departing owner to sell their interest back to the business in a “redemption” or to sell their interest to other owners in a “cross purchase.” Such buyouts are typically funded by life insurance. If term insurance is used, the owner may become uninsurable once the term ends because of health issues. A dispute may arise if this situation develops and the alternatives are unappealing. One or more of the remaining co-owners may be able to fund the transaction, but that would change ownership percentages. The business itself may be able to redeem the interest if life insurance is unavailable, but this may require the other shareholders to invest more into the business (if possible) as well as require an unanticipated change in ownership percentages.
Another question might involve procedures when the heirs of a deceased shareholder continue to hold insurance policies on the lives of the other shareholders. This is trickier if heirs are non-participants in the business. Finally, an agreement that fails to mention the disposition of real estate used in the business could be a dispute waiting to happen.
Vague valuation language. Vague language in buy/sell agreements relating to valuation has caused numerous problems (Lambert 2018). An agreement requiring a “fair value” payout in place of “fair market value” leaves room for a dispute. Requiring any buy-out at “book value” demonstrates an intent to favor the owners who stay over those who exit. Although there can be excellent business reasons for this, the term can be expected to generate a dispute, and courts may be sympathetic to a charge of majority oppression and unfair surprise.
An agreement that omits any language about marketability discounts can also lead to unhappy surprises and even litigation. Appraisers commonly employ marketability discounts in valuing closely-held businesses, so if the owners do not want discounts applied to value interests, that intent needs to be reflected in the agreement. An example would be Seagroatt Floral Co. v. Riccardi (Court of Appeals of New York, 1978), in which the court applied a discount. In some situations, vague language is compelled by statute. For example, New York Corporation Law Section 1104-a empowers holders of 20% or more of the outstanding shares of a corporation to present a petition for dissolution to escape being “locked in.” But IRC § 1118(a), (b) provides that after such a petition is filed, other shareholders or the corporation itself may elect to purchase the shares owned by the petitioners “at their fair value and upon such terms and conditions as may be approved by the court.” Such disputes end up in court valuation proceedings or fullblown lawsuits, such as Ferolito v. Arizona Beverages USA LLC, 2014, 2014 NY Slip Op 05153 (119 AD3d 642), a closely held local company with a buy/sell agreement that grew to $4 billion. The court had to decide the “fair value” of the minority interest after one co-owner triggered the agreement to sell his shares.
Failure to follow terms.
Even if a buy/sell agreement sets out rules for exits and entrances, if the business owners repeatedly or arbitrarily ignore those rules, a court may not help enforce them at a later time. For example, if the buy/sell agreement requires a majority vote for admission of a new owner, but new owners have been admitted without taking a vote, the owners may not be able to block a new owner’s admission by requiring a majority vote in the future.
Failure to update the agreement.
Once owners enter into a buy/sell agreement, it may never be reviewed again. After a few years, the dollar amounts or even the ownership percentages used in the agreement may no longer reflect reality. The life insurance policy levels may no longer be sufficient to fund a buy-out, and the agreement may not detail how the shortage is to be made up. The sale of a business can create other disputes, despite the presence of a buy/sell agreement. Consider the following example:
Advisors should be aware that their clients may be able to use buy/sell language to gain advantage or may be victimized by another business partner or even a family member.
Smith Corporation is owned by three brothers: Alan, Brian, and Carl. Alan and Brian each own 20% of the stock, while Carl owns 60%. Their agreement, drafted 15 years ago, gives surviving shareholders the right to purchase a deceased shareholder’s stock at a formula price, with the proceeds going to the deceased shareholder’s estate. The agreement is not funded by life insurance. The agreement specifically names each shareholder and their estate as parties bound by the agreement. The intent was to allow the brothers to keep control of the business.
Five years ago, Carl transferred his shares to a living trust as part of his divorce settlement. The trust names Carl as trustee during his lifetime and names Carl’s ex-wife, Jane, as successor trustee. The trust also provides that upon Carl’s death, all of Carl’s stock should be divided between his two adult children from his marriage to Jane. When Carl dies, Jane argues that the living trust is not bound by the Smith Company buy/sell agreement, since neither the trust nor Carl’s estate were party to the agreement, and she intends to transfer the shares to Carl’s two adult children, which will make them co-owners along with their two uncles. The children were estranged from their father and their uncles, and they want the business liquidated and the assets sold. Alan and Brian, both shareholder-employees, insist the buy/sell agreement prevents this result. Although mediation might settle this dispute, litigation might result.
Barring admission or forcing expulsion.
Owners may try to use buy/sell agreement language to bar the admission of new entrants, expel other owners and, in some cases, bar the exit of others. Advisors should be aware that their clients may be able to use buy/sell language to gain advantage or may be victimized by another business partner or even a family member. Whole legal treatises have been written on “oppressing” fellow business owners. O’Neal and Thompson’s Oppression of Minority Shareholders and LLC Members (Thomson Reuters) is full of examples of business partners and family members preying on one another.
