Business Planning Strategies

Buy-Sell PlanningStrategies for Competitive Businesses

A Strategy Overview Guidefor Business Owners

The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.

NOT A BANK OR CREDIT UNION DEPOSIT OR OBLIGATION • NOT FDIC OR NCUA INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT GUARANTEED BY ANY BANK OR CREDIT UNION

Contents 1 | Preserve Your Business’ Future

2 | Detailed Comparisons

4 | Part I: Planning in the Event of the Owner’s Death

10 | A Word About Trusteed Cross Purchase and Wait-

And-See Buy-Sell Agreements

13 | Part II: Planning in the Event of the Owner’s Disability

1

Businesses can transition expectedly or unexpectedly. That’s

why it’s important to plot a course toward protecting your

business and minimizing the impact a change in ownership

could have on those who depend on the business most.

Proper planning requires a comprehensive analysis, which

would include addressing a number of concerns, such as:

1 | What is the liquidation value of the business in

the event it has to be sold under less than favorable

circumstances? What value can be truly realized in

the event of a forced sale?

2 | What is the short- and long-term financial impact on

the family? How will the family survive without the

income? How will the family continue to maintain its

standard of living?

3 | What is the short-term impact on the business?

Can the business meet its short- and long-term cash

needs? Can the business even survive?

4 | What is the long-term impact on the business?

Can the business be transferred to a successor

without negatively impacting business operations

and employees? Will the transferring shareholder

realize full value for the transfer?

These questions highlight the critical need for the owner(s) of

a company to properly plan before life-changing events occur.

Establishing an effective business succession plan can often

be the most vital strategy any owner can implement to protect

those they love and preserve that of which they created.

A buy-sell arrangement, funded with life insurance and

disability income insurance, can be just the tool to put this

plan into action with the help of your tax and legal advisors

and your financial services representative.

In order to make this material practical, useful and easier

to comprehend, this overview will be divided into the

following two sections:

I | Planning in the event of the owner’s death; and

II | Planning in the event of the owner’s disability.

Preserve Your Business’ Future

The business interest is often the single largest asset of a closely held business owner’s estate. It is often used to provide the majority of current income and support to the business owner’s family. Understanding, and ultimately realizing, developing and implementing a succession plan for the entity, whether because of death or disability, is critical to the continued well-being of the family.

2

Entity Plan Cross Purchase Plan

Purchaser of Interest The business. Surviving owner(s).

Seller of Interest Withdrawing owner or deceased owner’s estate. Withdrawing owner or deceased owner’s estate.

The Plan Business purchases an owner’s entire interest at an agreed upon price, upon death, disability or retirement.

Surviving owners purchase an owner’s entire interest at an agreed upon price, upon death, disability or retirement.

Legality of Arrangement Typically, state law requires a corporation to redeem from surplus only.

Usually no restrictions.1

Life and Disability Buy-Sell Insurance Policies

Business is applicant, owner, premium payor and beneficiary of a policy on the life of each owner in an amount sufficient to meet the price in the agreement.

Each owner is applicant, owner, premium payor and beneficiary of a policy on each of the other owners (unless a trust is used). If more than 2 parties, then a trusteed cross purchase is recommended for disability underwriting.

Number of Policies Required Only one policy per owner is required. Formula for number of policies needed is n(n-1), where n = number of owners (unless a trust is used).

Premiums Business cannot deduct premium payments. Owners cannot deduct premium payments.

Claims of Creditors Business creditors may enforce a claim against both the cash value and the proceeds of business-owned life insurance.

Business creditors cannot reach cash values or proceeds of policies owned by individuals; however, each owner’s creditors can.

Taxability of Insurance Proceeds

Life insurance proceeds are generally received income tax free. However, the corporate alternative minimum tax (AMT) may apply. Disability income insurance benefits may be received tax-free.2

Life insurance proceeds received by surviving owners are income tax free. Disability income insurance benefits may be received tax-free.2

Alternative Minimum Tax (AMT)

Receipt of death proceeds might trigger AMT for C Corporation. No AMT for S Corporations or partnerships.

No AMT.

Taxability of Proceeds Received by Disabled Shareholder

The actual purchase of the business interest is likely to have income tax ramifications for both buyer and seller. When the buy-out is between a corporate entity and a disabled owner and the transaction qualifies as a complete redemption of a shareholder’s stock, the payments received generally will be treated as a capital gain or loss. When the buy-out is between a partnership and a disabled partner and results in a termination of the disabled partner’s interest, it is taxed as a liquidation of his or her interest.

If the buy-out is a cross purchase between the shareholder-employees, it will also be considered a capital transaction and taxed accordingly. The disabled owner is taxed only on the gain from the sale of the business interest.Where the buy-out is a cross purchase between partners, it is taxed as a sale of the partner’s interest.

