Transferring a Business to Co-Owners

1. Transferring a Business to Co-Owners Sam G. Torolopoulos, CPA/ABV, ASA Dennis M. Axman, CLU, ChFC, AEP, CFP

2. Advanced Business Succession Planning • Business Succession Planning for S Corporations • Combination Buy-Sell Strategy

3. Business Succession Planning Concerns • Principal business owner’s death can cause serious financial problems for estate, business, and deceased’s survivors • Heirs may be faced with significant business continuation problems • Buy-sell agreement can help to assure trouble-free transfer of the business in the event of the death, disability or retirement of an owner

4. Buy-Sell Agreement Basics • Most buy-sell arrangements generally state that eachowner agrees: • Not to dispose of his/her ownership interest during his/her lifetime without first offering it for sale to other owners or to business entity • That surviving owners or business entity will purchase, and deceased owner’s estate will sell, decedent’s ownership interests • That purchase price based on pre-established formula will be used to determine a value for ownership interests

5. Buy-Sell Agreement Basics • For family transfers FMV will be used on form 706 as per IRC § 2703 (a) General rule For purposes of this subtitle, the value of any property shall be determined without regard to - • (1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or • (2) any restriction on the right to sell or use such property.

6. Buy-Sell Agreement Basics • (b) Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: • (1) It is a bona fide business arrangement. • (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. • (3) Its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction.

7. Financing Buy-Sell Agreements with Life Insurance and Disability Buy Out Insurance • Surviving business owners need means to raise funds • Acquiring funds to complete buyout can be difficult • Borrowing, selling business assets, or depleting cash reserves uncertain and risky • Life insurance is key to financing buy-sell agreement • Policy cash values are source of funds for buyout at owner’s disability, incapacitation, or retirement • A disability buy out policy can provide funds as needed for the disability of an owner

8. Traditional Types of Buy-Sell Arrangements • Cross-Purchase Buy-Sell Agreement • Stock-Redemption Buy-Sell Agreement

9. Cross-Purchase Buy-Sell Agreement • How It Works • All owners agree to purchase each other owner’s interest in business • Each owner owns and is beneficiary of life insurance policy insuring every other owner’s life

10. Cross-Purchase Buy-Sell Agreement • Major Advantages • Each owner receives basis increase equal to purchase price of deceased owner’s interest • If properly structured, business can make bonus payments to owner(s) for premium payments and take tax deduction for them

11. Cross-Purchase Buy-Sell Agreement • Major Disadvantages • May require numerous policies if there are multiple owners • Younger and/or healthier owner pays higher insurance cost for policy on life of older and/or less healthy co-owner

12. Stock-Redemption/Entity-Purchase Buy-Sell Agreement • How It Works • Business agrees to purchase deceased owner’s shares • Business owns and is beneficiary of life insurance policy on each owner • Business uses death benefit for buyout when needed

13. Stock-Redemption/Entity-Purchase Buy-Sell Agreement • Major Advantages • Business’ funds, not owners’, used to pay premiums • Only one policy per owner needed

14. Stock-Redemption/Entity-Purchase Buy-Sell Agreement • Major Disadvantages • No basis increase for surviving owners • Sale of business may be completely taxable if family attribution rules apply • Business’ receipt of death benefit may be subject to Alternative Minimum Tax (AMT)

15. Understanding Basis Issues with Buy-Sell Agreements • Example: Jerry and Kerry • Purchased printing business for $150,000 • Are equal, 50% owners of C corporation • Current value is $1 million • What if Kerry dies?

