How insurance funds business buy sell agreements

By Richard C. Wilson

Start the review with three questions: Who will purchase the interest? Who owns and receives the insurance? Which agreement and policy provisions address the purchase trigger and payment?

Use the sections below to examine purchase structures, an Insurance LLC arrangement, agreement prices and disability policy provisions.

Research notice: Based on primary sources linked below. Read the cited authorities alongside the actual agreement and policy. Ask an estate attorney, CPA and insurance adviser to review the documents before acting.

Death and disability as purchase triggers

The Insurance Compact's adopted individual disability buy sell insurance policy standards concern individually underwritten policies, including those marketed through employer and association groups. The Compact standards are product standards within their stated scope, rather than rules for every insurance policy.

Within that scope, a purchase agreement is a written agreement between the insured and the owners to buy the insured's entire business ownership interest upon total disability. Separate standards address disability income, business overhead expense and key person plans.

For policies within that scope, the elimination period determines when purchase benefits become payable, subject to satisfaction of all policy terms and conditions by the insured. The period begins when disability starts as defined in the policy.

Benefits may or may not accrue during the elimination period, at the option of the company. Required time may be consecutive or nonconsecutive. Injury and sickness may have separate elimination periods.

Under those same standards, monthly payment and lump sum payment are each defined as payable for total disability after the elimination period is satisfied. A combination payment joins those two methods. The specifications page shows the payment methods and amounts.

Payment is no greater than the actual purchase price or the policy benefit amount. Payment cannot exceed the aggregate benefit amount.

Bring the agreement's disability language, the policy definition of total disability, the elimination period provision and the specifications page to the same review. Ask the adviser to walk through the provisions together.

Coordination among agreement, policy and ownership

Connelly describes a cross purchase arrangement in which shareholders buy life insurance policies on one another to fund purchases of shares at death. A corporate redemption instead has the corporation purchase the shares.

In the agreement before the Court, the surviving brother had the first purchase option. If he declined, the corporation had to redeem the shares. Neither structure should be treated as eliminating every tax consequence.

For federal estate tax valuation of the deceased shareholder's closely held corporate stock, Connelly held that the corporation's obligation to redeem his shares at fair market value did not offset the insurance proceeds committed to that redemption.

The holding does not establish the result for every redemption obligation or cross purchase arrangement. The Court reserved situations in which redemption could reduce corporate value, including liquidation of operating assets that decreases future earning capacity.

Identify the purchaser in the signed agreement, then compare that identity with the policy owner and beneficiary. Ask counsel to review the purchase option, any fallback obligation and the transaction's tax treatment using the actual documents.

For an ordinary taxable purchase of shares, the general basis rule is cost. Exceptions may apply under the same Internal Revenue Code subchapter and subchapters C, K and P.

Those subchapters concern corporate distributions and adjustments, partners and partnerships, and capital gains and losses. For inherited basis and its exceptions, use the inherited basis guide to prepare a separate discussion about the estate and seller.

When a corporation redeems stock within §317(b), §302(a) provides exchange treatment only if §302(b)(1), (2), (3), (4) or (5) applies. Otherwise, §302(d) generally directs §301 distribution treatment, except as otherwise provided in the subchapter.

Ask the adviser to address redemption qualification, ownership attribution, any family attribution waiver and S corporation distribution questions before characterizing a particular transaction.

Life insurance premiums are not deductible under §264(a)(1) when the taxpayer is directly or indirectly a beneficiary under the policy. Review disability premiums separately rather than applying that life insurance rule to another kind of coverage.

For employer owned coverage, bring the notice and consent documents, policy issue records and reporting records to the adviser. Use the IRS reporting form and instructions to prepare questions about reporting, recordkeeping, applicable issue dates, exchanges and material changes.

Policies held through an Insurance LLC

The proposed Insurance LLC in the IRS ruling would be the policy owner and beneficiary. Management would rest with managers rather than members. A bank would serve as the initial manager.

A replacement manager had to be a corporate trustee or a bonded individual. The individual could not be a related or subordinate party with respect to members or their assignees under the ruling's stated standard.

Insured individuals could not vote on the LLC's exercise of incidents of ownership for any covered policy, regardless of whose life that policy insured. These were that taxpayer's proposed facts, rather than universal LLC requirements or a safe harbor.

Upon an insured's death, proceeds would be allocated to the capital account of the member who contributed the policy or that member's assignee. Distributions would be proportional to the respective capital accounts maintained for that policy.

Distribution required the manager to determine that all purchase obligations associated with the policy were satisfied or assured of satisfaction.

The IRS concluded that the specified individuals would not possess incidents of ownership under §2042 for the policies contributed outright or through the specified trust. That conclusion relied solely on submitted facts and representations and an unchanged operating agreement.

The ruling expressed no opinion on other federal tax consequences. Directed only to the requesting taxpayer, the ruling could not be used or cited as precedent.

Use the proposed arrangement to frame questions about managers, replacement qualifications, voting restrictions, policy specific accounts and purchase obligations. Ask separately about transfer for value treatment, entity classification and distribution taxation.

Redemption prices and business value

An agreement price receives little estate tax valuation weight if the decedent could sell the securities at any price during life. A lifetime price restriction alone also does not establish estate tax value.

The regulation examines the particular agreement and circumstances. Even with a lifetime restriction, the agreement must represent a bona fide business arrangement.

The agreement cannot be a device to pass shares to the natural objects of the decedent's bounty for less than adequate and full consideration in money or money's worth. Otherwise, the agreement price is disregarded.

Bring the agreement, amendments, lifetime transfer restrictions and valuation records to counsel and the appraiser. Ask them to distinguish the contractual purchase price from the value used for federal transfer tax purposes.

Ask counsel to review §2703 separately using the statute and regulation linked in Sources.

How disability purchase coverage ends

For disability purchase policies within the scope of the Compact standards described above, the policy must state how and when coverage may end. Permitted termination provisions may use the earliest applicable event from the following list.

• The policy expires unless the owner renews it under its renewal provisions.
• The paid premium period ends and the premium remains unpaid at the end of the grace period.
• The insurer receives the owner's written request to end the policy.
• A suspension period expires without the insured requesting that suspension end before expiration.
• The insured dies.
• The insured no longer has ownership in the business or is no longer employed or working for it.
• The lump sum or aggregate benefit amount has been paid.
• The purchase agreement is terminated or executed.

These are permitted provisions. Every policy need not contain every event.

Read the actual renewal, premium, suspension and termination provisions with the policy owner. Ask what the agreement calls for if the policy ends.

Common questions

Resources to check out

• Connelly: Business redemption decision: Read the decision's holding and discussion of alternative purchase structures.
• IRS Form 8925: Reporting and instructions: Prepare employer owned policy reporting questions for your adviser.
• Disability purchase coverage: Insurance Compact policy standards: Examine the product scope, elimination period, payment methods and termination provisions.
• Agreement restrictions: Federal transfer tax valuation: Bring the regulation to a separate discussion of §2703.
• IRS private letter ruling: Insurance LLC: Examine the taxpayer specific proposed arrangement and the ruling's express limitations.