1. Transferring a Business to Co-Owners Sam G. Torolopoulos, CPA/ABV, ASA Dennis M. Axman, CLU, ChFC, AEP, CFP

2. Advanced Business Succession Planning Business Succession Planning for S Corporations Business Succession Planning for S Corporations Combination Buy-Sell Strategy Combination Buy-Sell Strategy 1

3. Business Succession Planning Concerns Principal business owner’s death can cause serious financial problems for estate, business, and deceased’s survivors Principal business owner’s death can cause serious financial problems for estate, business, and deceased’s survivors Heirs may be faced with significant business continuation problems Heirs may be faced with significant business continuation problems Buy-sell agreement can help to assure trouble-free transfer of the business in the event of the death, disability or retirement of an owner Buy-sell agreement can help to assure trouble-free transfer of the business in the event of the death, disability or retirement of an owner 2

4. Buy-Sell Agreement Basics Most buy-sell arrangements generally state that each owner agrees: Most buy-sell arrangements generally state that each owner agrees: Not to dispose of his/her ownership interest during his/her lifetime without first offering it for sale to other owners or to business entity Not to dispose of his/her ownership interest during his/her lifetime without first offering it for sale to other owners or to business entity That surviving owners or business entity will purchase, and deceased owner’s estate will sell, decedent’s ownership interests That surviving owners or business entity will purchase, and deceased owner’s estate will sell, decedent’s ownership interests That purchase price based on pre-established formula will be used to determine a value for ownership interests That purchase price based on pre-established formula will be used to determine a value for ownership interests 3

5. Buy-Sell Agreement Basics For family transfers FMV will be used on form 706 as per IRC § 2703 (a) General rule For family transfers FMV will be used on form 706 as per IRC § 2703 (a) General rule For purposes of this subtitle, the value of any property shall be determined without regard to - (1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or (1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or (2) any restriction on the right to sell or use such property. (2) any restriction on the right to sell or use such property. 4

6. Buy-Sell Agreement Basics (b) Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: (b) Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: (1) It is a bona fide business arrangement. (1) It is a bona fide business arrangement. (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. (3) Its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction. (3) Its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction. 5

7. Financing Buy-Sell Agreements with Life Insurance and Disability Buy Out Insurance Surviving business owners need means to raise funds Surviving business owners need means to raise funds Acquiring funds to complete buyout can be difficult Acquiring funds to complete buyout can be difficult Borrowing, selling business assets, or depleting cash reserves uncertain and risky Borrowing, selling business assets, or depleting cash reserves uncertain and risky Life insurance is key to financing buy-sell agreement Life insurance is key to financing buy-sell agreement Policy cash values are source of funds for buyout at owner’s disability, incapacitation, or retirement Policy cash values are source of funds for buyout at owner’s disability, incapacitation, or retirement A disability buy out policy can provide funds as needed for the disability of an owner A disability buy out policy can provide funds as needed for the disability of an owner 6

8. Traditional Types of Buy-Sell Arrangements Cross-Purchase Buy-Sell Agreement Cross-Purchase Buy-Sell Agreement Stock-Redemption Buy-Sell Agreement Stock-Redemption Buy-Sell Agreement 7

9. Cross-Purchase Buy-Sell Agreement How It Works How It Works All owners agree to purchase each other owner’s interest in business All owners agree to purchase each other owner’s interest in business Each owner owns and is beneficiary of life insurance policy insuring every other owner’s life Each owner owns and is beneficiary of life insurance policy insuring every other owner’s life 8

10. Cross-Purchase Buy-Sell Agreement Major Advantages Major Advantages Each owner receives basis increase equal to purchase price of deceased owner’s interest Each owner receives basis increase equal to purchase price of deceased owner’s interest If properly structured, business can make bonus payments to owner(s) for premium payments and take tax deduction for them If properly structured, business can make bonus payments to owner(s) for premium payments and take tax deduction for them 9

11. Cross-Purchase Buy-Sell Agreement Major Disadvantages Major Disadvantages May require numerous policies if there are multiple owners May require numerous policies if there are multiple owners Younger and/or healthier owner pays higher insurance cost for policy on life of older and/or less healthy co-owner Younger and/or healthier owner pays higher insurance cost for policy on life of older and/or less healthy co-owner 10

