“For quite some time, trusteed buy sell agreements have been the planning technique of choice for many advisors doing transition planning for businesses that have multiple owners. But there have always been lurking questions about the efficacy of trusteed buy sell agreements. Now that the so-called “Insurance LLC” has received increased attention, some have speculated that it may replace the trusteed buy sell agreement as the planning technique of choice.”

Special purpose, “insurance-only” Limited Liability Companies (LLC) have been used for many years in the wealth transfer and non-qualified fringe benefits fields. Now, Paul Vecchione and Jim Magner provide LISI members with their commentary on the planning opportunities presented by special purpose, insurance-only LLCs that some advisors are using to help solve their client’s business continuation planning needs.

Paul T. Vecchione is a Partner of EisnerAmper Insurance & Financial Services, LLC and head of their succession planning practice. EisnerAmper is one of the largest accounting firms in the nation with nearly 1,300 employees, including 180 partners. The firm offers responsive accounting, tax and consulting services with an entrepreneurial focus, providing clients with smart, analytical insights delivered in an approachable style.

For more than a decade Paul has specialized in both personal and corporate financial engineering.  Paul’s areas of concentration are pension and retirement planning, executive benefits and estate & succession planning.  As a Partner of the firm, Paul has assisted in transitioning several clients’ closely held businesses, and has guided CEOs and Human Resource Directors through the maze of corporate and employee benefit planning, handling the most complex issues and budgetary concerns. Paul has chaired AALU’s Qualified Plans Committee for three years, and is a member of AALU’s Business Insurance and Estate Planning Committee.

Jim Magner is an attorney with Guardian Life Insurance Company of America’s Business Resource Center for Advanced Sales. Prior to joining Guardian, Jim was General Counsel for a national broker dealer/brokerage general agency. Jim previously worked as an Attorney-Advisor in the IRS’s Office of Chief Counsel, in Washington, DC. While with the Office of Chief Counsel, Jim wrote private and public rulings on estate, gift, GST and charitable remainder trust issues. Jim’s articles have appeared in such publications as Estate Planning, Tax Notes, the Journal of Financial Service Professionals and Steve Leimberg’s Estate Planning & Retirement Planning newsletters. Jim has co-authored a number of books on estate and insurance planning topics, including Estate and Personal Financial Planning and Tools & Techniques of Life Settlement Planning.

Here is their commentary:

EXECUTIVE SUMMARY:

For quite some time, trusteed buy sell agreements have been the planning technique of choice for many advisors doing transition planning for businesses that have multiple owners. But there have always been lurking questions about the efficacy of trusteed buy sell agreements. Now that the so-called “Insurance LLC” has received increased attention, some have speculated that it may replace the trusteed buy sell agreement as the planning technique of choice.

FACTS:

Transition Planning for Multiple-Owner Businesses

Business continuation agreements come in three basic forms: redemption agreements where the business is the owner and beneficiary of the life insurance policies, cross purchase agreements where each business owner is the owner and beneficiary of a policy on the other business owners, and so-called “hybrid” arrangements, one of the most common of which is the trusteed cross purchase agreement.

While astute planners acknowledge that a number of factors often work against redemption agreements (e.g., loss of basis step-up, exposure of insurance values to claims of the business’ creditors, alternative minimum tax, etc[i]) where there are large numbers of owners, the corresponding need for a large number of policies mitigates against a cross purchase agreement and is a major factor that causes many planners to consider implementing a trusteed buy-sell agreement. [ii]

Advantages of Trusteed Buy-Sell Agreements

Trusteed buy-sell agreements have a number of features that on first blush make them attractive, the most prominent of which is the fact that the trustee is required to purchase only one policy is per business owner.[iii] In addition, centralized management of a large block of policies is often preferable to each insured owning and maintaining multiple policies on multiple insureds. AMT would not appear to apply when life insurance is trust-owned,[iv] and there may be a degree of creditor protection afforded to the insureds from trust-owned life insurance.[v]

Issues Associated with Trusteed Buy-Sell Agreements

Despite these advantages, astute planners have long recognized that trusteed buy-sell agreements come with their own set of built-in planning issues.

What Is It?