Charter provisions in small businesses may require super majority voting on important matters, so minority owners have little say in running the business. For example, New York Business Corporation Law (BCL) §§ 402 and 616 allow incorporators to include supermajority requirements for specific acts. The New York Limited Liability Company Law §§ 402 and 417 allow LLCs to set supermajority (or even unanimous) consent requirements for major business changes in their operating agreement, and New York Partnership Law §§ 20(c)(3) and 45 allows supermajority requirements in partnership agreements for actions that would impact the continuation or operation of the business, unusual acts, or fundamental changes.
Majority owners can use this supermajority rule to make it difficult for minority shareholders to increase their ownership. Existing owners may want to restrict ownership to exclude owners who may want to change business strategy, compensation, or dividend policies. In some cases, new owners may want to replace management or may liquidate the business, ending the jobs of other shareholders and employees.
Majority owners may want to prevent a retiring owner or the estate of a deceased owner from selling their interest to anyone not already a shareholder. The buy/sell agreement may allow them to effectively block the sale of stock. Rights of first refusal can bring about the same result.
The majority can sometimes block an exit by a minority owner by bogusly claiming an inability to fund a buyout. In other situations, majority shareholders may wish to do the opposite and eliminate minority ownership altogether. Some buy/sell agreements provide for mandatory sales for minority shareholders, but optional sales for majority shareholders. There are other practical strategies to harass fellow shareholders. For example, majority owners can withhold discretionary bonuses to deprive minority owners of liquidity. The power to fire a shareholder-employee gives majority owners a large amount of leverage.
Agreements sometimes provide for sales of stock but fail to mention gifts of stock. Typically, gifts would take place between family members. For example, a business owner may want to pass control of a company to their children. This may be against the wishes of the other shareholders who want to avoid working with a younger inexperienced individual. Fellow owners may not want to be in business with a deceased shareholder’s spouse. If the non-family shareholders insist that gifts are not permitted under the buy/sell agreement, the matter might be headed to court under the theory that omission of a right in the buy/sell agreement does not mean the right does not exist.
Unanticipated tax results.
A buy/sell agreement can trigger different tax results for different owners. Upon a triggering event, shareholders with low basis will face substantially larger capital gains tax bills than those with high basis, even when receiving identical payments. Original founders typically have a very low basis in their shares, while later investors who bought in at higher valuations have a much higher stock basis. If the trigger is a divorce, only one shareholder may be selling stock. If the trigger is an owner’s death, several owners may be involved and have very different tax consequences. The heirs of a deceased owner may take a fair market basis in inherited stock or other ownership interest, so their income tax cost may be minimal. If the trigger precipitates the liquidation of the entire business, long-time owners may face a substantial income tax bill.
In a liquidation not triggered by death, the consequences for longtime owners may be less extreme. The gain can be caused by differences between inside and outside basis. In pass-through entities like partnerships and S corporations, differences between a shareholder’s outside basis (in their ownership interest) and their share of the entity’s inside basis (in its assets) can create severe tax consequences. If an IRC § 754 election is not in place, a departing partner who joined recently might face a much higher tax bill than majority partners, despite all owners receiving an equal distribution.
Co-owners can experience different tax results depending on their AGI. When a buy/sell agreement includes a mandatory installment payment structure, owners with modified adjusted gross income exceeding certain thresholds may be subject to the Net Investment Income Tax (NIIT) and its additional 3.8% tax burden. Transfer of an insurance policy after an owner’s death can create tax issues. For example, if a business owner dies holding two cash value policies on the lives of fellow partners and their heir sells these policies to the other partners, then this transfer-for-value may imperil the tax-free nature of the life insurance [IRC § 101(a)(2)].
Ownership of life insurance policies to facilitate a cross-purchase buy/sell agreement can create unexpected transfer tax results. Although the receipt of life insurance death benefits is not subject to income taxation, the cash value of the insurance policies on the lives of the co-owners owned by their fellow partners is included in the owners’ estates for federal estate tax purposes. A few states also impose a state estate tax. Ownership of life insurance policies also has potential to interfere with other estate tax planning. For example, a business owner’s estate plan may rely on deferred payments of the federal estate tax under IRC § 6166. This provision requires one or more closely held business to comprise at least 35% of the probate estate. Triggering a buy/sell agreement may inadvertently disrupt this planning. The Connolly case discussed below illustrates the not-so-obvious cash flow and estate tax consequences of buy/sell agreement triggering. Although Connolly is viewed as a tax case, it also has nontax implications.
Part 3: Connelly v. US—Disadvantages of Redemptions
Estate of Connelly v. United States, a 2024 case decided by the US Supreme Court, has clarified the valuation of corporate-owned life insurance policies used for succession buy-outs [Estate of Connelly v. United States, 602 U.S. (2024)]. Intending to keep their business in family ownership, the two Connolly brothers entered into a buy/sell agreement with their corporation, providing their corporation would pay for and own $3.5 million of life insurance on the life of each brother, which the corporation could use to redeem (buy) the deceased’s brother’s stock if the surviving brother opted not to personally exercise his right of first refusal to purchase the shares directly from the deceased’s estate. Because there were only two shareholders, either buyout option would have resulted in the surviving brother becoming sole owner of the corporation. The corporation did in fact receive a $3.5 million payout of life insurance on Michael Connelly’s death.
