Section 79 Planning Opportunities

Closely held businesses produce over 50% of the Gross National Product (“GNP”). Less than 50% of these businesses have a continuation plan and almost one-third of these companies (29%) use a buy-sell arrangement to assist in their planning. (See, Estate Planning Uses of Buy-Sell Agreements Funded with Life Insurance, Sabene Hitchcock-Gear, J.D., ALI-ABA, Oct. 28, 1999.) Buy-Sell agreements are very simple tools that over the years have grown to meet increasing needs of closely held businesses.

Buy-Sell Agreements try to address many of the following problems:

• Death Buyout;
• Disability Funding;
• Withdrawal from Employment (for competitive or noncompetitive purposes);
• Retirement Planning;
• Tax Issues ' income, transfer, estate and gift;
• Protection from Creditors (corporate and individual);
• Fixing the Value of the Business Interest of the Owner; and
• Settle Shareholder Differences.

These goals are disparate, and many of the tools currently available do not address all goals successfully. Generally speaking, a buy-sell agreement contains a restriction on the right to transfer a business interest during the life and at the death of the business owners, as well as an option, or other right, to acquire property at a specified price. The agreement typically sets the value of a closely held business for transfer tax purposes in the form of a fixed amount or a formula. Such a value may reflect the fair market value of the property at the time of the agreement (rather than a later date such as the date of the owner's death). The buy-sell agreement is often funded by life insurance policies.

The two basic types of buy-sell agreements are a redemption agreement and a cross-purchase agreement. A redemption agreement is a contract between the business owners and the business entity (e.g., a corporation, a joint venture, an L.L.C. or a partnership) to redeem the owners' interests during their lives and/or upon their deaths. (Such an agreement may be subject to limitations imposed by state law. For example, there may be a restriction on the ability of a corporation to purchase its own stock due to capital surplus requirements or insolvency.) When a redemption agreement is funded with life insurance, the business owns the policies and pays the premiums. The premiums are not deductible by the business for income tax purposes, and the life insurance proceeds received upon the death of a shareholder are not included in the income of the business. (In the case of a corporation, the proceeds may, however, expose the corporation to an alternative minimum tax.)

A cross-purchase agreement is a contract between the owners of the business to buy the interests held by the other owner(s) during their lives and/or upon their death. When such agreements are funded by life insurance, the policies are purchased by the individual parties to the agreement rather than the business. Sometimes the business pays for the insurance policies through additional compensation or bonus payments passed through to the owners.

The decision whether to utilize redemption or a cross-purchase buy-sell agreement (or a combination thereof) may be founded upon a number of non-tax and tax considerations. In the case of a business with two owners, one non-tax consideration is the cost of carrying the life insurance policy, i.e., funding of a first-to-die policy may be made at a considerably lower premium than individual policies. Other non-tax considerations include whether a corporation may repurchase the stock under the state law; if an owner/officer/director is violating a fiduciary duty to owners and to creditors by repurchasing the ownership when the business may not be in a financial condition to do so; and whether percentage ownership and control of unequal owners changes significantly by the redemption.

Since the enactment of the Tax Reform Act of 1986, there may also be significant tax considerations involved in selecting either a redemption or cross-purchase agreement. A redemption agreement may create an alternative minimum tax (“AMT”) for C corporations. S corporations, however, are not subject to the tax.

In addition, with respect to a redemption agreement, the premiums paid for life insurance to fund the buy-sell agreement are not deductible to a corporation. Although the proceeds are not subject to corporation income tax, the insurance proceeds may trigger AMT issues.

On the other hand, a cross-purchase agreement requires the shareholders to use after-tax dollars to acquire the life insurance policies for purposes of funding the buy-sell agreement. The insurance proceeds, however, may not be subject to income tax at the corporation or individual level. This is not a concern for partnerships. (See, Lawrence L. Bell, Valuation of Buy-Sell Agreements under Chapter 14 of the Internal Revenue Code, Journal of the American Society of CLU & ChFC, Sept. 1992 at 48.)