For planners who like to be able to put the planning tools they implement into discrete boxes, the trusteed buy-sell agreement presents its own set of definitional challenges. Is it really a legitimate trust arrangement, with perhaps the client’s attorney or CPA acting as a trustee on behalf of the beneficiary/insureds?  Or, is it more in the nature of an escrow arrangement, with the escrow agent acting on behalf of the principal/insureds? In this regard, boilerplate documents can be found that utilize both the trust and escrow approach. The issue is not academic, for, as noted below, the extent to which the insureds exercise control over the trustee/escrow agent/policy owner has a direct bearing on the incidents of ownership-estate tax inclusion issue.

If It Is a Trust, Whose Trust Is It?

Trusteed buy-sell agreements come in two flavors: business-sponsored where the entity establishes the trust for the benefit of the business owners, and individual-sponsored where the insured/business owners establish the trust. As discussed below, entity-sponsored trusts can pose difficult income tax issues.

How Are Premiums Paid and Allocated?

Whenever life insurance is owned by someone other than the insured in so-called third party ownership arrangements, complications arise. In the case of trusteed buy-sell agreements, the allocation of premiums gets tricky when there are significant disparities in age and underwriting classifications. Wholly apart from cost is the more complicated issue of how premiums are funded and allocated. If an executive bonus or split dollar arrangement is utilized, the mechanics to establish the plan appear simple.  But finding an acceptable method for allocating cost can be very complicated.

Lurking Transfer-for-Value Issues

Perhaps the most troubling aspect associated with trusteed buy-sell agreements is the fact that the transfer-for-value (TFV) issue at the first death has forced planners to either find a partnership exception to the transfer for value rule, or simply unwind the agreement after the first owner’s death and start over again. Although there is no physical transfer of the policies owned by the trustee at the first death, the deceased owner’s interest in the policies on the other owners’ lives shifts to the surviving owners pro rata, and most advisors think this creates a TFV problem.[vi] In fact, some planners refuse to utilize the arrangement if they are unable to find or create a partnership exception to the TFV rule.[vii]

Lurking Income Tax Issues

A beneficiary of a trust is generally not subject to income tax on trust distributions that represent tax-exempt income under Section 652. While many advisors would argue that Section 652(b) ensures that the income tax-free character of life insurance proceeds retain their character after being distributed from the trust, some argue that an entity-sponsored trust could change the tax treatment of the life insurance proceeds upon distribution.

For example, some advisors may assert that an entity-sponsored trust is taxed like a secular trust under Section 402(b), which results in distributed death proceeds being taxable to the extent that they exceed basis under Section 72.[viii] On the other hand, if a corporation were to create a trust to benefit shareholders solely in their capacity as shareholder and not employees, some advisors would maintain that Section 652(b) treatment would apply.

Lurking Estate Tax Inclusion Issues

The degree of control trust beneficiaries have over the trustee can impact the estate tax inclusion/exclusion of the life insurance proceeds. In cases where the trustee looks too “directed” by the beneficiaries, the Service has found the proceeds to be estate tax includible.[ix] On the other hand, where the trustee is truly independent, the Service has ruled against inclusion.[x]

Background on Special Purpose, Insurance-Only LLCs

Over the past ten years, special purpose, insurance-only LLCs have been used with surprising frequency in both the wealth transfer and non-qualified fringe benefits markets. While Tom Commito was the first to popularize the use of the “Preferred Return LLC” as a split dollar work-around,[xi] some in the wealth transfer field have focused on using LLCs as an alternative to life insurance trusts.[xii]

Scott Dondershine’s 2002 Estate Planning article appears to be the first to address the use of insurance-only LLCs as a vehicle for business continuation planning.[xiii] Steve Gorin, a frequent LISI contributor, appears to have been the first attorney to apply for a private ruling on the estate inclusion aspects of an Insurance LLC used for business continuation purposes.[xiv] Finally, two attorneys, Lindsey Smith and Joseph Condeni, have trade-marked the phrase “The Life Insurance Limited Liability Company,”[xv] so LISI members need to be vigilant about how they refer to the planning technique.

Insurance LLCs as Substitutes for Trusteed Buy-Sell Agreements

An Insurance LLC used as a substitute for a trusteed buy-sell agreement will look somewhat similar to those familiar with how trusteed buy-sell agreements operate, but there are important differences.

Structure: How Does A “Buy-Sell Insurance LLC” Work?