Entity Plans vs. Cross Purchase Plans – How They Compare

Detailed Comparisons

1 If the corporation is a PC or Professional Corporation, a stock purchaser must be a licensed professional in the state of incorporation of the entity.2 If the business is a C Corporation, disability policy benefits paid to the corporation under an entity purchase agreement could trigger the Alternative

Minimum Tax (AMT).

3

Entity Plans vs. Cross Purchase Plans – How They Compare (continued)

Entity Plan Cross Purchase Plan

Value of Insurance Proceeds Includable in Owner’s Estate

If business is policyowner and beneficiary, only the value of business interest, not death proceeds, is includable.

Value of policies on surviving owners includable in estate of deceased owner.

Tax Basis of Purchaser In a C Corporation, there is no increase in basis to surviving stockholders on redemption of decedent’s interest. Value of survivor’s stock is increased, but not the basis. When the surviving stockholder later sells the stock, the basis has carried over, resulting in greater taxable gain. In an S Corporation using cash accounting, it is possible to achieve a step-up in basis by electing a short tax year when a stockholder dies.In a partnership/LLC, step-up in basis is achieved when insurance proceeds are allocated to capital accounts of surviving owners.

Basis of purchasing owner is increased by the price they pay for the decedent’s interest. Subsequent lifetime sale results in less taxable gain to them, due to the basis increase.

Family Owned Business – Attribution Rule

When related persons own stock and where a beneficiary of an estate owns stock, a redemption may result in a dividend taxable to the estate.

No dividend problems when stock is purchased by surviving stockholders.

Transfer of Policies Transfer of policies to surviving owners at death of one owner is not necessary (all policies are owned by the business).

The estate of the deceased owner will own policies on the lives of the surviving owners. Surviving owners may purchase policies on their lives from estate without transfer-for-value problems. Transfer-for-value problems may occur when a trusteed cross purchase arrangement is used.

Change of Plan to Cross Purchase

In a corporation, there is a transfer-for-value problem if the policy is transferred to a non-insured shareholder. In a partnership (or LLC taxed as a partnership), there is no transfer-for-value problem because transfers to and from a partnership or its partners meets an exception to the transfer-for-value rule under IRC § 101(a)(2)(B).

N/A

Change of Plan to Entity Purchase

N/A No transfer-for value problem if the policy is transferred to a company where the insured is an officer or a shareholder. In a partnership (or LLC taxed as a partnership), there is no transfer-for-value problem because transfers to and from a partnership or its partners meets an exception to the transfer-for-value rule under Internal Revenue Code (IRC) § 101(a)(2)(B).

4

Provide for Your Family and Heirs

Without a buy-sell agreement:

• They are left with an asset of real value that has no

guaranteed market that they may be forced to sell at

distressed prices.

• They have lost the deceased owner’s salary but will

receive no income to replace it.

• They may encounter delays in administration of the

estate caused by the attempts to sell the business.

Fortunately, these undesirable consequences can be

minimized through the use of a buy-sell agreement.

A buy-sell agreement is a legally binding contract that

requires one party to sell and another party to buy a

particular ownership interest in a business in the event of

the death, disability or retirement of a partner or stockholder

or upon certain other triggering events as specified in the

contract. These agreements may be used by any type of

business entity: sole-proprietor, corporation, partnership,

limited liability company (LLC), etc.

Under this arrangement, when an owner dies, if the provisions

are carried out, the plan will assure the prompt and orderly

sale of his or her business. This benefits your family, your

heirs, and the surviving owners of your business.

The most important guarantees to you as a business owner are the continuity of the business upon the death of another owner and the certainty that your estate will have an immediate guaranteed buyer for your interest at a price that represents fair market value. However, realizing these guarantees requires sound advance planning. In the absence of such planning, problems can arise.

Part I: Planning in the Event of the Owner’s Death

Problems for the Surviving Owners

The deceased owner’s heirs may:

• Insist upon an active role in management – whether or

not they have the capability or compatibility.

• Insist on dividends being paid, which may cause double

taxation and impairment of the firm’s ability to expand.

• Threaten to, or actually sell to “outsiders.”

• Call for liquidation, if they can’t get their way –

resulting in the loss of jobs as well as income and

wealth-building opportunities for the surviving owners.

Employees may:

• Feel insecure, and their morale may sag, along with

their productivity.

• Terminate employment – further crippling the firm,

causing costly replacement problems.

Creditors may:

• Tighten up on credit in light of the firm’s weakened and

uncertain condition.