Section 79 Can Provide A Unique Alternative

The rules of Section 79 of the Internal Revenue Code (“the Code”) apply to determine the taxation of the life insurance benefits provided to employees by the employer providing a group life carve-out program. The IRS determined in TAM 200002047 1/18/2000, ” 61; 79 that the employer can provide a basic group-term life insurance plan for its employees, for which the employer pays all premiums, and provide individual coverage for employees over a salary floor of $50,000. The IRS determined the amount of the premium attributable to the permanent policy for employees earning over $50,000 is not taxable to the employees. The employees covered by the group life carve out are taxed on the economic benefit as provided under Section 79.

In order to come to this conclusion, the IRS follows the four-prong test of Section 1.79-1(a), and determines if the definition of “permanent benefit” of the Regulations 1.79-0 is met. The Program meets both of these tests.

Section 79-1(a) states group-term life insurance must:

1. Provide a general death benefit excludable from gross income under section 101(a). The Program meets the definition of life insurance under 101(a) ( see, TAM 200502040).
2. Be provided to a group of employees. In keeping with TAM 200002047, all employees over a set salary level are provided the benefit program.
3. Be provided under a policy carried directly or indirectly by the employer. The employer pays all of the premiums so the third test is followed.
4. Compute the amount of insurance under a formula that precludes individual selection. The program does not permit an employee to individually select his or her benefit.

The last hurdle is to assure the Program is not a “permanent” benefit as defined under Regs. Sec.1.79-0. This test is satisfied three different ways:

1. The economic benefit to the covered employee does not extend beyond one policy year. The employee is covered on a year-to-year basis only so long as he is employed by the employer. The employee cannot take the death benefit with him if he terminates his position.
2. The only benefit provided to the employee is the current insurance protection. Covered employees only receive the rights to the death benefit so long as they are in the employment of the employer.
3. The term life coverage is not provided on a level premium for a period of more than five years. The contribution for the current death benefit provided to the employees is determined annually by independent actuaries using stable funding. The cost of the death benefit will be subject to change annually.

Because the Program through employer funding does not provide permanent benefits to employees under Regs. Sec.1.79-0, it does not have to meet the requirements of Sec. 79-1(b). Accordingly, the insurance provided is “group-term life insurance” for purposes of section 79 of the Code.

Transfer Tax Issues

In return for providing the payment for the premium, the company will receive an income tax deduction for the cost of the current death benefit and will not have to redeem the employee shareholder stock interest. In the event shareholder A dies prior to retirement, or terminates his or her association with the company, the company would have funded the death benefit and the employee would have recognized the economic benefit of the coverage. And the employee-shareholder will have assigned his or her interest in the death benefit to the remaining shareholders or a trusteed cross-purchase agreement.

Death of a Shareholder

Structured as outlined, shareholder A owns the insurance policy and is the insured, thereby giving him or her control over the cash value of the policy. The remaining shareholders, B and C, will be the recipients of the death benefit. Should A die prior to retirement, B and C will each receive a per capita share (one-half) of the death benefit as the endorsed beneficiaries. At A's death, his or her shares of ownership in the company will pass to his or her heirs and receive a step-up in basis. Shareholders B and C will purchase those shares for the fair market value stipulated in the buy-sell agreement; therefore, B and C will have acquired A's share of the company, thereby increasing their overall cost basis in the company.

Termination Prior to Retirement

If shareholder A terminates his or her association with the corporation prior to retirement, shareholders B and C would release the death benefit endorsement. The death benefit on A's life would be available to pay the death buyout or could be further consideration for a lifetime buyout. This payment could relieve the company from the redemption of stock from A or provide for benefits under the trusteed cross-purchase agreement, or could be used by B and C to fund their own retirement or benefit packages.

