Planning for Closely Held Business Owners - 7 Funding Strategies for Buy-Sell Agreements

Question 1

Describe the types of funding strategies for death and disability planning

Question 2

Illustrate the relationship between buy-sell agreements and death and
disability planning.

Answer 2

A disability buy-out provision in a buy-sell agreement will direct the disabled business owner, after a certain period of total disability (typically 12 months), to sell their portion of the business to the remaining owners, or to the business entity itself.

Question 3

What is “The Private Annuity”?

Answer 3

The business owner (transferor) transfers ownership of
the business to the family member (transferee) in
exchange for the transferee’s promise (which must be
unsecured) to make payments to the transferor for life

Question 4

What is Section 6166?

Answer 4

Extension of time for payment of estate tax where estate consists largely of interest in closely held business

Question 5

What are the conditions for section 6166?

Answer 5

Section 6166 is available only if the decedent was a U.S.
citizen or resident at the time of death and the value of
the decedent’s interest in any closely held business
(proprietor, partnership, S Corp., LLC) exceeds 35% of
the value of the decedent’s adjusted gross estate
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Question 6

Describe the installment payments of section 6166?

Answer 6

Elect to defer completely for five years payment of the
portion of the estate taxes attributable to the closely held
business interest and thereafter pay the deferred portion
of the estate taxes in up to 10 annual installments.
* May aggregate businesses of which at least 20% owned.
* The estate tax attributable to non-closely held business
assets is due at the regular time, i.e., nine months from
the decedent’s date of death
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Question 7

Are the interest payments made by the estate deductible? (True or false)

Answer 7

False

Question 8

Is there a gift tax cost for the annuitant in a private annuity?

Answer 8

If the private annuity is structured successfully with an
actuarially correct annuity, there is no gift tax cost and the
value of the annuity is not included in the annuitant’s estate

Question 9

Is a bond may be required to be posted to secure
the payment of the deferred tax?

Answer 9

True

Question 10

What has reduced the appeal of private annuities?

Answer 10

Proposed regulations taxing the transaction from its inception

Question 11

When is a private annuity the best option for an annuitant?

Answer 11

If the annuitant’s basis is high (such as a
stepped-up basis received by a surviving spouse), the
private annuity remains a viable planning alternative

Question 12

What are Estate Freeze Installment Sales to Intentionally Defective Grantor Trusts?

Answer 12

It is designed to allow an income tax-free sale
of property with appreciation potential to be
made to a trust whose beneficiaries are the
heirs of the trust grantor
* The appreciation on the property sold to the
trust is removed from the trust grantor’s
estate; hence the freeze
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Question 13

What is a qualified interest?

Answer 13

any interest which consists of the right to receive either
fixed amounts payable at least annually or the
right to receive annual payments of a fixed
percentage of the fair market value of the
trust property as determined annually

Question 14

What are a grantor retained annuity trust (GRAT) and a grantor retained unitrust (GRUT) ?

Answer 14

These are irrevocable trusts to which the trust grantor (the
business owner) transfers property (some part of the
business interest) while retaining the right to receive an
annuity or unitrust interest (i.e., a “qualified interest” within
Code Section 2702) for a fixed term of years

Question 15

What happens to GRATs and GRUITs when the term of years expires

Answer 15

the property passes to
the designated remainder beneficiaries of the trust (the
business owner’s children)

Question 16

What is a zeroed-out GRAT?

Answer 16

one that results in no taxable gift to the grantor’s
beneficiaries based on the valuation of the retained
interest of the grantor, but still allows the transferred
property to be removed from the grantor’s estate if
the grantor survives the term of the trust

Question 17

The trust is drafted so that the grantor is
treated as the owner of the trust for _______
tax purposes, but not for _______ tax purposes

Answer 17

income
tax purposes, but not for estate tax purposes

Question 18

True or False: GRATs and GRUTs are only effective in accomplishing their intended transfer tax savings if the grantor survives the term of the trust.

Answer 18

True

Question 19

Describe certain administrative powers in the trust to be retained by the grantor?

Answer 19

With the trust so prepared, the sale of assets by the grantor to the trust avoids capital gain taxes, and the note interest to be received by the grantor is not subject to income tax
* The transaction is treated as a sale by the grantor to him or herself (Rev. Rul. 85-13)
* Appreciation on the assets sold by the grantor to the trust
grows outside the grantor’s estate to the benefit of the trust
beneficiaries (Rev. Rul. 2008-22)

Question 20

How much gift tax is used in estate freezes?

Answer 20

10%

Question 21

What happens if a grantor dies within the term?

Answer 21

The grantor’s estate includes the actuarial value of the remaining annuity to be paid

Question 22

Can a defective trust can be funded with S corporation
shares? (True or False)

Answer 22

True

Question 23

True or False? GRATs and GRUTs will qualify
as S corporation shareholders

Answer 23

True

Question 24

What is Rev. Rul. 2004-64?