5

Entity (Stock Redemption) PlanThe corporation owns life insurance on the stockholders

and uses the proceeds to purchase (redeem) their stock at

death. Entity or stock redemption, in many ways, offers

the virtues of simplicity and ease of administration. If the

agreement is funded by life insurance, the corporation is the

owner, premium payor and beneficiary of a policy on the

life of each stockholder. The premiums are nondeductible

by the corporation. Using the corporation as the premium

payor may ease the cost burden for a stockholder who is

younger and/or has minority interest.

The fact that the corporation can record the cash value of a

policy as an asset on its balance sheet may be viewed as a

plus by the insured’s accountants, bankers and other financial

professionals. When a stockholder dies, the corporation

receives the proceeds income tax free4 and pays the proceeds

to the decedent’s estate in exchange for the redemption of

stock. Following the death of a stockholder, the surviving

owners of the corporation own the decedent’s shares in

the same ratio as their ownership had been prior to the

redemption.

One drawback to the stock redemption plan is that the

surviving stockholders are not able to increase the basis of

their shares following redemption because the corporation

has purchased the stock of the deceased stockholder.5

This could affect the capital gain amount if the surviving

shareholders ever were to gift or sell their respective shares.

Protect Your Business and FamilyThere are two basic forms of buy-sell agreements:

• An entity plan: The business purchases an owner’s

entire interest at an agreed upon price upon death,

disability or retirement. If the business is a corporation,

the plan is referred to as a stock redemption agreement.

In a partnership context, the plan is called a liquidation

of interest.

• A cross purchase plan: The remaining owners

purchase the withdrawing owner’s entire interest at an

agreed upon price. It is also possible that individuals

who are not currently owners (such as employees,

outsiders or family members) may be parties to

the agreement.3

While the buy-sell agreement legally requires the survivors

to buy and the estate to sell, the arrangement could fail if

the survivors do not have the financial capacity to make the

purchase following an owner’s death. Life insurance can be

an excellent way to fund a buy-sell agreement.

Buy-sell agreements may also be triggered by the disability,

retirement, or other termination of service by a stockholder; or

by a stockholder’s attempted sale, gift, pledge (bankruptcy), or

other transfer of stock.

3 If the corporation is a PC or Professional Corporation, a stock purchaser must be a licensed professional in the state of incorporation of the entity.4 If the C Corporation has gross annual receipts in excess of $7,500,000 for the three previous years then the alternative minimum tax (AMT) could apply.

The proceeds will not be tax free to the corporation. AMT not applicable to S Corporations.5 It is possible to achieve a step-up in basis for S Corporation surviving stockholders with a stock redemption plan if the corporation uses cash basis accounting. This is done by the survivors electing a short fiscal year when a stockholder dies. IRC § 1377, 1367(a).

6

If the stock redemption plan is selected for a family-owned

corporation, the possible application of the attribution rules of

Internal Revenue Code (IRC) § 318 must be considered. For

example, if the corporation redeems all of the shares owned

directly by a decedent’s estate, but the other shareholders are

the decedent’s children, the redemption may be treated as a

taxable dividend, rather than as a tax-free sale or exchange.

Certain planning techniques can circumvent these rules and

should be taken into account if a stock redemption plan is

used for a family-owned business.

Practice Tip: Step-up in basis to surviving owners.

Whether the buy-sell agreement is structured as an

entity or a cross purchase plan, the surviving P/LLC

owners receive a step-up in basis for the purchase

of the decedent’s interest. With an entity plan this

is achieved by allocating the insurance proceeds

received by the LLC to the capital accounts of the

surviving owners which increases their basis in

the LLC. With a cross purchase plan the surviving

purchasing members get a direct increase in basis

equal to the price they paid for the purchased interest

with the insurance proceeds. Thus, unlike with entity

purchase in the corporate setting there is a great deal

of flexibility within the partnership setting as it is

possible to have a reduced number of policies with

the entity purchase and still achieve step up in basis

for the survivors.

7

Business Owner(s)•Policy premiums are paid for by the business and are not tax-deductible.•If a death or disability of an owner occurs, the policy proceeds are paid to the

business and are generally income tax free.•If this was a C or S Corporation, the surviving owner would not get a step-up

in basis. (The surviving owner could be subject to a larger capital gains tax if the business is ever sold.)

•No personal tax liabilities if a proper valuation of the business is done at the time of death, however, with a disability a disabled owner buy out results in a termination of the disabled owner interest, it is taxed as a liquidation of his or her interest.

The Benefits and Tax Considerations

The Benefits

Tax Considerations

Benefits to Your Business Benefits to You•An entity purchase buy-sell agreement allows a smooth transition to a new

ownership arrangement in the event of the death or disability of one of the owners.

•The agreement can reduce the potential delays, conflicts and expenses of the heirs of the deceased or disabled owner who are making a claim on the business.

•Cash values on certain life insurance policies may be available as reserve funds for your business.6

•Peace of mind that the business can continue to operate in the event of the death or disability of an owner.