Retirement of a Shareholder

The next consideration is the issue of A's retirement. Shareholders B and C on the trusteed cross-purchase agreement could retain the death benefit or exchange one benefit for A, dropping the right in B and C's policies. The cash value of the policy will be under the control, and for the benefit, of A under the terms of the deferred compensation arrangement. And, consistent with covenant not to compete, shareholder A could access the cash value subject to the terms of the contracts. Release of the endorsement returns to shareholder A the right to transfer the ownership of the policy to an irrevocable trust, an insurance limited partnership, his or her spouse, other family members, or appropriate charity as the beneficiary of the policy. Depending on the licensing requirement, A could have assigned his or her rights previously. As the owner of the policy, shareholder A would also have the opportunity to convert the residual cash value into a stream of supplemental retirement income.

Transfer for Value Issue

Adverse tax treatment can occur when a traditional cross-purchase agreement expires. This situation occurs when existing policies owned by departing shareholders who do not meet one of the exceptions to transfer for value rules are transferred. Ordinarily, in a cross-purchase agreement, each shareholder owns a life insurance policy on the life of each of the shareholders. Upon the death of the first shareholder, each of the remaining shareholders will use the proceeds of the policy they own on the life of the deceased shareholder to carry out his or her obligation to purchase a pro rata share of the deceased shareholder's stock. After this, the remaining shareholders will need to acquire additional insurance to fully fund their continuing obligations under the agreement, because each remaining shareholder will now own an increased portion of the business. If the remaining shareholders purchase the policies held by the estate of the deceased shareholder, the purchase will be a transfer for value. The redemption agreement approach does not have this problem, but on termination of the agreement during the life of the shareholder, or upon withdrawal from the corporation, the transfer of policies may also trigger transfer for value issues. (Sometimes the transfer for value rule can be avoided after the death of the first shareholder by allowing the deceased shareholder's estate to sell policies on the other shareholders to the company, and then converting the agreement to an entity agreement.)

The Plan would resolve the following issues in structuring buy-sell agreements for client corporations:

• The death benefit could be paid directly to shareholders B and C; therefore, it would not trigger an alternative minimum tax issue for the corporation.
• Shareholders B and C would have cash available at shareholder A's death, termination, or retirement to purchase A's shares outright or to make a substantial initial payment toward the purchase of those shares.
• Direct purchase by B and C would increase the cost basis of their share of the corporation equal to the purchase price.
• Transfer-for-value problems would be eliminated.

Conclusion

The issues raised initially are resolved with the Plan.

• Death Buyout. Death benefits are available during employment to buy out a shareholder-employee's interest.
• Disability Funding. The Plan benefit (cash values) owned by the shareholder-employee may be accessed, income-tax free.
• Withdrawal from Employment. Because the shareholder-employee owns the policy, there would be no transfer of the policy upon the triggering event. The buy-sell agreement (collateral assignments) can limit access to the cash value. The ability to provide benefit, income-tax free, will reduce the cost in providing the benefits.
• Retirement Planning. The value of the Plan benefit can offset the funding need for retirement.
• Tax Issues. The use of the Plan method avoids the income tax consequences, and with proper assignment and ownership, the benefits may be available to the shareholder-employee and his/her family estate- and gift-tax free.
• Protection from Creditors, both Corporate and Individual. The Plan benefits are not subject to the claims of either corporate or individual creditors.
• Fixing the Value of the Business. The Plan can fund for the buyout in line with the buy-sell agreement.
• Settling Shareholder Differences. The Plan can create a funding vehicle to permit settlement of shareholder controversy with non-taxable dollars and create golden handcuffs or golden parachute, where appropriate.

Buy-Sell Agreements are often used as planning tools that can assist and address death buyouts, disability and withdrawal of principals. By using existing and recognized tools as described in the Plan, you can now also provide for non-taxable retirement benefits with cost containment and corporate reimbursement. This effective use of Buy-Sell agreements with the final Split Dollar Regs, 409A, COLI Best Practices, and the recent TAMs, addresses the goals of shareholders and the companies in buy-sell agreements.