Answer 24

There was no gift by the
grantor to the trust beneficiaries when the grantor
paid the trust’s income tax
– The grantor was satisfying the grantor’s own
obligation

Question 25

True or False: Split-dollar arrangements generally produce taxable income to the employee.

Answer 25

True

Question 26

What is split-dollar insurance?

Answer 26

-means of providing a benefit to the employee while also benefiting the employer
-arrangement to share, or “split,” the premium payment on a life insurance policy, typically between an employee and employer.
- “arrangement whereby the party with the need
and the party with the ability to pay premiums join in purchasing an insurance contract
in which there is a substantial investment element.”

Question 27

What are the two types of split-dollar arrangements?

Answer 27

1. The endorsement method; and
2. The collateral assignment method.

Question 28

What is the endorsement method?

Answer 28

Under the endorsement method, the employer owns the life insurance policy. By means
of a policy endorsement, the employer transfers an interest in the policy to the key
employee.

Question 29

What are the three ways to structure the payment terms of a buy-out?

Answer 29

There are basically three ways to structure the payment terms of a buy-out: lump sum
payment, installment payments, or a combination of the two

Question 30

What is a lump-sum payment?

Answer 30

A lump-sum payment is
typically called for when the buy-out is funded with insurance. The agreement should
specify that the due date of the payment shall coincide with receipt of the insurance
proceeds

Question 31

What is the collateral assignment method?

Answer 31

Under the collateral assignment method, the employee owns the life
insurance policy. By filing an assignment with the insurer, the employee grants a
security interest in the policy to the employer

Question 32

What are the 4 most common ways the “split” of premiums can be done in a split dollar method?

Answer 32

1. The employer pays all the premiums and the employee pays nothing.
2. The employer pays an amount equal to the increase in cash surrender value of the
   policy each year or the net premium due, if lower, and the employee pays the
   rest.
3. Same as the second option except the employee pays a level amount over a
   period of time.
4. The employee pays the lesser of the “PS 58” cost or the net premium and the
   employer pays the rest.

Question 33

True or False: The most common type of policy utilized with a split-dollar arrangement is a whole life
insurance policy

Answer 33

True

Question 34

What is an installment payment?

Answer 34

Installment payments are generally used when no insurance is in place. The
payment term should be long enough to allow for the company’s financial stability and
short enough to provide needed cash flow for the disabled owner and his or her family.
Generally, the installment period should be between three and five years.

Question 35

Describe a combination of a lump sum payment and an installment payment?

Answer 35

A
combination of lump sum and installment payments is typically used when insurance
proceeds are not adequate to cover the full buy-out price. It should be noted that a
reasonable rate of interest needs to be provided on the installment payments. Not only
is this fair to the disabled owner, it is required by the tax laws

Question 36

A split-dollar
arrangement may be

Answer 36

• An equity split-dollar arrangement
• A classic split-dollar arrangement
• A “reverse” split-dollar arrangement

Question 37

An equity split-dollar arrangement

Answer 37

In an equity split-dollar arrangement, the excess (of cash surrender value over total
premiums paid) accrues to the employee’s benefit.

Question 38

A classic split-dollar arrangement

Answer 38

In a classic split-dollar arrangement,
the excess accrues to the employer’s benefit. In both types of arrangement, the face
amount of life insurance, less the portion of the cash value to which the employer is
entitled, is held for the employee’s (i.e., the employee’s beneficiary’s) benefit.

Question 39

A “reverse” split-dollar arrangement

Answer 39

In
a “reverse” split-dollar arrangement, the employee owns the policy and cash surrender
value, and the employer is entitled to the death benefit.
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Question 40

Whawt are the three scenarios that should be evaluated in a business continuity plan?

Answer 40

If there is a sole owner or if all of the owners are of approximately the same age
and plan to retire at the same time, either a pre-arranged business sale must
take place (to employees, a supplier, a competitor, etc.) or the “retirement” plan
must be left open based upon an ultimate sale to an unrelated third party.
* If the owners are of different ages, and the younger owners wish to continue the
business, a predetermined retirement buy-out agreement can be arranged to
effectively cover the older owner(s). The issues listed above regarding terms and
price will need to be considered.
* If the future possibilities for the business and the retiring owners cannot be
anticipated, the retirement buy-out agreement might be left open and simply be
structured as a “right of first refusal” for the other shareholders and/or the
corporation.

Question 41

What is the tax treatment of a split-dollar arrangement?

Answer 41

Under IRS regulations, the tax treatment is
dependent upon whether the employer or the employee owns the policy.

Question 42

What are the two basic types of split dollar arrangements?

Answer 42

The endorsement method; and
2. The collateral assignment method.