12. Stock-Redemption/Entity- Purchase Buy-Sell Agreement How It Works How It Works Business agrees to purchase deceased owner’s shares Business agrees to purchase deceased owner’s shares Business owns and is beneficiary of life insurance policy on each owner Business owns and is beneficiary of life insurance policy on each owner Business uses death benefit for buyout when needed Business uses death benefit for buyout when needed 11

13. Stock-Redemption/Entity- Purchase Buy-Sell Agreement Major Advantages Major Advantages Business’ funds, not owners’, used to pay premiums Business’ funds, not owners’, used to pay premiums Only one policy per owner needed Only one policy per owner needed 12

14. Stock-Redemption/Entity- Purchase Buy-Sell Agreement Major Disadvantages Major Disadvantages No basis increase for surviving owners No basis increase for surviving owners Sale of business may be completely taxable if family attribution rules apply Sale of business may be completely taxable if family attribution rules apply Business’ receipt of death benefit may be subject to Alternative Minimum Tax (AMT) Business’ receipt of death benefit may be subject to Alternative Minimum Tax (AMT) 13

15. Understanding Basis Issues with Buy-Sell Agreements Example: Jerry and Kerry Example: Jerry and Kerry Purchased printing business for $150,000 Purchased printing business for $150,000 Are equal, 50% owners of C corporation Are equal, 50% owners of C corporation Current value is $1 million Current value is $1 million What if Kerry dies? What if Kerry dies? 14

16. Types of Buy-Sell Arrangements: Effect on Basis Cross-Purchase: Taxable Gain to Jerry Cross-Purchase: Taxable Gain to Jerry Jerry’s Original Investment: $ 75,000 Cost of Share Purchase from Kerry’s Estate: +$500,000 Total Cost Basis: $575,000 Jerry’s Original Investment: $ 75,000 Cost of Share Purchase from Kerry’s Estate: +$500,000 Total Cost Basis: $575,000 Sale Price = Fair Market Value (FMV) of Business: $1,000,000 Less Jerry’s Total Cost Basis: –$575,000 Jerry’s Total Taxable Gain: $425,000 Sale Price = Fair Market Value (FMV) of Business: $1,000,000 Less Jerry’s Total Cost Basis: –$575,000 Jerry’s Total Taxable Gain: $425,000 15

17. Types of Buy-Sell Arrangements: Effect on Basis Stock Redemption: Taxable Gain to Jerry Stock Redemption: Taxable Gain to Jerry Jerry’s Original Investment: $ 75,000 Jerry’s Original Investment: $ 75,000 Sale Price = FMV of Business: $1,000,000 Total Cost Basis: –$75,000 Jerry’s Total Taxable Gain:$925,000 Sale Price = FMV of Business: $1,000,000 Total Cost Basis: –$75,000 Jerry’s Total Taxable Gain:$925,000 16

18. IRC Section 101(j) New Code provision created by Pension Protection Act of 2006 New Code provision created by Pension Protection Act of 2006 Establishes best practices provision for COLI Establishes best practices provision for COLI Unless requirements under 101(j) are met, portion of death benefit from COLI will be included in gross income of employer Unless requirements under 101(j) are met, portion of death benefit from COLI will be included in gross income of employer 17

19. Maintaining Tax-Free Status for COLI Death Benefits IRC § 101(j) IRC § 101(j) The following requirements must be met to maintain tax-free status for COLI death benefits: The following requirements must be met to maintain tax-free status for COLI death benefits: Proper notice and consent from insured employee Proper notice and consent from insured employee Must be met prior to issuance of life insurance policy Must be met prior to issuance of life insurance policy One of two exceptions stated in IRC § 101(j) must be met One of two exceptions stated in IRC § 101(j) must be met 18

20. Importance of Buy-Sell Planning for S Corporations Can protect S corporation status Can protect S corporation status Maximizes advantages inherent in special tax attributes of S corporations Maximizes advantages inherent in special tax attributes of S corporations 19

