3. Marco teórico-metodológico
3.2 Inspiración metodológica en el proyecto TRACE
The terms of the payment arrangement should always be coordinated with any disability insurance policy that is acquired to fund the buy-out agreement. If a disability insurance policy is used to fund a disability buy-out, the definition of disability in the agreement should be the same as in the policy. Then, the insurance company, rather than the business, will decide whether the business owner is disabled. In fact, the parties to the buy-sell arrangement should not be in the position of having to determine whether the business owner has met the agreement’s definition of disability. Having the same definition avoids triggering the buy-out without having the insurance benefits to pay for
186 IRC §704(6). 187 IRC §1377(a)(2).
the purchase. Keep in mind that disability insurance policies will likely represent only a portion of the buy-out price because insurers only underwrite a portion of the business’ value. The balance of the purchase price is often paid with a promissory note.
There is generally a period of time, the elimination period, specified before the disability is deemed permanent and the purchase obligation is triggered. The elimination period in the policy should be the elimination period in the buy-sell agreement. Considerations in choosing an elimination period include premium cost (if a policy will be used) and the probability of recovery. As the elimination period lengthens, both the premium cost and the chance of recovery from the disability decrease. During the elimination period, it is likely that the disabled owner will be carried on the payroll.
Typical valuation dates, which should be specified in the buy-sell agreement, include the date of the onset of the disability or the end of the elimination period. These dates can be a year or two apart, and the value of the business can be significantly different on each of these dates.
Some disability buy-out policies provide cash at the time that the buyer is required to make payment to the disabled selling owner, while others simply reimburse the purchaser of the business interest after the purchaser has made payments to the disabled selling owner. The payment schedule under the disability buy-out policy should match the payment schedule under the buy-out agreement.
If the disability buy-out is triggered, the disabled owner may desire to acquire any life insurance policies owned by others. If the buy-sell agreement gives the right to the insured to purchase any life insurance policies owned by the others in the event of disability, this right is not an incident of ownership in the policy causing estate inclusion.188
If the business owner recovers from a disability, should she be allowed to return to the business? Upon the owner’s disability, the business made many adjustments in order to continue, such as transferring customer responsibility and hiring replacements. Trying to reverse these adjustments may not be a good choice for the business. This issue should be addressed in the agreement.
188Smith v. Comm'r, 73 T.C. 307 (1979), acq. in result, 1981-2 C.B. 2. However, the Service’s position on this issue has been
inconsistent. Howard M. Zaritsky and Stephan R. Leimberg, Tax Planning with Life Insurance, 2d Edition, 2003/2004 Financial Professionals’ Edition, ¶ 3.03[3][k], citing for estate inclusion: Rev. Rul. 79-46, 1979-1 C.B. 303, Priv. Ltr. Ruls. 9128008 (Mar. 29, 1991) and 9127007 (Mar. 26, 1991); and citing against estate inclusion: Priv. Ltr. Ruls. 9421037 (Feb. 28, 1994), 9233006 (May 11, 1992) and 8049002 (Aug. 18, 1980).
IX.Community Property Considerations
Nine states189 have community property laws that impact buy-sell planning. For example, business interests may be community property, which is deemed to be equally owned by both spouses but may be "titled" in the name of only one spouse. While the "titled" spouse may enter into a buy-sell agreement, the agreement may not bind the non-titled spouse. The non- titled spouse may choose to keep or sell their portion of the business interest in a manner different than the terms of the buy-sell agreement. This may be contrary to the expectations of the business owners. It also may result in adverse taxation in corporate entity purchase arrangements as a result of the attribution rules190 or a failure to qualify as a §303 redemption.191
To avoid buy-sell problems upon the event of death or divorce when the business interest is community property, several solutions are available. The non-titled spouse may agree to be bound by the buy-sell agreement. The non-titled spouse may transfer their community property interest to the titled spouse. In a will, the titled spouse may give to the non-titled spouse other property if the non-titled spouse allows their interest to pass under the terms of the buy-sell agreement (the non-titled spouse’s will should also give the community property interest in the business to the titled spouse). A community property agreement between the spouses could provide for the disposition of the business interest according to the buy-sell agreement or could provide that the business interest is separate property, not community property.
Similar issues arise if life insurance funding a cross purchase buy-sell agreement is community property. If the non-owner spouse is able to claim half the death benefit by virtue of community property laws, the buy-sell plan may be frustrated.192 In addition to the above suggestions, the titled spouse could use separate property to pay all premiums and preserve the policy (and death benefit) as separate property. In an entity purchase agreement where life insurance is owned by the entity, community property ownership of the policies is not an issue.
189 Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas and Washington; marital property in Wisconsin.
190 For example, H’s 200 shares in a C corporation are community property and therefore deemed owned 50/50 with his spouse,
W. H's 100 shares are redeemed at his death, but W refuses to sell her 100 shares. Since W's shares are attributed to H's estate, the estate will receive taxable dividend treatment on the funds paid to the estate.
191 To qualify for a §303 redemption, the stock must comprise at least 35% of the decedent’s adjusted gross estate (“AGE”). IRC
§303(b)(2)(A). Suppose that H’s business interest is $400,000, which is community property titled in his name, and $600,000 of separate property. H’s AGE is $800,000 ($600,000 of separate property and $200,000 of his community property interest in the business); his business interest comprises 25% of his AGE ($200,000 / $800,000). A §303 redemption is not available to H’s estate.
192 By way of contrast to the community property law in other states, in Louisiana, the proceeds of life insurance payable to
another beneficiary generally are not considered community property. See T.L. James & Co., Inc. v. Montgomery, 332 So. 2d 834 (La. 1976).
X. Terminating the Buy-Sell Plan
If there is no more need for a buy-sell arrangement, the parties can simply terminate the agreement. However, what to do with life insurance policies funding the buy-sell is another question. If the policies are permanent, typically the insureds will want their own policies. This can be accomplished by sale or distribution if the business owns the policies, or by swapping cross-owned policies.193