Giving Scrutiny to Your Business Continuity Part 3
Here's the third of a four part series titled Giving Scrutiny to Your Business Continuity.
The Situation
Five years ago you and a partner started Aggressive, Inc. Since then, business has been good and your Business Continuity Agreement carries a $1 million valuation. You fund the agreement with two $500,000 life insurance policies-one on the life of each partner.
Funding Alternatives
Before we examine agreements in detail, let's review the four alternatives that exist to create the cash necessary to buy out a deceased partner's $500,000 interest in Aggressive, Inc. The costs associated with these various alternatives are shown in Diagram D.
Funding Alternative 1: Borrowing $500,000 at the time of a partner's death may be difficult. Credit positions often change when an owner dies. Nonetheless, as Diagram D shows, if a loan was available at 10 percent and repaid over a 10 year period, the cost to create $500,000 would be $813,727. It costs $1.62 to create each dollar.
Funding Alternative 2: Aggressive, Inc.'s corporate surplus might provide the cash necessary to buy out the deceased partner's interest, but it's not likely. An active and growing company doesn't retain large cash reserves. However, if the cash were available in corporate surplus, the second graph on Diagram D illustrates that each dollar costs one dollar. That is without any tax considerations.
Funding Alternative 3: The alternative of term insurance may be appropriate and practical in the very early years of a company. Eventually, however, the cost becomes prohibitive. The need for cash is permanent; term insurance is only a temporary solution. As Diagram D shows, the cost of term premiums to create a $500,000 death benefit for a 40-year-old male living to life expectancy is $477,740.
Funding Alternative 4: The permanent life insurance alternative, shown on the right of Diagram D, allows a business owner to create significant benefits payable at death. As the graph illustrates, the total premium outlay to create a paid-up $500,000 permanent policy is $77,900. Premium payments are required for only 10 years. Death benefits would, however, remain intact until death. The cost to create a dollar through permanent insurance? Less than 16 cents.
Clearly, the long-term view supports funding by permanent insurance.
Agreement Alternatives
In most cases, the Cross-Purchase agreement is the preferred instrument over the Stock Redemption agreement. While both have equal legal integrity, the Cross-Purchase has tax advantages at death.
A Stock Redemption agreement, on the other hand, may be advantageous when multiple shareholders are involved. For example, if ten shareholders were considering an agreement, it would be more convenient to have a single buyer in the event of death, i.e. the corporation under a Stock Redemption agreement. The following example for Aggressive, Inc. depicts scenarios for both agreements:
Stock Redemption
When your partner dies, the company receives tax-free insurance proceeds of $500,000 and pays it to your partner's estate to buy the stock. Assuming you each paid in $10,000 when Aggressive, Inc. was formed, and you later sold it for $1,000,000, you would have a capital gain of $990,000.
DIAGRAM D
Aggressive, Inc.
Alternatives to Create $500,000 for the Purchase of a Deceased Partner’s Interest
Cross-Purchase
When your partner dies, you (not the company) receive the tax-free $500,000 insurance proceeds to buy the stock. If you later sold Aggressive, Inc. for the same $1,000,000 as above, you would reduce your capital gain by $500,000 to $490,000 (versus $990,000). All you did to reduce the capital gain liability was structure the Business Continuation Agreement as a Cross-Purchase (so the surviving stockholder was responsible to buy the stock) rather than a Stock Redemption (where the corporation buys the stock).
The tax impact on your partner's survivor is the same under both agreements the estate receives the $500,000 income tax free. The savings occur at the time of the next sale. The Cross-Purchase structure "steps up" the cost basis $500,000 by permitting the surviving owner to use a cost basis of $510,000 rather than looking all the way back to when Aggressive, Inc. began, with a per-shareholder cost of $10,000.
The "stepped-up" cost basis is the primary reason the Cross-Purchase agreement is often favored over the Stock Redemption agreement. But circumstances vary. That is why you need expert legal and insurance counsel.
The Splendor of Split-Dollar
Business owners naturally prefer that the business pays the insurance premium from corporate funds, rather than taking it from personal funds. The IRS would frown on this arrangement were it not for another concept, thought by many to be the most appropriate companion to business continuity planning. It's called Split Dollar (Diagram E). The concept of Split Dollar is more appropriate for a C corporation. In an S corporation, the concept referred to as Executive Bonus is usually better.
Split Dollar uses business dollars to help owners obtain personal insurance and cash benefits on a favored basis, even if it only involves one shareholder. However, let's continue to assume there are two partner-owners.
DIAGRAM E
Split Dollar Insurance
(Collateral Assignment Approach)
Partner A is owner and beneficiary of policy on Partner B. Partner A makes collateral assignment to Aggressive, Inc. which may use policy values at any time and receive full return of premiums paid at Partner B's death.
At Death of Partner B:
Partner A complies with Business Continuity Agreement.
At Retirement of Partner B:
For example, Partner A purchases a policy on Partner B and names himself as owner and beneficiary. Partner A makes an agreement (Collateral Assignment) with Aggressive, Inc. to repay any premiums advanced by the company as premium payments at the time of the insured's death, disability, or withdrawal.
Partner A agrees to pay tax on the economic benefit he or she receives as a result of the company paying the premiums. This economic benefit is traditionally measured by the lowest applicable term insurance premium offered by the insurance company.
Imagine, for example, that Aggressive, Inc. pays a $10,000 annual premium on a $500,000 permanent policy on the life of each owner. Each partner in effect receives $10,000 annually from the company to be used to pay premiums on a policy he or she personally owns. The $10,000 "advance" is not considered income, however. The income tax liability is limited to the economic benefit which, assuming a 40-year-old partner, would be around $375. Under 1991 law, the tax cost would be no more than 31 percent of that, or $120 dollars. Income arbitrage results since the benefit generated is far greater than the required method of taxing it.
If an insured partner dies, in this case Partner B, the company would receive income tax-free proceeds equal to the premiums advanced, which would terminate the Collateral Assignment made between the surviving partner and the company. Partner A would receive the balance of the proceeds income tax-free. He or she would then be able to use the proceeds to complete the contractual responsibilities under the terms of the business continuation plan.
Split Dollar employs the use of a permanent life insurance policy. That means either Universal Life or Whole Life. Once again, a trusted advisor and a thorough examination of alternatives is the only way to ensure you are making the most efficient use of your insurance dollars.