Buy-Sell Agreements are a popular way to handle succession issues when a small business has more than one owner. In order to explain the basics, let’s set up an example.
Jimmy and Jenny are 50/50 owners in ABC Company. They’re both getting up there in age and are worried about what would happen if one of them died. If that were to happen, neither partner would want to be in business with the other partner’s spouse.
So they set up a Buy – Sell Agreement.
Their individual partnership interests are estimated to be worth $1M apiece. ABC buys a $1M life insurance policy on each partner. If either partner dies, the life insurance proceeds would be used to pay the surviving spouse for the partnership interest.
This was a popular way of handling this basic need because it was a tax free transaction. The proceeds of the life insurance policy were considered non-taxable prior to a recent Supreme Court Case.
In Connelly v. United States one partner died back in 2013 and had a $3.5M life insurance policy in place to pay the other partner for their share of the business. On the date of death, the business was valued at $3.86M.
Prior to the recent decision, these transactions were considered non-taxable. The payout was excluded from the company’s balance sheet because it was offset by the liability to repurchase the stock. In this instance, the $3M payout as an asset would have been nullified by a corresponding $3M liability,
But in a unanimous decision, the Supreme Court ruled that the transaction was a taxable event. The Court reasoned that the $3M payout was an asset, but that the corresponding liability was not an actual liability like a mortgage or Account Payable.
As such, the value of the company was increased by $3M, which increased the value of the estate, leading to an additional estate tax of almost $900K.
Let me leave you with this…
The implications of this case are enormous. If you find yourself in this sort of situation, the question becomes, what do you do? There are four things that come to mind…
1 – Check Your Buy-Sell Agreement
Given what has happened it may no longer provide you with the tax free transaction you were expecting. Have it reviewed by an estate attorney for validity.
2 – Make Sure The Appraisal Is Up To Date
Because the value of companies change over time, most of these agreements require the appraisal on the partnership interest to be updated annually. If this has not occurred, it may lead to problems.
3 – See If The Policies Are Still In Place
Normally these agreements happen over longer periods of time. If the payments on the life insurance policies haven’t been kept up, there might not be anything backing up the agreement.
4 – Look At Who Is Paying For The Policies
If the company is funding the policies, then go into it knowing that the payout will be added to the value of your estate. The current Federal Estate Tax Credit is $13.6M per individual. The credit in the State of Illinois is only $4M. If this addition puts you over the limit, you might need to rethink the whole thing.
One solution would be for the individual owners to own and pay for the life insurance policies funding the agreement. The Connelly Case Decision specifically noted that these Cross-Purchase Agreements are a solution. But this can become rather expensive as owners get older.
Again, the implications of this ruling are enormous. If you have questions, please call.
We’re all going to get through this. Let’s get through it together.
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