16. Types of Buy-Sell Arrangements: Effect on Basis • Cross-Purchase: Taxable Gain to Jerry • Jerry’s Original Investment: $ 75,000Cost of Share Purchasefrom Kerry’s Estate: +$500,000Total Cost Basis: $575,000 • Sale Price = Fair Market Value(FMV) of Business: $1,000,000Less Jerry’s Total Cost Basis: –$575,000Jerry’s Total Taxable Gain: $425,000

17. Types of Buy-Sell Arrangements: Effect on Basis • Stock Redemption: Taxable Gain to Jerry • Jerry’s Original Investment: $ 75,000 • Sale Price = FMV of Business: $1,000,000Total Cost Basis: –$75,000Jerry’s Total Taxable Gain: $925,000

18. IRC Section 101(j) • New Code provision created by Pension Protection Act of 2006 • Establishes best practices provision for COLI • Unless requirements under 101(j) are met, portion of death benefit from COLI will be included in gross income of employer

19. Maintaining Tax-Free Status for COLI Death Benefits • IRC § 101(j) • The following requirements must be met to maintain tax-free status for COLI death benefits: • Proper notice and consent from insured employee • Must be met prior to issuance of life insurance policy • One of two exceptions stated in IRC § 101(j) must be met

20. Importance of Buy-Sell Planning for S Corporations • Can protect S corporation status • Maximizes advantages inherent in special tax attributes of S corporations

21. Requirements for S Corporation Status • Violating any of the following requirements can result in termination of S corporation status: • Corporation must be domestic corporation • Corporation must not have more than 100 shareholders • Family can elect to be treated as one shareholder • Only individuals, decedent’s estate, estates of individuals in bankruptcy, certain exempt organizations per Internal Revenue Code Section 1361(c)(6), and certain trusts are eligible shareholders of S corporations • Shareholder cannot be nonresident alien • Corporation only can have one class of stock, although different voting rights are allowed

22. Utilizing S Corporation’s Special Tax Attributes • Advantage of using short-year election: • Using short-year election avoids basis issues occurring when buy-sell is structured as stock redemption

23. Avoiding Wasted Basis with S Corporations • Cost basis increased when corporation receives either taxable or nontaxable income • Nontaxable income includes amounts received from death benefit on corporation-owned life insurance policies • Stock-redemption arrangement for S corporation results in basis increase for surviving shareholders based on each one’s pro rata share of ownership • Amount of increase depends on whether S corporation can make short-year election

24. Using a Short-Year Election • S corporation must be on cash basis accounting method • Short-year election to terminate S corporation tax year without terminating “S” election can be made at death of deceased shareholder • Election terminates deceased shareholder’s interest in S corporation • Life insurance proceeds will then be received in following tax year • Surviving shareholders can receive basis increase for entire amount of life insurance death benefit in new tax year

25. Impact of Receipt of Insurance Proceeds on Basis for S Corporations • Example: Kelly Blue and John Black • Both are 50% owners of Color Me Printers, anS corporation • Each owner has current basis of $100,000 • Corporation has no retained earnings and profits • $1 million policy purchased on each owner in stock-redemption buy-sell • John Black dies

26. Impact of Receipt of Insurance Proceeds on Basis: Failing to Make a Short-Year Election • Impact on Kelly Blue’s Basis • Total Death Benefitfrom Policy on John: $1,000,000 • Kelly’s Opening Basis: $100,000 • Pro Rata Basis Increasefor Kelly: +$500,000 (50% of proceeds) • Kelly’s Ending Basis: $600,000

27. Impact of Receipt of Insurance Proceeds on Basis: Making a Short-Year Election • Avoiding Wasted Basis: Short-Year Election • Kelly Blue elects to terminate his S corporation’s tax year before John’s death benefit is received • Color Me Printers’ Total Death Benefit Received fromPolicy on John: $1,000,000 • Kelly’s Opening Basis: $100,000 • Kelly’s Basis Increase: +$1,000,000 • Kelly’s Ending Basis: $1,100,000

28. Additional S Corporation Concerns • Stock-redemption buy-sell agreement for an S corporation avoids other taxation-related disadvantages pertaining to C corporations: • Family attribution issues • Alternative Minimum Tax liability

29. What Is a Combination Buy-Sell Arrangement? • Arrangement in which separate general partnership is established to structure and fund buy-sell agreement • Combines benefits of cross-purchase and stock redemption and avoids drawbacks of both

30. Benefits of Using a Combination Buy-Sell Arrangement • Properly structured combination buy-sell arrangement provides benefits of both stock-redemption and cross-purchase agreements by: • Requiring only one insurance policy per owner • Dividing premium burden equitably among all owners • Providing full cost basis for purchased shares of business to all surviving business owners • Enabling business to deduct bonuses paid to owners, who then contribute same amounts to partnership for insurance purchase • Avoiding possible levy of AMT on business from receipt of life insurance death benefit when an owner dies

