The Insurance-Only LLC – A Consideration for Buy-Sell Agreements

When business owners have partners and consider their succession planning, the topic of a buy-sell agreement comes up.  This post discusses the possible use of an “insurance-only LLC” as part of a buy-sell.

A buy-sell agreement sets the terms of a buyout of one partner by another partner or partners if one partner leaves the business.  The buy-sell almost always addresses the death of a partner, and may also address disability, retirement or other exit of a partner.  Some of the key terms in a buy-sell include (1) what are triggering events for a buyout, (2) whether the buyout is mandatory or optional, (3) the terms of the buyout (eg, all cash, an unsecured note, or a secured note) and (4) how to value the business and establish the purchase price for the buyout.

It is common for business owners to purchase life insurance in order to fund a death buyout.  In a “cross purchase” agreement, each owner owns a policy on the other owner(s)’ lives and the buy-sell provides that the remaining owner(s) will purchase the deceased owner’s equity.  In a “redemption” agreement, the company owns the life insurance policies and the buy-sell provides that the company will purchase the deceased owner’s equity.

Cross purchase agreements are more common than redemption agreements.  Generally, in a redemption agreement, the buyer doesn’t get a step-up in basis, the policy value may be exposed to the creditors of the business and there can be alternative minimum tax issues.  On the other hand, if there are multiple owners, a traditional cross purchase requires many insurance policies since each owner owns a policy on all the other owners.

A “trusteed buy-sell agreement,” is a cross-purchase agreement where a trust is created to own the life insurance policies.  The trust owns one policy on each owner, which solves the “multiple policies” problem.  The trustee manages and maintains the policies, which centralizes the management of the arrangement.  There are, however, potential issues with trusteed buy-sell agreements, such as (1) whether the trust is a bona fide trust arrangement (or is it more accurately an escrow arrangement), (2) how premiums are paid and allocated (especially when there is a substantial disparity in the premium amounts for the policies), and (3) a potential transfer-for-value rule issue when the first owner dies.

The “insurance-only” LLC is a potential solution to the above issues.  The insurance-only LLC essentially is a cross purchase arrangement where an LLC is created to own the life insurance policies on the business owners.  The LLC has a third-party manager so there is centralized management of the group of policies.  The LLC elects to be treated as a partnership for tax purposes.  Usually, the operating business will make distributions to the owners, and they can make capital contributions to the LLC so the LLC can pay premiums (this also may be structured as a split-dollar arrangement).

When one of the owners dies, there are several steps.  First, the LLC redeems the membership interest that was owned by the deceased member (ie, from the deceased member’s estate).  Then, the life insurance proceeds are collected and distributed to the remaining members of the LLC.  Finally, the remaining members (eg, the other business owners) use the proceeds to purchase the deceased business owner’s equity in the business.

The insurance-only LLC thus solves certain issues posed by a trusteed buy-sell agreement, including how premiums are paid and the potential transfer-for-value rule issues.  Moreover, the insurance-only LLC may be structured so that each owner’s irrevocable insurance trust is a member of the LLC rather than the owner himself or herself, so that the equity purchased from the deceased owner is not included in the surviving owners’ estates.

It should be noted that the arrangement is technical to draft and not risk-free.  The IRS has a “no rule” policy on whether an insurance-only LLC will be treated as a partnership for tax purposes and whether the transfer of policies to the insurance-only LLC is exempt from transfer-for-value issues.  See, eg, Revenue Procedure 2022-3.  Some state statutes on LLCs and LPs require a profit motive for an entity.  Planners also should consider asset protection issues, such as whether a creditor could reach the assets in the insurance-only LLC (remedies vary among states) and whether a creditor of a deceased owner could reach the death benefit.

In sum, it is very important that business owners maintain technically sound and up-to-date buy sell agreements.  The insurance-only LLC can be a creative approach for an advanced buy-sell.