Private Client Services Update – Use of LLCs to Own Buy-Sell Insurance
By William L. Holt, Estate, Trust & Wealth Transfer
Buy-sell agreements funded by life insurance are a popular tool in planning for the succession and longevity of a business upon the death of a business owner. Through buy-sell agreements, business owners can agree to a predetermined disposition of each owner’s interest in the business upon his or her death or upon other events. The two main buy-sell planning scenarios generally involve an agreement among the business owners under which: 1) the business entity will buy back the deceased owner’s share upon death (referred to as a ‘redemption agreement’), or 2) the other owners will directly buy out the deceased owner’s share upon death (referred to as a ‘cross-purchase agreement’). As one might imagine, the unexpected death of a business owner can quickly create the need for liquidity to fund these obligations under a buy-sell agreement, and accordingly, life insurance on the lives of business owners is frequently used to provide this needed liquidity.
Limitations of Traditional Buy-Sell Planning
Despite the many benefits of the traditional buy-sell strategies, there remain significant limitations that prevent widespread implementation among many businesses that could greatly benefit from buy-sell planning. Below are a few of the frequently cited limitations of traditional buy-sell planning:
- The cash value and death benefit of the life insurance policies often can be reached by creditors of the business (under a redemption agreement) or creditors of the individual business owners (under a cross-purchase agreement).
- Under a cross-purchase buy-sell agreement, the number of policies required to carry out the plan can become difficult to manage depending on the number of business owners, as each owner must own a policy on the life of each other owner. For example, in a business with three owners, six policies are needed.
- The success of a buy-sell plan can be largely dependent on the responsibility and oversight of the individual owners and the plan can be compromised if the individual owners fail to pay the premiums on their policies or if they refuse to pay over or use the death benefits pursuant to the buy-sell agreement.
- The financial burdens of the premiums may be allocated disproportionately if younger owners have to own policies on older owners, which carry higher premiums and vice versa.
- Undesired income tax consequences can be triggered by the “transfer for value” rule when remaining policies are transferred between owners, as will be necessary at the death of an owner, as well as other times during the plan.
The Benefits of Using an LLC
A recent advancement in buy-sell planning is the use of a limited liability company (LLC) separate from the underlying principle business entity to own the buy-sell insurance. Under this approach, the business owners would still execute a “cross-purchase” agreement but would form an LLC to own a life insurance policy on the life of each owner. Using an LLC to own and administer the insurance policies can combine the benefits of “redemption” and “cross-purchase” agreements while eliminating the disadvantages of both. The use of an LLC can lessen the administrative burden, make use of tax benefits, afford flexibility in structure, and provide numerous other benefits as discussed below.
- Avoids Numerous Policies: Typically, a cross-purchase buy-sell agreement requires each business owner to own a policy on the life of each other business owner. However, by using an LLC to own the buy-sell insurance, the LLC owns all the policies, so only one policy per shareholder is needed.
- Protection from Creditors: In a typical buy-sell agreement situation, if the policy is owned by the principal business entity, the policy may be subject to the creditors of the business. Similarly, if the policies are owned by the business owners in their individual capacities, the policies may be subject to the reach of creditors of the individuals. However, by using a separate LLC whose main purpose is to own the buy-sell insurance, the policies generally are protected from the reach of creditors of the principal business and creditors of the individual business owners. Further, IRS guidance supports the valid business purpose of such an LLC used solely to own insurance.
- Tax Benefits: Typically in buy-sell planning, unwanted income tax consequences are often triggered as a result of the “transfer for value” rule under Internal Revenue Code §101 which treats as income any valuable consideration received in exchange for the transfer of any right to receive life insurance proceeds. This situation can arise in numerous scenarios during traditional buy-sell planning. For example, in traditional cross-purchase buy-sell planning, when any owner dies, the surviving owners typically purchase the life insurance policies owned by the deceased owner at his death (which the deceased owner owned on the other owners). This can trigger the “transfer for value” rule requiring income to be recognized. However, when using the LLC structure the transfer of policies generally is not necessary, and one of the exceptions to the “transfer for value” rule is the transfer to or from a partnership in which the insured is a partner, so this exception applies when transfers are necessary. Finally, IRS guidance provides that, so long as properly structured, insurance proceeds payable to the LLC would not be includable in the estate of a deceased owner.
- Transferability: The use of an LLC to own buy-sell insurance allows much easier transitions by permitting new owners to join the LLC and participate in the existing insurance framework, while also allowing current owners to exit the LLC prior to death, without triggering the “transfer for value” rule. At the death of an owner, his or her death benefit is used to buy the deceased owner’s interest in the principal entity and to cancel his or her interest in the LLC, eliminating any ongoing obligations.
- Economics: The use of an LLC allows for flexibility in structuring how the premium costs for insurance policies are borne by the owners. Among numerous other options, the LLC can be seeded with income-producing assets to fund the premiums. Another option is that the principal entity can pay the premiums indirectly through presumably equal distributions, dividends or compensation to the members or shareholders of the principal entity, who then contribute the funds to the LLC for payment of the premiums.
- Ease of Administration: The use of an LLC in buy-sell planning provides a centralized vehicle to administer the policies, rather than leaving the responsibility and oversight up to the individual owners.
The use of an LLC to own life insurance in conjunction with a properly structured buy-sell agreement can provide the ideal structure for a smoother transition and more security for small businesses upon the death of individual business owners.
Will Holt is an attorney at Kaufman & Canoles, where his practice focuses on estate planning, business law, and real estate matters. Will is a member of the firm’s Private Client Services Group and the Real Estate Strategies Group. Will is a graduate of the College of William & Mary’s Marshall-Wythe School of Law. He can be reached at (757) 259.3885 or firstname.lastname@example.org.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2023.