•In the event of death, the buy-sell agreement will provide the proper valuation formula or amount to be paid to the deceased’s estate. Utilizing life insurance as a funding vehicle in such an agreement is an ideal way to provide the funds necessary to meet that obligation.

•In the event of disability, the buy-sell agreement will provide the proper valuation formula or amount to be paid to the disabled partner. Utilizing disability insurance as a funding vehicle in such an agreement is an ideal way to provide the funds necessary to meet the obligation.

6 Distributions under the policy (including cash dividends and partial/full surrenders) are not subject to taxation up to the amount paid into the policy (your cost basis). If the policy is a Modified Endowment Contract, policy loans and/or distributions are taxable to the extent of gain and are subject to a 10% tax penalty. Access to cash values through borrowing or partial surrenders can reduce the policy’s cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.

Strategy – Entity (Stock Redemption) Plan

PREMIUMS

Insurance Company

The business and Owner A and Owner B enter into an agreement that states that, upon the death or disability of either owner, the business will buy out the interest of that

particular person for its agreed-upon fair market value.

Owner BOwner A

Business is premium payor and owner of policies on both Owners A

and B and is the beneficiary of policy proceeds in the event of the death or

disability of either owner.

OWNS

50%

OF T

HE B

USIN

ESS OW

NS 50% OF THE BUSINESS

POLICY PROCEEDS

Insurance Company

Owner A in the event of a disability.

Owner A’s estate/beneficiaries in the event of death.

Business

CASHBUSINESS INTERESTS

At Inception In the Event of the Death or Disability of Owner AIf Owner A dies or becomes totally disabled, policy proceedswill be paid to Owner A or A’s estate, in return for A’s interestin the business, which will transfer to the business.

8

Cross Purchase PlanThe stockholders own insurance on each other and

buyout the shares of the deceased partner. If more than

two stockholders are involved, a cross purchase plan may

be cumbersome due to the number of policies required.

The premiums paid for the life insurance used to fund a

cross purchase plan can be deducted as compensation paid

to the stockholders who own the policies. The premiums

may constitute taxable income to the stockholders, and

while discrepancies in age and stock ownership may create

problems, in many cases, the payment of bonuses or other

adjustments in compensation can reconcile an unbalanced

allocation of cost.

A cross purchase plan avoids potential problems related

to the corporate AMT and the operation of the attribution

rules. In addition, a purchasing stockholder can increase

his or her basis in the stock acquired under a cross purchase

agreement because he or she pays for the shares personally.

An increased basis is important to the stockholder who

anticipates a possible sale or gift of the stock at some point

in his or her lifetime.

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POLICY OWNED

POLICY OWNED

Owner B Owner A

Insurance Company

Owns 50% Owns 50%

PREMIUMS PREMIUMS

Business

Owners A and B enter into an agreement that if either should become disabled or die, the surviving partner will buy out the business interest from the

individual/estate using the policy proceeds.

BUSINESS INTEREST

CASH

Insurance Company

Owner B owns 100% of the business after Owner A's

business interest is transferred to Owner B (in

exchange for the cash paid to Owner A or his/her estate).

Owner A receives disability income in the event of disability. Owner A's

estate/beneficiaries receive cash from Owner B (from policy proceeds) in the

event of death.

POLICY PROCEEDS

At Inception In the Event of the Death or Disability of Owner A

Strategy – Cross Purchase Plan

Benefits to Your Business Benefits to You•A buy-sell agreement allows a smooth

transition to a new ownership arrangement in the event of death or disability.

•The agreement can reduce the potential delays, conflicts and expenses of those making a claim on the business.

•In the event an owner dies or becomes totally disabled and the buy-sell agreement is activated, the surviving or non-disabled owners will receive a step-up in basis under this agreement – reducing the amount of taxable capital gain upon a future sale of the business interest.

•Peace of mind that the business can continue to operate in the event of the death or disability of an owner.•In the event of death, the buy-sell agreement will provide the proper valuation formula or amount to be

paid to the deceased’s estate. Utilizing life insurance as a funding vehicle in such an agreement is an ideal way to provide the funds necessary to meet that obligation.

•In the event of disability, the buy-sell agreement will provide the proper valuation formula or amount to be paid to the disabled partner. Utilizing disability insurance as a funding vehicle in such an agreement is an ideal way to provide the funds necessary to meet the obligation.

Owners Deceased Owner’s Estate Disabled Owner•Premiums paid personally by each individual

owner are NOT tax deductible.•The proceeds received from the surviving owner

paid to the estate for the deceased’s interest (assuming the fair market value) will be an income tax wash.

•The life insurance policy owned by the decedent on the lives of the other owner(s) may be purchased or surrendered.

