A Better Business Succession Mousetrap: A New Way To Fund and Utilize Buy-Sell Insurance

One of the most commonly used techniques to provide liquidity for closely held businesses is to insure a buy-sell arrangement on behalf of its owners. Buy-sell arrangements typically come in two varieties: redemption and cross-purchase. Either type can be funded with life insurance, but both types of arrangements and the associated funding of those arrangements suffer from the same infirmities.

In the first case, the insurance purchased for either type of arrangement is not a deductible corporate expense. Unfortunately, term life insurance is not always the most appropriate vehicle to fund a buy-sell, as it is possible for the insured to outlive the policy term. The alternative, non-deductible universal or whole life, is simply too expensive in too many instances. As a result, too many arrangements are simply unfunded either at inception or as a result of a principal outlasting the term of affordable term coverage.

However, most buy-sell arrangements, particularly on behalf of businesses with two or three owners, suffer from a more fundamental defect. Few arrangements address the future of the business after the death of the second owner. In a sense, a funded buy-sell arrangement often masks the underlying problem: a lack of a true business succession plan.

In the author’s experience, efforts to fund a buy-sell through a retirement plan are complicated and unwieldy. For reasons beyond the scope of this article, use of a defined benefit plan for this purpose is unworkable. The only possible alternative is a profit-sharing plan where each employee has the option of electing to purchase life insurance with those funds in his or her account. However, these purchases are subject to the “incidental benefit” limitations, which limit the amount and types of funds that can be used to purchase life insurance. In general, less than 50 percent of a participant’s account may be used to purchase whole life insurance and no more than 25 percent can be used to purchase term or universal life insurance. In most cases, it is simply very difficult to fund a sufficient amount of buy-sell insurance with the amount permitted under the incidental limitations.

However, there are exceptions to the foregoing limitations. Funds that have been “aged” in a profit-sharing plan for two or more plan years, rollover funds and funds that are subject to immediate in-service distribution may be used to purchase life insurance without limit. So virtually any effort to use profit sharing funds to fund a buy-sell must utilize one of these exceptions. Unfortunately, these days most profit sharing plans have a 401(k) component whereby participants, including the owners, defer part of their own salaries into the 401(k). In most cases, 401(k) elective deferrals cannot qualify for use under these exceptions. In addition, many 401(k) service providers will not permit participants to purchase life insurance as part of their investment portfolio.

There is another disadvantage to the use of incidental benefit life insurance in a qualified plan: the “economic benefit” costs, formerly known as P.S. 58 costs. Under the so-called “economic benefit rule,” participants on whose life insurance is maintained must report, as current taxable income, the value of the life insurance protection maintained on their behalf. These costs are generally determined by use of IRS Table 2001, which applies the one-year premium term rate or the insurance company’s alternative term rates. This requirement, in effect, renders a portion of the cost of the arrangement an after-tax expense to the participant.

The mechanics of an arrangement require that the arrangement among partners/shareholders be structured as a “cross-purchase” arrangement. Each “key” employee maintains insurance on the life of others and upon the death of one of the key employees, insurance proceeds are paid to the accounts of the other key employees. Distributions from those accounts to those individuals can be used to purchase the shares of the deceased key employee. Key person life insurance is simply a better alternative, which is permitted in qualified plans under Revenue Ruling 54-51. The insurance is a general investment of the trust, not dedicated to the account of any participant. As a consequence, there are no economic benefit costs to be paid. There are no incidental benefit limitations, although investments are generally limited to employer contributions (as opposed to employee elective deferrals). Clearly, the combination of fewer restrictions on the amount of insurance that may be purchased and better tax treatment makes key person strategies a better choice.

However, different mechanics are required to monetize the proceeds of a profit-sharing plan. Because the insurance proceeds are allocated to the accounts of all participants, it is the profit-sharing plan that will purchase the proceeds. Under Section 407 of ERISA, any profit-sharing plan that is an “eligible individual account” plan may invest up to 100 percent of its assets in employer securities. The only restriction is that the qualified plan pay no more than fair market value for the shares purchased.

A casual observer may have concerns over the purchase of part of the company by a profit-sharing plan, effectively converting it into an employee stock ownership plan (ESOP). However, the profit-sharing purchase is, in reality, a beneficial element of a true business succession plan. It is a key opportunity for a business owner to begin the process of transferring leadership of the company to a new generation, while simultaneously realizing a fair value for the business. The bottom line is that acquisition of the remaining shares by one or two individuals with a presumably short career is simply not a viable business succession strategy. While a discussion of the advantages of ESOPs as a tool to incentivize employees is beyond the scope of this article, it is sufficient to say it could lead to a far better result than the use of insurance proceeds to fund a purchase by a one or two surviving partners/shareholders model.

The sale of a significant percentage of the business to the profit-sharing plan presents a golden opportunity for the company to develop new talent and reward and incentivize employees. This talent will be in place after the death of the first key employee and ideally will be able to take over operation of the company upon death of the second (or third) owner, after sale of the remaining shares of the ESOP. More importantly, an employer who shares these plans with its employees can use plans for an eventual sale of the company to employees as a tool to recruit and retain key talent.

The final and perhaps most valuable advantage is that once the entire company is sold to the ESOP, it may be able to elect subchapter S corporation status and operate as a tax-free company. In doing so, the future of the company and the employment of its employees is assured. In effect, the company is creating its own buyer, which is the best way to ensure its future.

A version of this article was originally published here in Fox Rothschild’s For Your Benefit newsletter.

Harvey M. Katz serves as co-chair of Fox Rothschild’s Employee Benefits & Compensation Department. His practice focuses on all aspects of pension, executive compensation and employee benefits law.

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