Question 43

How is the employee taxed if the employer owns the policy?

Answer 43

The employee is taxed on the economic benefit of the
life insurance.

Question 44

How is the employee taxed if the employee owns the policy?

Answer 44

the premiums paid by the employer are
treated as loans to the employee as long as the employee is obligated to repay the
employer.

Question 45

What is the endoresment method?

Answer 45

Under the endorsement method, the employer owns the life insurance policy. By means
of a policy endorsement, the employer transfers an interest in the policy to the key
employee

Question 46

What is the collateral assignment method?

Answer 46

Under the collateral assignment method, the employee owns the life
insurance policy. By filing an assignment with the insurer, the employee grants a
security interest in the policy to the employer.

Question 47

When are the premiums paid considered as taxable compensation?

Answer 47

The premiums paid are considered as taxable compensation income if the
employee is not required to repay the premiums.

Question 48

According to the IRS, a split dollar
arrangement will not be treated as nonqualified deferred compensation under Section
409A if:

Answer 48

1. The insurance only provides death benefits to or for the benefit of the employee,
   or
2. The arrangement is treated as a loan arrangement under Treasury Regulations
   Section 1.7872-15 and the employer is not obligated to forgive the related
   indebtedness nor is the employer obligated to continue to make premium
   payments without charging the employee a market interest rate on funds
   advanced.

Question 49

What is the simplest way to provide funding for death or disability buy-outs?

Answer 49

insurance

Question 50

True or False? Life insurance can be obtained on each shareholder by the corporation, the other
shareholders, or both.

Answer 50

True

Question 51

If, in the future,
the buy-out protection is not needed, the policy can be

Answer 51

• Transferred to the insured if the insurance is desired personally
• Possibly sold

Question 52

The use of a partnership in this instance might not be as simple as forming a partnership
entity specifically for the purpose of holding insurance. In order to have a partnership
that is recognized as valid for tax purposes, there must be

Answer 52

1. More than one partner, and
2. A joint profit motive.

Question 53

Example: to ensure the
tax validity of the partnership, there needs to be some type of operating business within
the partnership.

Answer 53

Robert, Carl, and Barney are the shareholders of a C corporation that manufactures
metal parts. They wish to structure their buy-sell agreement as a cross purchase
agreement to prevent the tax and legal pitfalls of a stock redemption. To avoid having to
purchase multiple insurance policies on each shareholder, they want to hold policies in a
partnership. Thus, Robert, Carl, and Barney form a partnership to sell metal scraps for a
profit. They also hold the insurance policies in this partnership. This structure will satisfy
the joint profit requirement, and, therefore, the partnership will be recognized for tax
purposes.
Insurance can provide a cost-effective way to fund death and disability buy-out needs.
However, careful planning is needed to ensure the most efficient and tax-wise manner
of holding these insurance policies.

Question 54

What is an insurance buyout?

Question 55

What circumstances would one use a cross purchase vs. stock redemption plan?

Answer 55

Cross-Purchase Approach Trade-Offs. When a corporation purchases the stock of a departing shareholder, it’s called a “redemption.” When the other stockholders purchase the stock, it’s called a cross-purchase. Typically, the redemption versus cross-purchase decision doesn’t impact the ultimate control results.

Life insurance policies are typically used to fund the cross-purchase agreement and stock redemption.

Question 56

What are the different funding strategies of buy-sell arrangements?

Answer 56

Cash Flow
A sinking fund
Debt
Insurance

Question 58

Cash Flow

Answer 58

-usually the last resort
-The cash flow of the business may be slightly to significantly impacted by the exit, disability, or death of an owner, and may be disrupted
-if the buyout term calls for a lump sum payment, cash flow won’t be enough to meet the buyout obligation.

Question 59

A Sinking Fund

Answer 59

-works well for definitive future exit dates if the cash flow continues and a reasonable rate of return can be earned, to say nothing of risk if capital is exposed to loss
-If the sinking fund is owned by the business, then it has the opportunity to develop a corporate asset that improves the financial position of the business and can help it obtain future financing
-will fail to create the necessary liquid capital if an owner dies or becomes disabled and a buyout must occur today or in the near future

Question 60

Debt

Answer 60

-In theory, financing a buyout can provide the necessary capital in the exact amount whenever needed to purchase the interest of an exiting owners
-the lending institution will see a significant amount of risk in a business that just lost a key contributor and therefore question the business’ cash flow and debt capacity
-unpredictable

Question 61

Insurance

Answer 61

-does not exist for retirement or termination risk, insurance can deliver proceeds to a business to meet the exit obligations of a death or disability
-financing the risk with insurance allows cash and assets to be deployed to higher and better uses in the business, for example on capital investments, R&D, or other investments to grow the business.