•Generally, the proceeds from a disability income insurance policy are paid to the disabled owner income tax free. When the buy-out is between an entity and a disabled owner and results in a termination of the disabled owner’s interest, it is taxed as a liquidation of his or her interest.

The Benefits and Tax Considerations

The Benefits

Tax Considerations

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Trusteed Cross Purchase PlanA trusteed cross purchase plan is a legal agreement between

a third party and the partners or stockholders that provides

for the planned disposition of their ownership interests in

the event of a death, disability or retirement. The trustee or

escrow agent acts to carry out the obligations of the partners

or stockholders.

Using Life Insurance in a Trusteed Cross Purchase Plan:

An impartial third party is appointed and acts as custodian

for the insurance policies. To guarantee the continued

existence of the third party, a corporate trustee or escrow

agent may be selected. Typically, he or she should be the

owner and beneficiary of the policy. The agreement may

provide that the trustee collects the premiums from the

insureds. At the death of a partner or stockholder, he or

she distributes the proceeds to the deceased partner’s or

stockholder’s estate in exchange for the ownership interest.

A Word About Trusteed Cross Purchase and Wait-and-See Buy-Sell Agreements

7 Certain transfers of life insurance contracts may jeopardize the income tax-free payment of the death proceeds (above basis in the contract). The client should always consult their tax and legal advisors prior to making any changes to ensure that the transfer either is not a transfer-for-value or meets one of the exceptions to the transfer-for-value rule and thus the death benefit will still be received income tax free.

Advantages of Using a Trusteed Cross Purchase Plan:

An impartial third party is used to oversee the agreement. If

a funding problem arises with one of the owners, the trustee

can notify the remaining partners or stockholders to alert

them of the situation. The policy proceeds are received tax

free by the trustee. Pursuant to the agreement, he or she

distributes the proceeds from the insurance policy to the

decedent’s estate in exchange for the ownership interest.

A well-designed plan will guarantee that the partner’s

or stockholder’s family will receive a fair price for the

business interest.

Disadvantages of Using a Trusteed Cross Purchase Plan:

Possible transfer-for-value7 issues may exist. For example,

assume A, B, C and D are equal stockholders in a corporation

with a funded trusteed cross purchase agreement. Under the

arrangement, each stockholder is the beneficial owner of a 1/2

interest in the policies insuring the other three stockholders.

Now assume that A dies. A prohibited transfer-for-value could

occur if A’s proportional interest in the outstanding policies

insuring B, C and D pass to the surviving stockholders upon

A’s death. At the next death, a portion or all of the death

benefit may now be income taxable unless an exception to the

transfer-for-value rule is found.

3

Wait-And-See ApproachThe wait-and-see buy-sell agreement is a hybrid buy-sell

agreement that combines elements of the traditional entity

purchase and the cross purchase buy-sell agreements.

Unlike those arrangements, the specific purchaser of an

owner’s business interest remains uncertain until death,

retirement, or disability actually occurs. This provides

the business owner with flexibility as to the transfer of

ownership when the triggering event occurs.

The wait-and-see buy-sell agreement provides that the

business entity has the first right to purchase the ownership

interest in question after the triggering event, then the other

owners have the right to purchase, and if any ownership

interests remain, then the business entity must purchase the

remaining ownership interests.

How the Wait-and-See Buy-Sell Agreement Works

Let’s assume that we have three shareholders: Tom, Steve

and Mary. In the typical wait-and-see buy-sell agreement,

this would be the situation at Tom’s death:

• The corporation would have a first option to buy Tom’s

stock from his estate.

• Should the corporation fail to exercise this option, or

exercise it only with respect to a portion of Tom’s stock,

then Steve and Mary would have a second option to

buy his stock (or the remainder of it).

• If Steve and Mary should leave any of Tom’s stock

unpurchased, then the corporation must purchase any

remaining portion (or all) of his stock. This assures

Tom’s family that all of the stock will be purchased,

and assures the surviving shareholders that they will

succeed in having full control of the corporation.

Using Life Insurance to Fund the Agreement

Each of the individual owners and the business entity

are potential life insurance buyers. The entity has the

greatest exposure since it has a binding obligation to

purchase the interest if the two options are unexercised,

or incompletely exercised.

When the Wait-and-See Buy-Sell Agreement is Not Appropriate

The wait-and-see approach is obviously not appropriate for

a sole proprietorship or a single-owner corporation. Further,

if the owners are related, the family attribution rules are a

potential problem in the event of a redemption under the

first option, or a mandatory purchase under the third step.

11

12

8 It is possible to achieve a step-up in basis for S Corporation surviving stockholders with a stock redemption plan if the corporation uses cash basis accounting. This is done by the survivors electing a short fiscal year when a stockholder dies. IRC § 1377, 1367(a).