31. Overview of Combination Buy-Sell Strategy • Business and its owners establish buy-sell agreement for sale of business • Owners of business create separate general partnership • General partnership owns and is beneficiary of life insurance policies insuring life of each owner • Owners contribute funds to partnership; funds can be paid as bonuses to owners by business

32. Combination Buy-Sell Strategy • What happens when an owner dies? • Partnership receives income tax-free death benefit from policy • Disbursement of death benefit: • Purchase deceased partner’s interest in partnership • Distribute any remaining amounts to shareholders tax-free up to each shareholder’s basis • With distributed amounts, per buy-sell agreement, partners/owners can either: • Purchase deceased shareholder’s interest directly, or • Contribute funds to business so business can redeem decedent’s interest

33. Taxation and Allocation of Partnership Distributions • Distributing Proceeds: Importance of Basis • Distributions up to partner’s basis not taxable • Partner’s initial basis equal to total capital contributions partner made to partnership • Death benefit increases partner’s basis pro rata by partner’s percentage interest in partnership • Surviving partner’s basis can be increased by entire amount of death benefit if special allocation provisions are included in partnership agreement and used

34. Establishing the Partnership: Importance of “Business Purpose” • Adequate business purpose for partnership must exist • Debate continues on whether partnership formed solely to hold life insurance for buy-sell agreement is valid partnership • PLR 9309021 • Owners should consider contributing or having partnership own or manage other assets in addition to life insurance • Partnership might own and rent property, plant or equipment to the Company

35. Example: Bow Wow Kennel Supplies Corporation • Three equal shareholders of Bow Wow Kennel Supplies Corporation: • Jim, 60 years old, • Bob, 40 years old, and • Joe, also 40 years old • Owners agree to use combination buy-sell strategy for business succession plan

36. Example: Bow Wow Kennel Supplies Corporation • Creating the Partnership: JBJ Partnership • Jim, Bob, and Joe establish JBJ Partnership to fund and structure combination buy-sell arrangement for Bow Wow • JBJ also manages additional properties owned by Bow Wow to establish legitimate business purpose • Each owner receives $100,000 bonus from Bow Wow and then contributes it to JBJ • JBJ then uses contributed funds to purchase $1 million policy on each shareholder • JBJ charges and collects ongoing rent and uses rent money to pay ongoing insurance premiums

37. Example: Bow Wow Kennel Supplies Corporation • Impact of Jim’s Death • Jim dies 5 years after JBJ Partnership is created • $1 million death benefit paid to JBJ from life insurance policy on Jim • JBJ first uses funds to buy Jim’s interest in partnership, then distributes remaining amounts to Bob and Joe • Bob and Joe can use amounts to buy Jim’s interest in Bow Wow per buy-sell agreement

38. Example: Bow Wow Kennel Supplies Corporation • Taxation of Distributions from JBJ to Surviving Owners • Without Special Allocation Provisions in Partnership Agreement: • Bob and Joe’s partnership basis increase: $333,333 (1/3 of $1 million) • With Special Allocation Provisions in Partnership Agreement: • Bob and Joe’s partnership basis increase: $500,000 (1/2 of $1 million)

39. Example: Bow Wow Kennel Supplies Corporation • Impact on Surviving Shareholders’ Basis in Bow Wow • If Bob and Joe each pay $500,000 purchase price of Jim’s share, Bob and Joe each have basis in Jim’s share of $500,000 • Higher basis reduces taxable gain if Bob and Joe sell Bow Wow later

40. Who Can Benefit from Combination Buy-Sell Arrangements? • Owners who want all the benefits of a cross-purchase and stock redemption without any of their drawbacks

41. Summary • Importance of Business Succession Planning • Ensures successful transfer of one’s business interest • Reduces risk of loss at death of an owner • Supplies needed funds for buyout if life insurance is purchased and disability buyout insurance is purchased