Closely held businesses produce over 50% of the Gross National Product (“GNP”). Less than 50% of these businesses have a continuation plan and almost one-third of these companies (29%) use a buy-sell arrangement to assist in their planning. (See, Estate Planning Uses of Buy-Sell Agreements Funded with Life Insurance, Sabene Hitchcock-Gear, J.D., ALI-ABA, Oct. 28, 1999.) Buy-Sell agreements are very simple tools that over the years have grown to meet increasing needs of closely held businesses.

Buy-Sell Agreements try to address many of the following problems:

• Death Buyout;
• Disability Funding;
• Withdrawal from Employment (for competitive or noncompetitive purposes);
• Retirement Planning;
• Tax Issues ' income, transfer, estate and gift;
• Protection from Creditors (corporate and individual);
• Fixing the Value of the Business Interest of the Owner; and
• Settle Shareholder Differences.

These goals are disparate, and many of the tools currently available do not address all goals successfully. Generally speaking, a buy-sell agreement contains a restriction on the right to transfer a business interest during the life and at the death of the business owners, as well as an option, or other right, to acquire property at a specified price. The agreement typically sets the value of a closely held business for transfer tax purposes in the form of a fixed amount or a formula. Such a value may reflect the fair market value of the property at the time of the agreement (rather than a later date such as the date of the owner's death). The buy-sell agreement is often funded by life insurance policies.

The two basic types of buy-sell agreements are a redemption agreement and a cross-purchase agreement. A redemption agreement is a contract between the business owners and the business entity (e.g., a corporation, a joint venture, an L.L.C. or a partnership) to redeem the owners' interests during their lives and/or upon their deaths. (Such an agreement may be subject to limitations imposed by state law. For example, there may be a restriction on the ability of a corporation to purchase its own stock due to capital surplus requirements or insolvency.) When a redemption agreement is funded with life insurance, the business owns the policies and pays the premiums. The premiums are not deductible by the business for income tax purposes, and the life insurance proceeds received upon the death of a shareholder are not included in the income of the business. (In the case of a corporation, the proceeds may, however, expose the corporation to an alternative minimum tax.)

A cross-purchase agreement is a contract between the owners of the business to buy the interests held by the other owner(s) during their lives and/or upon their death. When such agreements are funded by life insurance, the policies are purchased by the individual parties to the agreement rather than the business. Sometimes the business pays for the insurance policies through additional compensation or bonus payments passed through to the owners.

The decision whether to utilize redemption or a cross-purchase buy-sell agreement (or a combination thereof) may be founded upon a number of non-tax and tax considerations. In the case of a business with two owners, one non-tax consideration is the cost of carrying the life insurance policy, i.e., funding of a first-to-die policy may be made at a considerably lower premium than individual policies. Other non-tax considerations include whether a corporation may repurchase the stock under the state law; if an owner/officer/director is violating a fiduciary duty to owners and to creditors by repurchasing the ownership when the business may not be in a financial condition to do so; and whether percentage ownership and control of unequal owners changes significantly by the redemption.

Since the enactment of the Tax Reform Act of 1986, there may also be significant tax considerations involved in selecting either a redemption or cross-purchase agreement. A redemption agreement may create an alternative minimum tax (“AMT”) for C corporations. S corporations, however, are not subject to the tax.

In addition, with respect to a redemption agreement, the premiums paid for life insurance to fund the buy-sell agreement are not deductible to a corporation. Although the proceeds are not subject to corporation income tax, the insurance proceeds may trigger AMT issues.

On the other hand, a cross-purchase agreement requires the shareholders to use after-tax dollars to acquire the life insurance policies for purposes of funding the buy-sell agreement. The insurance proceeds, however, may not be subject to income tax at the corporation or individual level. This is not a concern for partnerships. (See, Lawrence L. Bell, Valuation of Buy-Sell Agreements under Chapter 14 of the Internal Revenue Code, Journal of the American Society of CLU & ChFC, Sept. 1992 at 48.)