9 AMT not applicable to partnerships, S Corporations or LLCs taxed as partnerships.

SummaryThe decision to establish an entity or cross purchase plan may require several factors to be weighed. This chart may provide

some additional insight.

At Massachusetts Mutual Life Insurance Company (MassMutual), we have a variety of life insurance products that can be used

with a buy-sell agreement. With our quality products, support and advisors, we are ready to show you how a buy-sell plan can

work for you.

Factors to Consider in Determining the Form of Buy-Sell Agreement

Factor Consideration

Number of Parties The larger the number of parties, the more complex the establishment and administration of a cross purchase plan will be. This would include a far greater number of insurance polices if that was the funding vehicle.

Age and Ownership Differential

The greater the age difference, the larger the financial obligation imposed upon the younger/minority stockholder or partners, under a cross purchase plan. An entity plan may be preferable since it allows for a pooling of the premium obligations within the business (corporate dollars).

Life Insurance Funding

An entity purchase plan would not necessitate the business owners personally paying premiums for funding life insurance. However, split dollar life insurance may assist in funding a cross purchase.

Cost Basis Since a cross purchase plan generally will result in the surviving owner receiving a higher cost basis8 for the business interest, the survivor would incur lower capital gain for any subsequent sale. In a partnership or LLC taxed as a partnership (as noted previously) whether the buy-sell agreement is structured as an entity or a cross purchase plan, the surviving owners receive a step-up in basis for the purchase of the decedent’s interest.

Attribution of Ownership Rules

Due to potential dividend taxation under IRC § 301, redemption may be inadvisable for a family corporation. Therefore, a cross purchase plan may be the only viable approach.

Possibility of Plan Change

If the parties anticipate that they may change from one type of plan to another, the effect of the transfer-for-value rule {IRC § 101 (a)(2)} favors the initial establishment of a cross purchase plan for a corporation, since the policies could later be transferred to the corporation to fund a redemption without creating a transfer-for-value. However, the parties normally would not be able to transfer the policies from the corporation to the non-insured stockholders to fund a cross purchase plan, without creating a transfer-for-value and, therefore, subjecting the death proceeds to income taxation. In a partnership or LLC taxed as a partnership, the transfer-for-value rule is not as daunting since transfers of policies amongst partners in an entity taxed as a partnership (including LLCs taxed as partnerships) or to or from a partnership or LLC itself meet an exception to the transfer-for-value rule under IRC 101(a)(2)(B). Thus there is great flexibility to transfer policies to any partner or the partnership itself at any time before the insured passes without the death benefit incurring an income taxable result.

Tax Considerations Funding a stock redemption agreement requires attention to be paid to possible accumulated earning tax and the corporate alternative minimum tax. A cross purchase plan can ignore these concerns.9

Tax Bracket If the corporate tax bracket is higher than the policyowner’s individual tax bracket, a cross purchase arrangement would be the logical choice and vice versa. For a partnership and LLC taxed as partnership, the tax bracket would be the individual’s as there is no separate tax bracket for this type of entity rather just the individual tax bracket.

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Part II: Planning in the Event of the Owner’s Disability

You and Your Business Partners are a Team. What if a Disability Took one of you out of the Picture?The benefits of a well-crafted and appropriately funded

buy-sell arrangement, as triggered upon the death of a

business owner are generally recognized and appreciated.

Unfortunately, many business owners who are concerned

about selling their business interest upon death are not

as concerned about selling their business interest if they

become totally disabled. This mind-set is unfortunate

because the problems, with respect to the disposition of a

business interest, can be as detrimental upon total disability

as they are upon the business owner’s death. Furthermore,

the probability of a business owner being afflicted by a

long-term disability during the owner’s working lifetime

is substantially greater than the risk of death during those

working years.

It Happens More Often Than You’d Imagine:

Just over 1 in 4 of today’s 20-year-olds will become disabled

before they retire.10

Over 37 million Americans are classified as disabled; about

12% of the total population. More than 50% of those disabled

Americans are in their working years, from 18-64.11

In December of 2012, there were over 2.5 million disabled

workers in their 20s, 30s and 40s receiving SSDI benefits.12

Preserve Your Business’ Future

Problems That Arise With the Disability of an Owner

The total disability of a business owner places the owner

in the unenviable position of having to maintain an interest

in the business while the owner is physically or mentally

handicapped. This can create a severe strain for all the

parties who are involved in the business.

• First, the owner who is disabled obviously must

struggle with two burdens at once – the disability and

the business. As a result, the financial burden created

by the disability requires protection of both family

income and daily business operation expenses, not to

mention the possibility of a sale of the disabled owner’s

interest in the business.