21. Requirements for S Corporation Status Violating any of the following requirements can result in termination of S corporation status: Violating any of the following requirements can result in termination of S corporation status: Corporation must be domestic corporation Corporation must be domestic corporation Corporation must not have more than 100 shareholders Corporation must not have more than 100 shareholders Family can elect to be treated as one shareholder Family can elect to be treated as one shareholder Only individuals, decedent’s estate, estates of individuals in bankruptcy, certain exempt organizations per Internal Revenue Code Section 1361(c)(6), and certain trusts are eligible shareholders of S corporations Only individuals, decedent’s estate, estates of individuals in bankruptcy, certain exempt organizations per Internal Revenue Code Section 1361(c)(6), and certain trusts are eligible shareholders of S corporations Shareholder cannot be nonresident alien Shareholder cannot be nonresident alien Corporation only can have one class of stock, although different voting rights are allowed Corporation only can have one class of stock, although different voting rights are allowed 20

22. Utilizing S Corporation’s Special Tax Attributes Advantage of using short-year election: Advantage of using short-year election: Using short-year election avoids basis issues occurring when buy-sell is structured as stock redemption Using short-year election avoids basis issues occurring when buy-sell is structured as stock redemption 21

23. Avoiding Wasted Basis with S Corporations Cost basis increased when corporation receives either taxable or nontaxable income Cost basis increased when corporation receives either taxable or nontaxable income Nontaxable income includes amounts received from death benefit on corporation-owned life insurance policies Nontaxable income includes amounts received from death benefit on corporation-owned life insurance policies Stock-redemption arrangement for S corporation results in basis increase for surviving shareholders based on each one’s pro rata share of ownership Stock-redemption arrangement for S corporation results in basis increase for surviving shareholders based on each one’s pro rata share of ownership Amount of increase depends on whether S corporation can make short-year election Amount of increase depends on whether S corporation can make short-year election 22

24. Using a Short-Year Election S corporation must be on cash basis accounting method S corporation must be on cash basis accounting method Short-year election to terminate S corporation tax year without terminating “S” election can be made at death of deceased shareholder Short-year election to terminate S corporation tax year without terminating “S” election can be made at death of deceased shareholder Election terminates deceased shareholder’s interest in S corporation Election terminates deceased shareholder’s interest in S corporation Life insurance proceeds will then be received in following tax year Life insurance proceeds will then be received in following tax year Surviving shareholders can receive basis increase for entire amount of life insurance death benefit in new tax year Surviving shareholders can receive basis increase for entire amount of life insurance death benefit in new tax year 23

25. Impact of Receipt of Insurance Proceeds on Basis for S Corporations Example: Kelly Blue and John Black Example: Kelly Blue and John Black Both are 50% owners of Color Me Printers, an S corporation Both are 50% owners of Color Me Printers, an S corporation Each owner has current basis of $100,000 Each owner has current basis of $100,000 Corporation has no retained earnings and profits Corporation has no retained earnings and profits $1 million policy purchased on each owner in stock-redemption buy-sell $1 million policy purchased on each owner in stock-redemption buy-sell John Black dies John Black dies 24

26. Impact of Receipt of Insurance Proceeds on Basis: Failing to Make a Short-Year Election Impact on Kelly Blue’s Basis Impact on Kelly Blue’s Basis Total Death Benefit from Policy on John: $1,000,000 Total Death Benefit from Policy on John: $1,000,000 Kelly’s Opening Basis: $100,000 Kelly’s Opening Basis: $100,000 Pro Rata Basis Increase for Kelly: +$500,000 (50% of proceeds) Pro Rata Basis Increase for Kelly: +$500,000 (50% of proceeds) Kelly’s Ending Basis: $600,000 Kelly’s Ending Basis: $600,000 25

27. Impact of Receipt of Insurance Proceeds on Basis: Making a Short-Year Election Avoiding Wasted Basis: Short-Year Election Avoiding Wasted Basis: Short-Year Election Kelly Blue elects to terminate his S corporation’s tax year before John’s death benefit is received Kelly Blue elects to terminate his S corporation’s tax year before John’s death benefit is received Color Me Printers’ Total Death Benefit Received from Policy on John: $1,000,000 Color Me Printers’ Total Death Benefit Received from Policy on John: $1,000,000 Kelly’s Opening Basis: $100,000 Kelly’s Opening Basis: $100,000 Kelly’s Basis Increase: +$1,000,000 Kelly’s Basis Increase: +$1,000,000 Kelly’s Ending Basis: $1,100,000 Kelly’s Ending Basis: $1,100,000 26