For federal estate tax purposes, the IRS included this $3.5 million when valuing both the corporation and the stock in Michael’s estate. The estate argued that the insurance money used to redeem the stock should not be included in the corporation’s value because under the buy/sell agreement, the corporation was contractually obligated to pay $3 million to the estate to redeem Michael’s shares (the executor had agreed that $3 million was an acceptable price for the stock).
The Supreme Court, however, agreed with the IRS that, under the tax law, the corporate stock should be valued before, not after the redemption called for in the buy/sell agreement. This decision cost the estate about $900,000 in extra estate tax. A cross-purchase buy/sell agreement also would have put the corporation solely in the surviving shareholder’s control, but at a much lower estate tax cost. Accordingly, business owners who expect to be subject to federal estate tax should use a cross-purchase, not a redemption format, buy/sell agreement.
When a business has increased in value and owns a large insurance policy, redemption format buy/sell agreements will financially favor the surviving business owners over exiting owners or the heirs of deceased owners.
While the tax aspects of Connelly have been extensively covered, the non-tax financial aspects have been overlooked: specifically, how disadvantageous the redemption format buy/sell agreement can be. When a business has increased in value and owns a large insurance policy, redemption format buy/sell agreements will financially favor the surviving business owners over exiting owners or the heirs of deceased owners. One owner can get a substantial windfall at the expense of the others. The exiting owners pay income and transfer taxes—unlike those who stay behind who gain larger percentage ownership at no tax cost.
The Connelly brothers’ agreement is a good example. Before he died, Michael Connelly owned the majority share (77.18%) of the corporation and Thomas Conelly owned the remainder (22.82%). With the aim of maintaining family control, an insurance-funded buy/sell agreement committed the corporation to purchase a deceased’s owner’s shares if the survivor did not. On Michael Connelly’s death, the corporation was owed $3.5 million insurance benefits, and although the buy/sell agreement called for an appraisal, Thomas, as executor of his brother’s estate, decided the corporation would use just $3 million to redeem Michael’s stock.
Under this plan, Michael’s heirs would receive $3 million, and Thomas’ share of the business would increase from 22.82% ($1,524,376) to 100% ($6,680,000) using the court’s pre-redemption arithmetic. Thomas did not have to buy the stock or pay any taxes.
Even after the corporation paid out the $3 million to the estate, Thomas’ share of the balance sheet increased from $1,524,376 to $3,680,000. The heirs’ share in the estate would be diminished by estate tax. The plan essentially operated as a modern-day tontine. Although this might be appropriate in a family setting, it would probably come as a surprise to non-related business partners.
Part 4: How to Move to a Cross-Purchase Buy/Sell Agreement
Business owners with existing redemption format buy/sell agreements should consider the merits of converting to a cross-purchase buy/sell agreement. Although individuals with wealth above the federal exemption amount have added incentive to move away from a redemption, the randomness of final survivorship in the redemption scheme seems reason enough to move to a cross-purchase despite the added complexities.
Converting a redemption buy/sell agreement to a cross-purchase is essentially a two-step process: removing the policy from corporate ownership and next arranging a new cross-purchase agreement. Because cash-value life insurance is a valuable asset, transfers from the corporation to the insureds will be presumptively taxable under IRC § 101(a)(2). Transfer to a shareholder could be classed as a taxable dividend. Transfer of life insurance could also be classed as taxable compensation to an employee-shareholder. For example, if X and Y are co-owners, the insurance on X would be transferred to Y and vice versa. The value of the life insurance received would be taxable to each individual. To avoid taxation, X and Y might form a partnership that would enable them to use the IRC § 101 safe harbor exceptions.
An alternative approach to a transfer that would be taxed as a dividend or compensation is a taxable sale of life insurance to the shareholders. Cost factors and insurability issues may make this alternative impractical, depending on the age and health of the insureds. Continuing this example, X and Y would each buy their policy from the corporation. The fair market value of the insurance is usually the “interpolated terminal reserve,” premiums paid less unused premiums, minus any prior distributions. Revenue Procedure 2005-25 provides further guidance on valuation.
Another route to converting to a cross-purchase involves using an “insurance-only” limited liability company. The corporation would transfer X’s policy to X, Y’s policy to Y, and both would transfer their policies into this LLC. There would only need to be one life insurance policy for each shareholder. Each corporate shareholder is also a member of the LLC, which will be taxed under the partnership rules. When one of the corporate shareholders dies, the insurance policy death benefit is received by the LLC and allocated to the surviving owners. Two other alternatives beyond the scope of this article include setting up a trust to hold the policies and using a collateral assignment method.
Problem Solving
Buy/sell agreements can solve a variety of business problems, but they can also backfire and cause problems of their own. Although some problems can be identified and dealt with early, other problems may arise as the business and the lives of the individual owners change over the years. Advisors need to be alert for problems that go hidden and unnoticed.