• Second, the family of the disabled owner must witness

what they believe is an unnecessary struggle.

• Third, the business associates of the disabled owner

may feel that the business should not have to operate

without able-bodied management.

10 Social Security Administration, Fact Sheet June 2014.11 U.S. Census Bureau, American Community Survey, 2011.12 Social Security Administration Disabled Worker Beneficiary Data, December 2012.

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• Finally, both the creditors and the customers of the

business may experience an unsatisfactory change

in the policies and practices of the business after the

owner becomes disabled. Thus, all of those involved in

the business may be impacted adversely if the disabled

owner of a business interest attempts to stay with the

business notwithstanding the incapacity.

Provide the Solution:To help minimize undesirable consequences, a buy-sell

arrangement which includes a disability buy-out provision

with terms similar to the purchase of the business interest

at death may be used. Of course there are circumstances

existing upon the disability of the business owner which

may not be present at the owner’s death. However, these

differences should not obscure the advisability of including

disability buy-out provisions in the agreement. As part of the

agreement, the purchaser or purchasers should agree to buy,

and the business owner should agree to sell the interest in the

business if the business owner becomes totally disabled.

There are several factors to consider in preparing for the

potential disability of a business owner:

• The arrangements required to purchase a disabled

owner’s interest.

• The definition of disability for this purpose.

• The length of time the owner must be disabled before

the buy-out is triggered.

• Whether the buy-out is mandatory or optional, and how

the agreement is to be enforced.

• With respect to the business interest itself, how its value

will be determined and by whom, and when (at the

time of disability or later when the buy-out triggers).

• Whether the purchase price is fair and reasonable.

• Whether the buy-out is made in a lump sum or under

an installment sale.

In a disability buy-out agreement, the parties should be

clearly identified with their obligations to buy and sell in the

event of an owner’s disability. Also, the price or the method

of establishing the price should be specifically set forth.

Funding the buy-out with a disability income insurance

policy should help assure that money will be available to

execute the purchase (subject only to the insurer’s ability

to meet its financial obligations, all premiums being paid

when due, etc.).

A disability buy-out plan is specifically designed to help buy

out the business interest of an active owner who becomes

totally disabled. The potential conflict between the active

owners and the disabled owner may be avoided if they enter

into a properly drawn disability buy-out agreement and

fund it appropriately. Such an agreement provides for the

acquisition of the disabled owner’s share by the surviving

business associates and for the payment to the disabled

owner of an agreed upon price for the business interest.

15

Protect the Business and Family

There are three basic forms of DI buy-sell arrangements:

As with any buy-sell agreement, the buy-out of a disabled

owner’s interest can occur in one of three ways – by an entity

arrangement where the business itself buys back the interest

(an entity plan), or by a cross purchase where the remaining

owners buy the disabled person’s interest, or by a trustee plan.

1 | Entity Plan

An entity purchase buy-sell agreement is a legal

agreement between a business entity and its owners.

To illustrate how it works, assume a business is

owned equally by A and B. They each enter into an

agreement with the business for the purchase and sale

of their respective interests. Typically, the agreement

is binding, in that it obligates both A and B, and their

estates, to sell, and the business to buy, upon the

disability of either one of them.

The agreement establishes a value of the business

interest to be bought. In the event of an owner’s

disability, the agreement typically provides for

the transfer of the ownership interest in exchange

for cash or cash and an installment note. Once the

departing owner receives the cash, the business

interest is transferred to the business.

2 | Cross Purchase Plan

A cross purchase buy-sell plan is a legal agreement

among the owners that provides for the planned

disposition of their interests in the event of a

disability. To illustrate how this works, assume a

business is equally owned by two individuals, A

and B. They enter into an agreement providing for

the purchase and sale of their respective interests.

Typically, this agreement is binding and obligates

both parties, or their representatives, to either buy or

sell upon the disability of either one of them.

There may be situations in which an entity purchase

agreement could be preferable even with two or three

owners. For example, where the oldest owner has

the largest interest in the business, a cross purchase

agreement would require the younger owner, usually

lower-paid, to make the larger premium commitment.

An entity purchase agreement would pool the

premium burden, and be easier on the younger owner.

3 | Trusteed Purchase Plan

A trusteed cross purchase plan is a legal agreement

between a third party trustee and the partners

or stockholders that provides for the planned

disposition of their ownership interests in the event

of a death, disability or retirement. The trustee

or escrow agent acts to carry out the obligations

of the partners or shareholders.

16

Why a Buy-Out is Funded With DI Insurance:The same rationale for using a life insurance policy to fund

a buy-sell obligation upon the death of a business owner

applies to using a disability policy to fund a buy-out obligation

upon the total disability of a business owner. Admittedly,

depending on the value and the cash position of the business,

it may be possible to use current cash or borrowed funds

to help purchase the disabled owner’s business interest.