The Buy-Sell Insurance LLC involves three distinct moving parts: (1) the LLC used to own the life insurance, (2) the actual buy-sell agreement and (3) the operating entity. The Buy-Sell Insurance LLC is similar to a trusteed cross purchase arrangement in that the LLC is the applicant, owner and beneficiary of the life insurance policies.

The death of an insured triggers two purchases. The LLC first redeems the membership interest from the deceased member’s estate. Second, the life insurance proceeds are allocated and distributed to the surviving members. They then use the proceeds to purchase the interest the deceased owned in the operating entity.

Advantages of the Buy-Sell Insurance LLC

The Buy-Sell Insurance LLC would seem to offer all of the benefits of the trusteed cross purchase with none of the downsides. For example, the “one policy per owner” standard is maintained, as are the benefits of centralized policy management. Potential AMT exposure is avoided, basis step-up is provided to all surviving owner-insureds, and the proceeds should maintain their income tax-free status upon distribution to the members.[xvi]

So long as the LLC elects to be taxed as a partnership, all potential TFV issues would appear at first glance to be off the table. In PLR 9625013, the Service held that LLC members were classified as partners and thus qualified for the transfers “to the partner” exception to the TFV rule in Section 101(a)(2).

If the entity elects to be taxed as a partnership, one would think that the partner/partnership exception to the TFV rule would mean that existing coverage could be freely transferred to the LLC, new owners of the operating entity could be freely admitted to the LLC, and unlike the trusteed buy-sell, the agreement would not have to be unwound at the first death. However, as discussed below, given the Service’s recent no-rule position on insurance-only LLC’s, these TFV issues may not be as open-and-shut as they might first appear.

Revenue Procedure 2012-3: The IRS’s No-Rule Position on TFV Involving Insurance-Only LLCs

Before implementing a Buy-Sell Insurance LLC, advisors would do well to take note of the Service‘s no-rule position in Revenue Procedure 2012-3 as to whether certain transfers of life insurance policies to unincorporated organizations will be exempt under the TFV rule in Code Section 101.

With no ability to acquire a private ruling on whether: 1) the organization will be treated as a partnership under Sections 761 and 7701, or 2) the transfer of the life insurance policy to the organization will be exempt from the transfer for value rules of Section 101, when “substantially all of the organization’s assets consist or will consist of life insurance policies on the lives of the members,” clients will have to rely on opinion of counsel on critical aspects of the  Buy-Sell Insurance LLC.[xvii] Note that the TFV issue is of particular importance when in-force coverage is being “re-cycled” at the formation of a Buy-Sell Insurance LLC.

When “substantially all of the organization’s assets consist or will consist of life insurance policies on the lives of the members” advisors may be asked to provide “comfort” against IRS scrutiny. In this regard, the very name “Insurance-Only” seems to be a red flag inviting regulatory scrutiny.  That said, the Service has been somewhat generous to taxpayers in its private rulings on TFV issues, finding exceptions in a variety of fact patterns.

What about Creditor Protection?

While the creditor protection advantages of LLCs have been well documented,[xviii] two aspects of life insurance creditor protection need to be considered: the policy’s cash surrender value and its death proceeds. While the insureds are alive and the policies are in the LLC, a charging order is the best remedy judgment creditors may obtain against an insured-member where the LLC is domiciled in states that limit creditors to charging orders. Situs selection is critical and advisors would do well to avoid states that permit judicial foreclosure sales and broad charging orders.[xix]

As noted, the LLC must distribute the death proceeds to the surviving members so they can purchase the interest in the operating entity from the deceased member’s estate. Because these proceeds don’t remain in the protective custody of the LLC, state exemption statutes must be carefully reviewed. Unfortunately, state exemption statutes are scattershot, so situs and choice of law principles are important considerations.[xx] For example, while most state exemption statues provide protection against the insured’s creditors, a few exempt the death proceeds from the beneficiary’s creditors.[xxi]

Nuts-and-Bolts Planning Issues

There are a number of nuts-and-bolts planning issues that advisors must consider before implementing a Buy-Sell Insurance LLC.

