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Life insurance held by an LLC: A new strategy to fund buy-sell agreements
Posted in General

Many closely-held businesses, especially family-owned businesses, face difficult decisions in deciding how to buy a deceased owner’s interest. Often these types of businesses do not want “outsiders” obtaining the deceased owner’s interest. Two approaches are commonly used: a redemption by the business entity or a cross purchase agreement where the remaining owners purchase the deceased’s interest. Under either approach, life insurance policies on the business owner’s life are sometimes used to provide the necessary funds to purchase the deceased’s interest.

However, under either approach, problems may exist with using life insurance to fund the purchase. If the business entity holds the life insurance policies, creditors may be able to encumber the funds. Additionally, the Internal Revenue Service may seek to attribute both the purchase price and part of the insurance proceeds to the deceased owner’s estate. While a cross purchase agreement may avoid these problems, life insurance policies held by the owners present their own problems. These include the fact that multiple policies may have to be purchased and the surviving owners may not want to, or may not be able to due to creditors, use the insurance proceeds to purchase the deceased’s interest.

A possible solution to the problems posed by buy-sell agreements funded with life insurance recently received the blessing of the IRS in a private letter ruling (PLR). The scenario presented in the PLR, in its simplest form, involved an S corporation with three shareholders, a father and two children. The three entered into a buy-sell agreement in which each would purchase the stock of the other upon their death. Each purchased life insurance policies to fund the purchase agreement. Then, the policies were assigned to a newly formed limited liability company (LLC). Once the policies were held by the LLC, each individual contributed, over time, an amount equal to the policy premiums and, in return, received the right to receive the death benefits in proportion to the premiums paid. The father also had set up a long term, generation-skipping trust for each child. The trusts played a significant role in the father’s overall estate plan, and were intended to be the ultimate purchasers of the stock, rather than the child personally, to avoid attachment by the child’s creditors and estate tax on the stock at the child’s later death. These trusts were also members of the LLC.

The newly formed insurance LLC used in the PLR had some unique features. First, the manager of the LLC was a corporate trustee. This helped to ensure that the death proceeds were not used for an improper purpose. Additionally, the manager was instructed not to distribute any proceeds until the parties’ agreed upon their application toward the cross purchase agreement. Next, the LLC operating agreement contained special partnership accounting principles providing for two capital accounts for each member. Finally, the IRS required that the operating agreement not expressly authorize amendments by members and preclude members from voting on anything related to any of the insurance policies held by the LLC.

Using an insurance LLC may provide business owners increased security and flexibility in buy-sell agreements. It allows an overall reduction in the number of life insurance policies needed, while increasing the likelihood that funds will be available and will be used to fund the buy-sell arrangement. These features potentially allow an insurance LLC, as used in the PLR, to play a vital role in a taxpayer’s overall goal of transferring a closely-held business to subsequent generations while minimizing risks and tax consequences.

  • Partner

    John is a partner in the firm's Estate Planning Department. He focuses his practice on estates, trusts, family business and disability planning, and the administration of estates and trusts. John also has an active health law ...

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