However, from a simple economic point of view, using current

cash is often an expensive way to purchase a business interest.

Even if the business has sufficient capital, insurance may still

be the best way to fund the buy-out. Because the purchase

of a business interest is not a deductible expense, after-tax

dollars are needed. For example, in a 34% tax bracket, it takes

$151,515 before-tax dollars to leave $100,000 after taxes.

Premiums for disability buy-out (DBO) insurance are a

non-deductible expense. The benefits, however, are generally

received income tax free2 and can be used for the business

purchase. Upon the disability of an owner, the business may

be obligated to continue to carry the disabled owner and

pay salary and benefits for an indefinite period of time. In

addition, the disabled owner is often still entitled to a share of

profits and maintains his or her share of the overall business.

The DBO insurance policy provides a means to buy the

interest of a disabled owner, generally over a period of years,

once it is evident the disabled owner is not going to return.

The payment can be a monthly amount or a lump sum.

Important Tax Factors to Consider

Factor Consideration

Taxation of DI Benefits Whether the disability buy-out arrangement is structured as an entity, cross purchase or trusteed cross purchase agreement, the taxation of premiums and benefits is the same. The premiums paid are not tax-deductible but the benefits are generally received income tax free.

Taxation of a DI Buy-Out between corporate entity and disabled owner (entity purchase)

The actual purchase of the business interest is likely to have income tax ramifications for both buyer and seller. When the buy-out is between a corporate entity and a disabled owner and the transaction qualifies as a complete redemption of a shareholder’s stock, the payments received generally will be treated as a capital gain or loss.

Taxation of a DI Buy-Out if cross purchase

If the buy-out is a cross purchase between the shareholder-employees, it will also be considered a capital transaction and taxed accordingly. The disabled owner is taxed only on the gain from the sale of the business interest.

Taxation of Buy-Out between partnership (LLC taxed as a partnership) and disabled partner interest’s

When the buy-out is between a partnership and a disabled partner and results in a termination of the disabled partner’s interest, it is taxed as a liquidation of his or her interest.

Taxation of Buy-Out if cross purchase between partners

Where the buy-out is a cross purchase between partners, it is taxed as a sale of the partner’s interest.

Alternative minimum tax (AMT)

Only applies to C Corporations: If benefits are paid to the C Corporation under an entity purchase agreement this could trigger AMT.

17

What is the Definition Of Disability?The concept of “disability” as it relates to an owner’s active

participation in a business is often far more difficult to define

and describe than are most other buy-sell triggering events.

Setting forth the conditions under which an individual is

deemed to be disabled is essential to a successful arrangement.

An injury or sickness may leave a person unable to work

for days, months, years, or for the rest of his or her life.

Basically, when an active business owner is disabled for

a period in excess of one year (more or less, depending on

the business), the disability, whether “temporary” or

“permanent” for medical purposes, will affect the business

as if it were permanent.

Business considerations will usually dictate the replacement

of an unproductive and disabled individual; meanwhile, the

disabled owner needs the assurance that he or she will receive

fair payment for his or her business interest. A disability

buy-out agreement funded with disability income insurance

is a logical solution.

The success of a disability buy-out agreement may be largely

dependent on the insurance used to fund it. Thus, the most

logical definition of disability to use in the agreement is likely

to be the definition contained in the insurance policy that will

fund the buy-out. This places upon the insurance company the

burden of determining whether the owner’s disability meets

the policy’s definition, thus avoiding potential disagreements

among the owners.

Policies may define total disability as the inability to perform

the duties of the insured’s regular occupation or a reasonable

occupation based on the insured’s education, training

or experience. The individual’s ability to contribute in a

meaningful way to the business is what you want to insure for

the purposes of a disability buy-sell agreement. Even if the

owner can work in a different, unrelated business, he or she will

want to continue to be deemed totally disabled for purposes of

the buy-out and coverage under the policy because of his or her

inability to work in the former business.

Benefits of a Disability Buy-Out AgreementThe benefits of a well-crafted and properly funded disability

buy-out agreement can be summarized as follows:

Benefits to the active business owners:

• They acquire the business interest of the disabled

owner at a fair price.

• They maintain ownership and control.

• Benefits are received tax free9.

• There is a smooth transition of ownership.

• Third party decides when the definition of total

disability is met.

Benefits to the disabled business owner:

• He or she receives the funds necessary to purchase

the business interest.

• He or she does not need to worry about future

business fluctuations, including losses.

• He or she is taxed only on the gain from the sale

of the business.

Benefits to the business:

• Full funding is available when needed.

• Benefits are received tax free.

• No interest charges.

• No lien, credit restriction, or drain on profits.

AS5007 715 CRN201707-194086

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