Member-Managed vs. Manager-Managed

LLCs can be managed by their members, in which case the LLC is said to be member-managed. Alternatively, a professional manager can be retained, in which case the LLC is said to be manager-managed. In the case of a Buy-Sell Insurance LLC, the importance of assuring estate tax exclusion of the death proceeds means that the manager-management is the only sensible approach, and care must be taken to ensure that the insured-members never have any Section 2042 incidents of ownership. In fact, using a corporate trustee to manage the LLC may be recommended in some circumstances.[xxii]

Valuation of the Membership Interest

Special attention needs to be paid to the LLC operating agreement. For example, deceased members should be deemed to have withdrawn immediately upon death and all their rights in the LLC and those of their estates should be terminated. More importantly, the operating agreement should attempt to value a member’s interest exclusive of the insurance proceeds.[xxiii]

Various Methods Can Be Used to Pay Life Insurance Premiums

Although term insurance could be used as the funding vehicle in an Insurance LLC, especially in those cases where the need is short-term and/or cash is scarce, consideration must be given to how the premiums will be funded when permanent life insurance is used. In this regard, there are a variety of methods for paying premiums that can be utilized with an Insurance LLC.

If the operating business’ cash flow is sufficient, it could use an executive bonus plan to pay the premiums directly to the insurance carrier. Because underwriting issues could result in large premium differentials, it may be preferable for books and records purposes to have the operating business bonus the necessary cash directly to the members to allow them to make capital contributions to the LLC.

Where the operating business is a closely-held pass-through entity, loan covenants may prevent large outflows of cash that would be required to fund an executive bonus plan. A split dollar arrangement may be an attractive option, as the collateral assignment interest will be reflected as an asset on the entity’s balance sheet. Alternatively, an income producing asset in the LLC’s hands could generate all or a substantial portion of the cash flow required to pay premiums. Finally, if the LLC is to be funded with existing coverage and family members are LLC members, care must be taken to avoid the application of Section 2035.[xxiv]

Insurance-Only LLCs and State Law

Much has been written on the extent to which an LLC must have a valid business purpose.  In many states, all that is required on the LLC’s certificate of organization is a brief description of the “general character” of the business.[xxv] In many states, an LLC may engage in or carry on any lawful business or activity, although in one state, “insurance” is not a valid LLC business purpose.[xxvi] Once the entity is up and running, advisors would do well to adhere to all formalities required under state law, such as annual reports.

Is An Insurance-Only LLC a Split Dollar Arrangement?

The final split dollar regulations cover a wide range of ownership arrangements, including compensation, shareholder, independent contractor and private split dollar plans; they even cover arrangements where life insurance is jointly-owned. Notably, Section 1.61-22(c)(1)(iv) of the final split dollar regulations  is “Reserved” as a placeholder for possible future guidance with regard to “life insurance contracts owned by partnerships,” and this “strange silence” on partnership arrangements has been well-noted by Don Jansen. [xxvii]

Insurance LLCs would as a matter of course elect to be taxed as partnerships, and the fact that partnerships have been “reserved” for possible future guidance leaves an open question as to exactly what the Service intended in this area. The final split dollar regulations define a split-dollar life insurance arrangement as any arrangement between an owner and a non-owner of a life insurance contract that satisfies the following three tests:

• Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including a payment by means of a loan to the other party that is secured by the life insurance contract;
•  At least one of the parties to the arrangement paying remiums under is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and Recovery is to be made from, or is secured by, the proceeds of the life insurance contract;
•  The arrangement is not part of a group-term life insurance plan

For planners looking to draw parallels between “owners” and “non-owners” on one hand, and LLCs and their members on the other, the regulations don’t offer much help. Under the final split dollar regulations, the person named as the policy owner of the contract is deemed the owner of the contract, and a non-owner is any person, other than the owner of the contract, that has any direct or indirect interest in the contract. Although the LLC is merely “warehousing” the coverage (note that the buy-sell provisions are typically contained in a separate document), LLC members have many premium payment options that perhaps will prevent the entity itself from being deemed a split dollar “arrangement” in the Service’s eyes.

Don’t Forget Employer-Owned Life Insurance (EOLI) Notice & Consents

Life insurance used to fund an Buy-Sell Insurance LLC needs to comply with Section 101(j)’s notice and consent rules to ensure that the death proceeds retain their income tax-free character. Although Section 101(j)’s expansive definition of “employer” and “employee” encompasses LLCs and its members, because notice/consent and the requisite Form 8925 are relatively easy toobain, the EOLI rules should not be a significant impediment.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Paul Vecchione

Jim Magner

CITE AS:

LISI Business Entities Newsletter #130 (May 22, 2012) at http://www.leimbergservices.com/ Copyright 2012 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission

CITATIONS:

[i] One exception is the so-called “Short Tax Year Election” redemption plan that is commonly used with S Corporations.