28. Additional S Corporation Concerns Stock-redemption buy-sell agreement for an S corporation avoids other taxation-related disadvantages pertaining to C corporations: Stock-redemption buy-sell agreement for an S corporation avoids other taxation-related disadvantages pertaining to C corporations: Family attribution issues Family attribution issues Alternative Minimum Tax liability Alternative Minimum Tax liability 27

29. What Is a Combination Buy-Sell Arrangement? Arrangement in which separate general partnership is established to structure and fund buy-sell agreement Arrangement in which separate general partnership is established to structure and fund buy-sell agreement Combines benefits of cross-purchase and stock redemption and avoids drawbacks of both Combines benefits of cross-purchase and stock redemption and avoids drawbacks of both 28

30. Benefits of Using a Combination Buy-Sell Arrangement Properly structured combination buy-sell arrangement provides benefits of both stock- redemption and cross-purchase agreements by: Properly structured combination buy-sell arrangement provides benefits of both stock- redemption and cross-purchase agreements by: Requiring only one insurance policy per owner Requiring only one insurance policy per owner Dividing premium burden equitably among all owners Dividing premium burden equitably among all owners Providing full cost basis for purchased shares of business to all surviving business owners Providing full cost basis for purchased shares of business to all surviving business owners Enabling business to deduct bonuses paid to owners, who then contribute same amounts to partnership for insurance purchase Enabling business to deduct bonuses paid to owners, who then contribute same amounts to partnership for insurance purchase Avoiding possible levy of AMT on business from receipt of life insurance death benefit when an owner dies Avoiding possible levy of AMT on business from receipt of life insurance death benefit when an owner dies 29

31. Overview of Combination Buy-Sell Strategy Business and its owners establish buy-sell agreement for sale of business Business and its owners establish buy-sell agreement for sale of business Owners of business create separate general partnership Owners of business create separate general partnership General partnership owns and is beneficiary of life insurance policies insuring life of each owner General partnership owns and is beneficiary of life insurance policies insuring life of each owner Owners contribute funds to partnership; funds can be paid as bonuses to owners by business Owners contribute funds to partnership; funds can be paid as bonuses to owners by business 30

32. Combination Buy-Sell Strategy What happens when an owner dies? What happens when an owner dies? Partnership receives income tax-free death benefit from policy Partnership receives income tax-free death benefit from policy Disbursement of death benefit: Disbursement of death benefit: Purchase deceased partner’s interest in partnership Purchase deceased partner’s interest in partnership Distribute any remaining amounts to shareholders tax-free up to each shareholder’s basis Distribute any remaining amounts to shareholders tax-free up to each shareholder’s basis With distributed amounts, per buy-sell agreement, partners/owners can either: With distributed amounts, per buy-sell agreement, partners/owners can either: Purchase deceased shareholder’s interest directly, or Purchase deceased shareholder’s interest directly, or Contribute funds to business so business can redeem decedent’s interest Contribute funds to business so business can redeem decedent’s interest 31

33. Taxation and Allocation of Partnership Distributions Distributing Proceeds: Importance of Basis Distributing Proceeds: Importance of Basis Distributions up to partner’s basis not taxable Distributions up to partner’s basis not taxable Partner’s initial basis equal to total capital contributions partner made to partnership Partner’s initial basis equal to total capital contributions partner made to partnership Death benefit increases partner’s basis pro rata by partner’s percentage interest in partnership Death benefit increases partner’s basis pro rata by partner’s percentage interest in partnership Surviving partner’s basis can be increased by entire amount of death benefit if special allocation provisions are included in partnership agreement and used Surviving partner’s basis can be increased by entire amount of death benefit if special allocation provisions are included in partnership agreement and used 32

34. Establishing the Partnership: Importance of “Business Purpose” Adequate business purpose for partnership must exist Adequate business purpose for partnership must exist Debate continues on whether partnership formed solely to hold life insurance for buy-sell agreement is valid partnership Debate continues on whether partnership formed solely to hold life insurance for buy-sell agreement is valid partnership PLR 9309021 PLR 9309021 Owners should consider contributing or having partnership own or manage other assets in addition to life insurance Owners should consider contributing or having partnership own or manage other assets in addition to life insurance Partnership might own and rent property, plant or equipment to the Company Partnership might own and rent property, plant or equipment to the Company 33