Section 79 Can Provide A Unique Alternative

The rules of Section 79 of the Internal Revenue Code (“the Code”) apply to determine the taxation of the life insurance benefits provided to employees by the employer providing a group life carve-out program. The IRS determined in TAM 200002047 1/18/2000, ” 61; 79 that the employer can provide a basic group-term life insurance plan for its employees, for which the employer pays all premiums, and provide individual coverage for employees over a salary floor of $50,000. The IRS determined the amount of the premium attributable to the permanent policy for employees earning over $50,000 is not taxable to the employees. The employees covered by the group life carve out are taxed on the economic benefit as provided under Section 79.

In order to come to this conclusion, the IRS follows the four-prong test of Section 1.79-1(a), and determines if the definition of “permanent benefit” of the Regulations 1.79-0 is met. The Program meets both of these tests.

Section 79-1(a) states group-term life insurance must:

1. Provide a general death benefit excludable from gross income under section 101(a). The Program meets the definition of life insurance under 101(a) ( see, TAM 200502040).
2. Be provided to a group of employees. In keeping with TAM 200002047, all employees over a set salary level are provided the benefit program.
3. Be provided under a policy carried directly or indirectly by the employer. The employer pays all of the premiums so the third test is followed.
4. Compute the amount of insurance under a formula that precludes individual selection. The program does not permit an employee to individually select his or her benefit.

The last hurdle is to assure the Program is not a “permanent” benefit as defined under Regs. Sec.1.79-0. This test is satisfied three different ways:

1. The economic benefit to the covered employee does not extend beyond one policy year. The employee is covered on a year-to-year basis only so long as he is employed by the employer. The employee cannot take the death benefit with him if he terminates his position.
2. The only benefit provided to the employee is the current insurance protection. Covered employees only receive the rights to the death benefit so long as they are in the employment of the employer.
3. The term life coverage is not provided on a level premium for a period of more than five years. The contribution for the current death benefit provided to the employees is determined annually by independent actuaries using stable funding. The cost of the death benefit will be subject to change annually.

Because the Program through employer funding does not provide permanent benefits to employees under Regs. Sec.1.79-0, it does not have to meet the requirements of Sec. 79-1(b). Accordingly, the insurance provided is “group-term life insurance” for purposes of section 79 of the Code.

Transfer Tax Issues

In return for providing the payment for the premium, the company will receive an income tax deduction for the cost of the current death benefit and will not have to redeem the employee shareholder stock interest. In the event shareholder A dies prior to retirement, or terminates his or her association with the company, the company would have funded the death benefit and the employee would have recognized the economic benefit of the coverage. And the employee-shareholder will have assigned his or her interest in the death benefit to the remaining shareholders or a trusteed cross-purchase agreement.

Death of a Shareholder

Structured as outlined, shareholder A owns the insurance policy and is the insured, thereby giving him or her control over the cash value of the policy. The remaining shareholders, B and C, will be the recipients of the death benefit. Should A die prior to retirement, B and C will each receive a per capita share (one-half) of the death benefit as the endorsed beneficiaries. At A's death, his or her shares of ownership in the company will pass to his or her heirs and receive a step-up in basis. Shareholders B and C will purchase those shares for the fair market value stipulated in the buy-sell agreement; therefore, B and C will have acquired A's share of the company, thereby increasing their overall cost basis in the company.

Termination Prior to Retirement

If shareholder A terminates his or her association with the corporation prior to retirement, shareholders B and C would release the death benefit endorsement. The death benefit on A's life would be available to pay the death buyout or could be further consideration for a lifetime buyout. This payment could relieve the company from the redemption of stock from A or provide for benefits under the trusteed cross-purchase agreement, or could be used by B and C to fund their own retirement or benefit packages.

