Society of FSP - Advisors Forum Joint Teleconference

1. Society of FSP - Advisors Forum Joint Teleconference Exciting New Opportunities In Buy-Sell Planning with Life Insurance Presented byJames Flick, JD, CLU, ChFC and Timothy Messett, CLU April 23, 2008 1

2. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements IRS approved the use of a LLC to own life insurance purchased to fund a cross-purchase buy-sell agreement for S corporation shareholders. 2

3. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements • The benefits of this structure include: • Minimizes number of policies that must be purchased • Avoids income taxation of the death benefit under the transfer-for-value rule • Keeps the policies out of the shareholders’ estates • Protect the policies from business creditors • Protect the policies from the shareholders’ creditors • Assure compliance with the buy-sell agreement 3

4. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements Background on Buy-Sell Planning • Stock Redemption (entity purchase) • Under a redemption arrangement, the corporation redeems the shares of a deceased shareholder at his death • Advantages • The simplicity of only one life insurance policy per shareholder • Premium costs are allocated to the shareholders according to their percentage ownership in the corporation • Assumes compliance with the terms of the buy-sell 4

5. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements Stock Redemption (entity purchase) • Disadvantages • The loss of the step-up basis • The insurance policies are subject to attachment by the corporation’s creditors • If the corporation is a C corp, the death proceeds may also be subject to the alternative minimum tax (AMT) • If corporate-owned buy-sell policies are over-funded to provide non-qualified retirement benefits to the owners, the benefits are generally taxable • For an S-corp owner, the results are slightly better because the shareholder has some basis in the policy 5

6. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements Cross-Purchase Under a cross-purchase arrangement, each surviving owner buys the deceased shareholder’s stock directly from his estate • Advantages • Because individuals own the policies and receive the income tax-free death benefit, they can obtain a full basis step-up by buying the stock directly from the decedent’s estate • The common “wait and see” approach allows surviving shareholders to keep the insurance proceeds for themselves and use any retained corporate earnings to effectuate a redemption • Policies are protected from the corporation’s creditors 6

7. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements Cross-Purchase • Disadvantages • The most obvious disadvantage is the number of policies required to accomplish the funding • Policies are subject to attachment by shareholder’s creditors • A shareholder may fail to pay premiums or refuse to pay death benefits pursuant to the buy-sell agreement • The premium burden is allocated based on the cost of insurance of each other shareholder 7

8. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements Trusteed Agreement In a Trusteed Agreement, the policies are held by an irrevocable trust with an independent trustee • Advantages • The simplicity of only one life insurance policy per shareholder • Premium costs are allocated to the shareholders according to their percentage ownership in the corporation • Assumes compliance with the terms of the buy-sell agreement 8

9. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements Trusteed Agreement • Disadvantages The death benefits may be subject to income tax under the transfer-for-value rule • First problem—emerges when there are more than two shareholders and one shareholder dies. The beneficial interests in the policies on the surviving shareholders (which were owned by the decedent through the trust) transfer to the other (uninsured) surviving shareholders • Second problem—stems from the fact that the shareholders, as beneficiaries of the trust, are the beneficial owners of the insurance policies owned by the trust 9

10. PLR 200747002Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements Trusteed Agreement • Disadvantages The death benefits may be subject to income tax under the transfer-for-value rule c. Third problem—arises because each shareholder is a beneficial owner of a proportionate share of his own policy and effectively, through the trust agreement, names the other shareholders as beneficiaries of the policy 10

11. PLR 200747002 Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements The BILIT (business irrevocable life insurance trust) The BILIT uses irrevocable life insurance trusts (ILITs) as the centerpiece of the buy-sell arrangement. This strategy calls for a cross purchase arrangement whereby the policies each shareholder maintains on the other shareholders are held in their own respective ILITs. • Advantages • Policies are protected from shareholder’s creditors • Policies are not an asset in shareholder’s estate 11

12. PLR 200747002 Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements BILIT (business irrevocable life insurance trust) • Disadvantages • The administrative inefficiency caused by the need for multiple policies on each shareholder is not avoided • The policies may not be withdrawn from the arrangement without triggering taxation on cash value gains • As in the case of any cross purchase arrangement, a deceased shareholder leaves a transfer-for-value problem in his wake 12

13. PLR 200747002 Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements BILIT (business irrevocable life insurance trust) BILIT requires that the policies owned by the deceased shareholder’s irrevocable trust that insure the surviving shareholders are “purchased” by each surviving shareholder’s irrevocable trust. The death benefit on these two policies will then be taxed as ordinary income under the transfer-for-value rule. 13

14. PLR 200747002 Innovative Use of a LLC to Structure and Fund Buy-Sell Agreements New Approved Structure • Shareholders execute a cross purchase agreement • Shareholders form a LLC, taxed as a partnership, to own life insurance • The cross purchase agreement and LLC operating agreement have provisions that reference each other • Special provisions of LLC: • Manager is a corporate trustee. Any replacement must be a corporate trustee or an “independent” person • Members cannot vote on life insurance matters • Manager must use life insurance proceeds as required in the buy-sell agreement • A capital account is maintained for each member, with special allocations of premiums and proceeds 14

15. “LifeCycle” Buy-Sell: Original Use of a LLC to Structure and Fund Buy-Sell Agreements Differences with PLR: • PLR uses term insurance - LifeCycle uses cash value insurance • PLR limited to funding death buyout - LifeCycle can also be used for non-qualified retirement benefits • PLR LLC has more restrictive operating agreement - for example, LifeCycle does not require a corporate trustee as manager and restricts a member against voting only on policies on such member’s life (author of PLR admits that more restrictive provisions only necessary if seeking a letter ruling) 15

16. Are Death Benefits Included in the Estate of the Deceased Partner/Member? No, in PLR 200747002 and in PLR 200214028, IRS ruled that a partner/member does not possess any incidents of ownership in policy provided the death benefit proceeds are payable to or for the benefit the partnership/LLC. Since deceased partner/member does not possess incidents of ownership, the death benefits are not included in the decedent’s under IRC Section 2042(2).

17. How Are the Premium Payments Funded? Usually paid by the underlying business entity for the owners/employees. Payments are generally treated as bonuses under IRC Section 162. If business is taxed as an S corporation, payments can be treated as shareholder distributions. Each premium payment is treated as a contribution of capital by the partner/member.

18. Can Life Insurance With Cash Values be Used? PLR 200747002: Neither in its statement of facts nor in its law and analysis does the IRS mention whether the policies are term or have cash values. PLR 200214028: The statement of facts do not specifically state that the subject policies have cash value. However, it does state that a withdrawing partner has the option to purchase the policy on his life for its “surrender value”, implying that the policies do, or could, have cash values. In PLR 200214028, the IRS held that life insurance policies on decedent’s life held by and payable to a partnership under terms of partnership agreement to facilitate buy-out of decedent’s interest without liquidation of partnership aren’t included in decedent’s gross estate under Code Sec. 2042.

19. Special Planning Required When Life Insurance With Cash Value is Used. When a LLC is used in conjunction with a Business Buy-Sell Agreement, there are two buy-out obligations, the business buy-out and the LLC buy-out. If the policies purchased by the LLC will accumulate significant cash values, the life insurance death benefits should increase at least as fast as the cash value or additional death benefit should be purchased (in addition to any increases required to accommodate increases in the value of the business).