Business and tax planners have long sought a business entity that delivers the key advantages of pass-through taxation for the business and limited liability for its owners. Traditionally, S corporations and limited partnerships have been used to obtain these characteristics, but both have drawbacks.
A limited liability company (LLC) is the only business entity that allows complete pass-through tax advantages and the operational flexibility of a partnership, as well as corporation-style limited liability under state law and management participation by all members. A properly formed LLC is presumed to be taxed as a partnership, unless it elects to be taxed as a corporation. Many professionals who would otherwise incorporate with an S election are choosing instead to organize themselves as LLCs (or LLPs or LLLPs where authorized by state law).
An LLC is a legal entity separate from its owners (members). It may own property, incur debts and enter into contracts, and sue or be sued. Members are shielded from the entity’s liabilities. In professional LLCs, members are also shielded from negligent acts and omissions of their fellow members. They are not, however, relieved of liability for their own misdeeds or negligence.
Planning and financing a business continuation agreement is often the first service a life insurance professional offers to a small business client. The initial determination in this process is whether the design should be an entity-purchase arrangement (a liquidation-of-interest approach, in the jargon of LLCs) or a cross-purchase arrangement (a sale approach). The calculus of the corporate buy-sell may not apply. My intent here is to alert you to some of the planning possibilities.
The planner should always keep in the back of his or her mind the extent of the interest to be transferred. If more than 50 percent of the total LLC capital and profits are sold within a 12-month period, the LLC is dissolved. This technical dissolution forces members to recognize a taxable event even if the business continues in its day-to-day operations. However, these regulations indicate that if a member’s interest is liquidated rather than sold, there is no dissolution, even if that interest exceeds 50%.
Traditionally, planners have recommended a liquidation-of-interest approach (the entity-purchase arrangement). In the typical scenario, the LLC owns a life insurance policy on each of its members. The LLC is also the premium payer and beneficiary. No incidents of ownership of LLC-owned life insurance should be attributable to any member if the proceeds are payable to the LLC, even though the LLC applies the proceeds to the redemption price of a deceased member’s interest. This means only the value of the LLC interest is included in the member’s gross estate, not the death proceeds.
A member’s basis in his LLC interest is increased by tax-free as well as taxable items. Under most situations, members may withdraw amounts from the LLC equal to basis, tax free. Generally, the larger the member’s basis, the better. The income tax-free death proceeds of an LLC-owned life insurance policy will increase basis.
Following the maxim that those who bear the economic burden should reap the potential benefit, the LLC can make special allocations to members to account for the premium payments. This special allocation must be authorized by the partnership agreement and have “substantial economic effect.” To illustrate the practical implications of this special allocation, assume three members, Andy, Bill and Carol. Although the LLC owns and pays for the policy on Andy, the premium payment expenses are allocated to Bill and Carol. Upon Andy’s death, the proceeds are likewise allocated to Bill and Carol. The income-tax free death proceeds increase their bases in their respective LLC interests. The LLC, as policy beneficiary, collects the death proceeds and uses them to liquidate Andy’s interest. Because no part of the policy was allocated to Andy, it should not increase the value of Andy’s interest.
The complete retirement of a member’s interest in an LLC is governed by tax code section 736. There is great latitude in structuring the liquidation. Within uncertain limits, the buyout can be structured to treat the distribution as either a basis distribution or as a deductible expense-includ-ible income item (e.g., a pro-rata share of unrealized receivables or substantially appreciated inventory). A portion of the purchase price can be allocated to the purchase of goodwill. With a properly structured entity purchase agreement, it is possible for the selling member to have capital gains treatment while allowing the LLC to have a 15-year writeoff for the purchase of goodwill.
The alternative to the liquidation-of-interest approach is the cross-purchase approach. Here, the design looks much like a corporate cross-purchase arrangement. A member will own, pay for, and be the beneficiary of a life insurance policy on another member, contemplating using the death benefits to pay for the buyout. If a member dies, his or her LLC interest will pass to the heir, who enjoys a step-up in basis to the then-current fair-market value. The heir will then sell the LLC interest in accordance with the buy-sell agreement.
Because members are considered partners by virtue of their membership in the LLC for purposes of the transfer-for-value rule (see IRS private letter rulings 9625013 through 9615019), some interesting planning opportunities arise. Violating the transfer-for-value rule means the death proceeds become income taxable to the extent the benefits exceed what money the transferee has paid for the policy.
Two LLC members may jointly own a life insurance policy on a third member. This eliminates the need for multiple policies; that is, only one policy per member is required. If one joint policyowner dies, his interest transfers to the survivor. This transfer should be exempt from the transfer-for-value rule in-as-much as it is a transfer to a partner of the insured. By contrast, in the corporate context, joint ownership of a life insurance policy creates a transfer-for-value issue if one of the policyowners dies.
A private split-dollar arrangement may also be a useful strategy. Simply stated, split dollar is a sharing of premiums, death benefits, and sometimes cash values, between two parties. A private split-dollar arrangement is created where the two parties are not an employer and an employee.
To finance the buyout in an LLC, each member would own his own life insurance policy and endorse the net death benefit proceeds to another member in exchange for payment of the term cost. This can accomplish multiple objectives if the insurance policy is a universal life. By electing Option B (the increasing death benefit), the insured member can build cash values and yet still provide his business partner necessary liquidity to cover the buy-sell obligation.
Lawrence T. Jones, J.D., is second vice president, advanced sales, for National Life of Vermont. He attended the University of North Carolina in Chapel Hill law school. He can be reached by phone at 802-229-3460 or by email at email@example.com.