Purchase-sell agreements are a typical succession planning device for enterprise homeowners the place, upon a triggering occasion just like the demise of 1 proprietor, the surviving homeowners have both the choice or the contractual obligation to buy the deceased proprietor’s shares of the enterprise. Historically, buy-sell agreements are structured both as cross-purchase agreements (the place the surviving homeowners purchase the deceased homeowners’ shares immediately from their property) or entity-purchase agreements (the place the enterprise itself redeems the deceased proprietor’s shares).
The agreements are normally funded by life insurance coverage insurance policies on every proprietor: cross-purchase agreements are owned by every proprietor on each different proprietor, and entity-purchase agreements are owned by the enterprise on every proprietor. This has typically made entity-purchase agreements preferable for companies with greater than a small handful of homeowners, since an entity-purchase settlement solely requires the acquisition of one insurance coverage coverage per proprietor, whereas the variety of insurance policies wanted for a cross-purchase settlement will increase exponentially as extra homeowners are added to the group.
Which makes it notable that, in a latest ruling by the U.S. Supreme Courtroom within the case Connelly v. Inside Income Service, the courtroom dominated that life insurance coverage proceeds paid to an entity-purchase settlement improve the enterprise’s worth for the needs of figuring out the taxable property of the deceased proprietor, with the IRS arguing (and the courtroom agreeing) that if a hypothetical third-party purchaser had been shopping for the shares, they might be keen to pay for them based mostly on the total worth of the corporate… together with the life insurance coverage proceeds.
Consequently, enterprise homeowners who’ve applied entity-purchase agreements face the prospect of the insurance coverage proceeds used to fund these agreements being at the very least partially included of their taxable property, which, at a prime Federal property tax price of 37%, might lead to a considerably increased property tax legal responsibility for homeowners whose estates both exceed the present $13.61 million property tax threshold or for whom inclusion of the insurance coverage proceeds would bump them over the brink. And with the brink scheduled to be diminished by 50% when the Tax Cuts & Jobs Act expires after 2025, many extra enterprise homeowners stand to be impacted by the Connelly determination within the close to future.
The problem of ‘fixing’ an entity-purchase settlement which will topic homeowners to increased property tax is that it’s not doable to easily transfer possession of the business-owned insurance coverage insurance policies to the enterprise homeowners themselves, as a result of doing so might set off “switch for worth” guidelines that make the proceeds taxable on receipt for earnings tax functions. Nonetheless, one exception to the transfer-for-value guidelines makes it doable to switch a life insurance coverage coverage to a partnership owned by the insured particular person – which probably opens the door for enterprise homeowners to create a brand new “special-purpose buy-sell insurance coverage LLC” that’s handled as a partnership for tax functions and assumes possession of the insurance coverage insurance policies, which might serve the aim of shifting the insurance policies off the books of the unique enterprise with out operating afoul of the transfer-for-value guidelines.
The caveat, nevertheless, is that regardless of having acknowledged such insurance coverage LLCs as legit prior to now, there is not any assure that the IRS will proceed to take action – and within the wake of the Connelly ruling, they might probably scrutinize new and present insurance coverage LLCs, difficult the legitimacy of ones which will lack a legitimate enterprise function – which, if profitable, might trigger the LLC to be disregarded and the insurance coverage proceeds to turn into taxable, both to the property of the deceased proprietor for property tax functions and/or to all the enterprise homeowners for earnings tax functions!
The important thing level is that whereas an insurance coverage LLC could make it doable to transition away from an present entity-purchase settlement to 1 that will not create new property tax publicity with out unwinding the complete buy-sell settlement and ranging from scratch, doing so does add to the complexity of the enterprise succession plan and introduces potential dangers that it will not reach assembly the enterprise homeowners’ objectives. Which, for some homeowners, means it is perhaps preferable to easily begin anew with a standard cross-purchase settlement – however for others, who’re keen to just accept the dangers and navigate the challenges of drafting and adhering to an insurance coverage LLC, it might nonetheless be value it for the potential for property tax financial savings and suppleness.
