Alternatives for the Uninsurable
Sometimes life insurance is the preferred funding method for a buy-sell agreement, but one or more of the parties is uninsurable. There are alternative funding arrangements that can be used in this situation. Many of these are discussed in Fund Your Buy-Sell Agreement with Tools Other than Insurance, and include:
Cash Sinking Fund
Cash accumulated in a sinking fund can be used when there is an uninsurable shareholder in an attempt to accumulate at least a down payment on the business interest. Often, an amount equal to the appropriate insurance premium for the person's age is deposited in a separate account by the company that may be invested in a vehicle such as a mutual fund or an annuity. To the extent that the sinking fund is insufficient to pay for an owner's interest when the buy-sell transaction occurs, installment payment can be used to pay the remainder.
Caution: One drawback to the use of a cash sinking fund is that the fund is exposed to the company's creditors. The company could be ordered by the courts to use the money to pay creditors.
Installment payments can be used to fund the purchase of an uninsurable shareholder's business interest. An installment agreement could be established as part of the funding clause of the buy-sell agreement. Generally, the use of installment payments calls for a down payment (the larger the better) and periodic payments of the remaining balance plus interest. If the down payment is large enough, it may allow your estate to cover any estate and death taxes.
Deferred compensation can be established for an uninsurable shareholder to fund the buy-sell agreement. This alternative requires advance planning, so the earlier it is set up, the better. The use of deferred compensation can provide buy-sell agreement funding payments for the purchase of stock that are at least partly, if not totally, tax deductible to the business. By establishing deferred compensation funding for the buy-sell agreement, you accept the promise of future payment for salary that the company probably cannot afford to pay you today. The payment of income taxes that would be due on the additional salary is deferred until you actually receive the money. At the same time, the portion of the purchase price of your stock represented by deferred compensation is tax deductible to the company when it makes the payment.
Deferred compensation funding can be used when the buyer of your interest is the business itself or other shareholders. In both cases, part of the sale price of your interest is paid for with tax-deductible deferred compensation payments. When co-owners are the buyers of your business interest, the amount paid by the individuals is reduced by the deferred compensation amount.
Additional Coverage on Insurable Parties
One alternative sometimes considered in funding the purchase of an uninsurable shareholder's interest is the purchase of additional insurance coverage on insurable shareholders to make up for the lack of coverage on the uninsurable shareholder. One possibility is to buy double the coverage that would ordinarily be bought on the lives of the insurable shareholders. If the insured shareholder dies first, a portion of the insurance proceeds could be used to buy the insured shareholder's interest, with the remainder of the proceeds held in reserve for the future purchase of the uninsurable shareholder's interest. This would not be beneficial if the uninsurable shareholder were to die first.
Caution: It may be difficult to qualify for and buy coverage for double the amount needed.
Use of Policy with Higher Cash Values
Another possibility is to use the money that might have been spent on insurance for the uninsurable person to buy higher cash value building policies on the insurable shareholders. The logic used here is that if the uninsurable shareholder dies first, the insured shareholders can use the excess cash values to apply toward buying the interest of the uninsurable shareholder.
Caution: Buying higher cash values means buying higher face amounts, which also means higher premiums.
Use of Existing Insurance
An uninsurable shareholder may have personally owned insurance coverage that was purchased in the past when that person was insurable. When the existing personal coverage is more than might currently be needed due to changes in life circumstances, it is sometimes considered an option to transfer the existing coverage to a potential buyer under the buy-sell agreement to fund the purchase.
Caution: While this may seem like a good option, ultimately the business associates are protected at the expense of the insured shareholder's own family.
Caution: This option can result in a transfer-for-value, subjecting the death proceeds to taxation as income. In the absence of such a transfer, the proceeds would be received tax free.
Substandard or High-Risk Insurance
Many insurance companies are now issuing policies for those labeled as substandard or high-risk individuals. The insurance company charges a higher premium in compensation for the assumption of the additional hazard resulting from the person's advanced age or poor health. The cost of the premiums for this type of insurance might make one of the other alternatives more appealing.
Proceeds from borrowings or a property mortgage can be used to pay for the business interest of an uninsurable shareholder. There can be a lot of uncertainty associated with this option. There is the chance the buyer will not be able to get a loan or a mortgage when it is needed, or the economic environment could be such that it is difficult or too expensive to borrow.
Section 303 Stock Redemption
A Section 303 stock redemption is a closely held corporation's purchase of its own stock at a shareholder's death, which, when specific requirements are met, is subject to favorable tax treatment under Section 303 of the Internal Revenue Code. Congress enacted Section 303 specifically to help ease the liquidity problem faced by estates composed largely of an interest in a closely held business. The business entity might buy your ownership interest as specified under an entity purchase (stock redemption) buy-sell agreement. You do not need a formal agreement in place to sell your corporation stock under Section 303, but it is recommended that you do have one, especially if you are not a majority shareholder.
Appreciated Property Bailout
Appreciated property is property with a fair market value greater than the adjusted basis in the hands of the distributing corporation. In other words, the value of the property if it was sold outright is greater than the value on the company books. This can happen when the property has been held by the business for a long time. If your buy-sell agreement is between you and the corporation itself (an entity purchase (stock redemption) buy-sell agreement), the corporation may give you appreciated stock in another company, real estate, or other appreciated property in exchange for your stock in the corporation. This is an appreciated property bailout. An appreciated property bailout may result in taxable gain to the corporation and the shareholder participating in the exchange.
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