35. Example: Bow Wow Kennel Supplies Corporation Three equal shareholders of Bow Wow Kennel Supplies Corporation: Three equal shareholders of Bow Wow Kennel Supplies Corporation: Jim, 60 years old, Jim, 60 years old, Bob, 40 years old, and Bob, 40 years old, and Joe, also 40 years old Joe, also 40 years old Owners agree to use combination buy-sell strategy for business succession plan Owners agree to use combination buy-sell strategy for business succession plan 34

36. Example: Bow Wow Kennel Supplies Corporation Creating the Partnership: JBJ Partnership Creating the Partnership: JBJ Partnership Jim, Bob, and Joe establish JBJ Partnership to fund and structure combination buy-sell arrangement for Bow Wow Jim, Bob, and Joe establish JBJ Partnership to fund and structure combination buy-sell arrangement for Bow Wow JBJ also manages additional properties owned by Bow Wow to establish legitimate business purpose JBJ also manages additional properties owned by Bow Wow to establish legitimate business purpose Each owner receives $100,000 bonus from Bow Wow and then contributes it to JBJ Each owner receives $100,000 bonus from Bow Wow and then contributes it to JBJ JBJ then uses contributed funds to purchase $1 million policy on each shareholder JBJ then uses contributed funds to purchase $1 million policy on each shareholder JBJ charges and collects ongoing rent and uses rent money to pay ongoing insurance premiums JBJ charges and collects ongoing rent and uses rent money to pay ongoing insurance premiums 35

37. Example: Bow Wow Kennel Supplies Corporation Impact of Jim’s Death Impact of Jim’s Death Jim dies 5 years after JBJ Partnership is created Jim dies 5 years after JBJ Partnership is created $1 million death benefit paid to JBJ from life insurance policy on Jim $1 million death benefit paid to JBJ from life insurance policy on Jim JBJ first uses funds to buy Jim’s interest in partnership, then distributes remaining amounts to Bob and Joe JBJ first uses funds to buy Jim’s interest in partnership, then distributes remaining amounts to Bob and Joe Bob and Joe can use amounts to buy Jim’s interest in Bow Wow per buy-sell agreement Bob and Joe can use amounts to buy Jim’s interest in Bow Wow per buy-sell agreement 36

38. Example: Bow Wow Kennel Supplies Corporation Taxation of Distributions from JBJ to Surviving Owners Taxation of Distributions from JBJ to Surviving Owners Without Special Allocation Provisions in Partnership Agreement: Without Special Allocation Provisions in Partnership Agreement: Bob and Joe’s partnership basis increase: $333,333 (1/3 of $1 million) Bob and Joe’s partnership basis increase: $333,333 (1/3 of $1 million) With Special Allocation Provisions in Partnership Agreement: With Special Allocation Provisions in Partnership Agreement: Bob and Joe’s partnership basis increase: $500,000 (1/2 of $1 million) Bob and Joe’s partnership basis increase: $500,000 (1/2 of $1 million) 37

39. Example: Bow Wow Kennel Supplies Corporation Impact on Surviving Shareholders’ Basis in Bow Wow Impact on Surviving Shareholders’ Basis in Bow Wow If Bob and Joe each pay $500,000 purchase price of Jim’s share, Bob and Joe each have basis in Jim’s share of $500,000 If Bob and Joe each pay $500,000 purchase price of Jim’s share, Bob and Joe each have basis in Jim’s share of $500,000 Higher basis reduces taxable gain if Bob and Joe sell Bow Wow later Higher basis reduces taxable gain if Bob and Joe sell Bow Wow later 38

40. Who Can Benefit from Combination Buy-Sell Arrangements? Owners who want all the benefits of a cross- purchase and stock redemption without any of their drawbacks Owners who want all the benefits of a cross- purchase and stock redemption without any of their drawbacks 39

41. Summary Importance of Business Succession Planning Importance of Business Succession Planning Ensures successful transfer of one’s business interest Ensures successful transfer of one’s business interest Reduces risk of loss at death of an owner Reduces risk of loss at death of an owner Supplies needed funds for buyout if life insurance is purchased and disability buyout insurance is purchased Supplies needed funds for buyout if life insurance is purchased and disability buyout insurance is purchased 40