[ii] The formula for determining the number of policies is N x (N-1) where N is equal to the number of proposed insureds

[iii] These trusts are often referred to as “OPPO” or One Policy Per Owner trusts.

[iv] As discussed further on, AMT could apply where the trust is corporate-sponsored and the entity is a C corporation.

[v] Some trusteed agreements utilize spendthrift provisions, similar to what can typically found in irrevocable life insurance trusts.

[vi] “Using a Transactional Analysis to Avoid the Transfer for Value Rule,” L. Brody and S. R. Leimberg, 32 Estate Planning, No. 11, 3 (November 2005).

[vii] Interestingly, some specimen documents came complete with boilerplate partnership agreements, which presuppose that the creation of a “quickie” partnership lacking economic substance would pass IRS muster. Whether the mere co-ownership of life insurance is sufficient to be a real partnership can be problematic under the under the Revised Uniform Limited Partnership Act which may require a profit motive.

[viii] Section 72(m)(3)(C) retains Section 101 exclusion for incidental life insurance in qualified retirement plans, although a similar provision doesn’t appear to apply in the case of so-called “non-exempt” trusts.

[ix] TAM 9349002

[x] PLR 9622036

[xi] “Preferred Return Limited Liability Companies and Life Insurance” Lincoln Financial Distributors white paper, July, 2002.

[xii] See  Giarmarco, “Using LLCs As a Life Insurance Vehicle,” 94 Life Ass’n News 145 (Oct. 1999); Tyler & Jones, “Limited Liability Companies as Trust Substitutes,” 17 Probate & Prop. 49 (Nov./Dec. 2003) and 18 Probate & Prop. 54 (Jan./Feb. 2004) (comparing traditional life insurance trusts to an LLC used as a trust substitute)

[xiii] See “Planning for the Transfer of a Successful Closely Held Business” 29 Estate Planning 335, July 2002.

[xiv] See Gorin, “Insurance LLC Helps Business Owners” Trusts & Estate, Sept 1, 2007. Also see Forster, Smith & Amoia, “Buy-Sell Planning with an Insurance LLC” AALU Quarterly, Spring 2012; Gorin, Roush, Scolaro & Stone, “Using Partnerships to Own Buy-Sell Insurance,” ABA Section of Real Property, Probate and Trust Law, July 19, 2011.

[xv] http://www.smith-condeni.com/Smith_and_Condeni_LILLC.pdf

[xvi] IRC Sections 705(a)(1)(B) and 731.

[xvii] See Rev.Proc. 2012-3, Section 9; but compare PLR 9625013, the Service held that LLC members were classified as partners and thus qualified for the “to the partner” exception to the TFV rule in Section 101(a)(2).

[xviii] Steve Oshins and Mark Merric have commented extensively in LISI Asset Protection Planning Newsletters on the benefits of using LLCs.

[xix] See Merric, Comer & Monasky, LISI Asset Protection Planning Newsletter #190.

[xx] Some exemption statutes apply only for certain classes of beneficiaries, such as the insured’s spouse, children or other dependent relative. And while the proceeds are not paid directly to the decedent’s estate, would a court be tempted to subject them to the claims of the estate creditors on the theory that the buy-sell agreement puts them in the executor’s hands contractually.

[xxi] Section 19.5  Creditors’ Rights In Insurance, National Underwriter Advanced Markets,

[xxii] This is the strategy Steve Gorin utilized in PLR 200747002.

[xxiii] “Planning for the Transfer of a Successful Closely Held Business” Scott Dondershine’s 29 Estate Planning 335, July 2002.

[xxiv] See TAM 200431025 where Service focused on capital account allocations to find a step-transaction and no bona fide sale exception to Section 2035.

[xxv] http://www.sec.state.ma.us/cor/corpdf/c156c512dllccert.pdf

[xxvi] http://www.cyberdriveillinois.com/publications/pdf_publications/c334.pdf

[xxvii] See Donald Jansen “Split Dollar Has Split-So How Do We Finance Premiums Now?” 38^th Annual Heckerling Institute on Estate Planning, 2004.