Retirement of a Shareholder

The next consideration is the issue of A's retirement. Shareholders B and C on the trusteed cross-purchase agreement could retain the death benefit or exchange one benefit for A, dropping the right in B and C's policies. The cash value of the policy will be under the control, and for the benefit, of A under the terms of the deferred compensation arrangement. And, consistent with covenant not to compete, shareholder A could access the cash value subject to the terms of the contracts. Release of the endorsement returns to shareholder A the right to transfer the ownership of the policy to an irrevocable trust, an insurance limited partnership, his or her spouse, other family members, or appropriate charity as the beneficiary of the policy. Depending on the licensing requirement, A could have assigned his or her rights previously. As the owner of the policy, shareholder A would also have the opportunity to convert the residual cash value into a stream of supplemental retirement income.

Transfer for Value Issue

Adverse tax treatment can occur when a traditional cross-purchase agreement expires. This situation occurs when existing policies owned by departing shareholders who do not meet one of the exceptions to transfer for value rules are transferred. Ordinarily, in a cross-purchase agreement, each shareholder owns a life insurance policy on the life of each of the shareholders. Upon the death of the first shareholder, each of the remaining shareholders will use the proceeds of the policy they own on the life of the deceased shareholder to carry out his or her obligation to purchase a pro rata share of the deceased shareholder's stock. After this, the remaining shareholders will need to acquire additional insurance to fully fund their continuing obligations under the agreement, because each remaining shareholder will now own an increased portion of the business. If the remaining shareholders purchase the policies held by the estate of the deceased shareholder, the purchase will be a transfer for value. The redemption agreement approach does not have this problem, but on termination of the agreement during the life of the shareholder, or upon withdrawal from the corporation, the transfer of policies may also trigger transfer for value issues. (Sometimes the transfer for value rule can be avoided after the death of the first shareholder by allowing the deceased shareholder's estate to sell policies on the other shareholders to the company, and then converting the agreement to an entity agreement.)

The Plan would resolve the following issues in structuring buy-sell agreements for client corporations:

• The death benefit could be paid directly to shareholders B and C; therefore, it would not trigger an alternative minimum tax issue for the corporation.
• Shareholders B and C would have cash available at shareholder A's death, termination, or retirement to purchase A's shares outright or to make a substantial initial payment toward the purchase of those shares.
• Direct purchase by B and C would increase the cost basis of their share of the corporation equal to the purchase price.
• Transfer-for-value problems would be eliminated.

Conclusion

The issues raised initially are resolved with the Plan.

• Death Buyout. Death benefits are available during employment to buy out a shareholder-employee's interest.
• Disability Funding. The Plan benefit (cash values) owned by the shareholder-employee may be accessed, income-tax free.
• Withdrawal from Employment. Because the shareholder-employee owns the policy, there would be no transfer of the policy upon the triggering event. The buy-sell agreement (collateral assignments) can limit access to the cash value. The ability to provide benefit, income-tax free, will reduce the cost in providing the benefits.
• Retirement Planning. The value of the Plan benefit can offset the funding need for retirement.
• Tax Issues. The use of the Plan method avoids the income tax consequences, and with proper assignment and ownership, the benefits may be available to the shareholder-employee and his/her family estate- and gift-tax free.
• Protection from Creditors, both Corporate and Individual. The Plan benefits are not subject to the claims of either corporate or individual creditors.
• Fixing the Value of the Business. The Plan can fund for the buyout in line with the buy-sell agreement.
• Settling Shareholder Differences. The Plan can create a funding vehicle to permit settlement of shareholder controversy with non-taxable dollars and create golden handcuffs or golden parachute, where appropriate.

Buy-Sell Agreements are often used as planning tools that can assist and address death buyouts, disability and withdrawal of principals. By using existing and recognized tools as described in the Plan, you can now also provide for non-taxable retirement benefits with cost containment and corporate reimbursement. This effective use of Buy-Sell agreements with the final Split Dollar Regs, 409A, COLI Best Practices, and the recent TAMs, addresses the goals of shareholders and the companies in buy-sell agreements.