Question 62

What are the two types of buy sell insurance address the risk of death and disability of an owner?

Answer 62

1. Term Buy Sell Life Insurance
2. Term Buy Sell Disability Insurance

Question 63

What does Key Man Life Insurance do?

Answer 63

-provides capital to the business above and beyond the needs of the buy sell agreement.
-insurance can offset lost revenue, increased expenses, and other needs related to the loss of an active owner.

Question 64

Term Buy Sell Life Insurance

Answer 64

Funds the liquid capital that is needed for the buy-sell agreement that will be triggered and the business (or other owners if a cross-purchase agreement) at the death of an owner

Question 65

Term Buy-Sell Disability Insurance

Answer 65

-can be designed to meet the needs of a buy-sell agreement’s disability provision.
-the waiting period (the time between when a disability begins, and when the proceeds are payable; may be 180, 365, or even 720 days) needs to be the same in the disability insurance policy and the buy-sell agreement

Question 66

What is mezzanine financing?

Answer 66

This agreement is set up such that the lender can convert debt to equity interest should the company default on the loan. A high-risk, private placement, often used by smaller companies

Question 67

What is distressed debt or special situations?

Answer 67

Broad category referring to investments
in equity or debt securities of financially stressed companies. Since this area
focuses on investing in entities that are in default, under bankruptcy protection, or
headed in that direction, investors must evaluate not only the ability for the entity
to make a comeback but also which class of securities might be more beneficial to
hold during a restructuring process.

Question 68

What is venture capital funding?

Answer 68

Not always a monetary vehicle. This could include support in terms of leadership or technical advice. Whatever is provided is exchanged for ownership in the company or a share of the earning potential

Question 69

What is an LBO?

Answer 69

Leveraged Buyouts (LBO). At its most basic level, an LBO is a method of acquiring
a company with money that is nearly all borrowed. This allows investors to make a
large acquisition without committing a lot of capital. The acquirers of the target
company often attempt to sell or take the target company public after five or ten
years in the hopes of making sizable profits. Doing an LBO can be expensive and
complex, but if successful can provide considerable returns

Question 70

What is restructured debt or operations?

Answer 70

Can include a sale of equity to new investors and hiring of new leadership as a response to financial issues created from the failure of a product or a way to improve the business.

Restructuring includes mergers, acquisitions, divestitures, recapitalizations, leveraged
buy-outs, reorganizations, downsizings,

Question 71

What is an angel investor?

Answer 71

This investor uses his or her own money and is less concerned with future profit in lieu of innovation. The investor’s portfolio usually contains less than 10% in this type of investment.

Question 72

What is preferred stock recapitalization?

Answer 72

To employ this strategy, a business owner recapitalizes stock into voting preferred shares and non-voting common shares. The owner then gifts the non-voting common shares to children. The business owner’s retention of cumulative preferred shares provides a qualified payment because the owner retains the right to receive dividends at a fixed par value.

Question 73

Types of instruments used in mezzanine and distressed debt financing?

Answer 73

Equity and debt

Question 74

Types of instruments used in venture capital financing?

Answer 74

Convertible notes, SAFE notes, and preferred equity

Question 75

Types of instruments used in leveraged buyout?

Answer 75

Bonds and private notes.

Question 76

Pros and Cons of Distressed debt?

Answer 76

Pros:
Seeing high returns through restructuring

Being paid out in the case of bankruptcy

Cons:
Lack of access to financial information

Potential competition with other investors

Future financial distress

Question 77

Pros and Cons of Mezzanine Financing?

Answer 77

Pros:
Interest is a tax-deductible business expense, thus substantially reducing the actual cost of the debt.

more manageable than other debt structures because borrowers may move their interest to the balance of the loan.

Cons:
A high-risk private placement.

Entities that
obtain financing in this manner must pay a higher cost due to the investor’s junior
positio

Question 78

Pros and Cons of Venture Capital funding?

Answer 78

Pros:
Business expertise

Additional resources

Connections

Cons:
Loss of control

Minority ownership status

Question 79

Pros and Cons of Leveraged Buyout?

Answer 79

Pros:
Allows you to buy the largest possible business

Increases your rate of return

Minimizes the size of your equity contribution

Can be financed using SBA-backed loans

Cons:
Minimal financial cushion to manage problems

Equity can quickly disappear

Obtaining additional financing is impossible

Question 80

Pros and Cons of restructure debt?

Answer 80

Legal protection to the business from the lenders

Pros:
Protection of the

company’s assets

Protection of the company from closing down will run as a going concern

Jobs of the employees are saved

Better recovery for creditors than bankruptcy

Cons:
Lower recovery by lowering interest payments and increasing schedule

Write-offs may hit the balance sheet of the creditors.

No assurance that the business will run smoothly and will make timely payments even after debt restructuring