Business owners often dread the concept of “succession planning.” Succession planning requires owners to confront their own mortality and the transition of control over their cherished businesses​.

The process can, simply, seem daunting. While succession planning is perhaps considered as much of a necessary evil as visiting a dentist while expecting a cavity, proper planning can help alleviate the transition and facilitate the continuity of the business for the next generation in particularly challenging times.

Where to Begin

Many business owners may struggle with where to begin. One of the most essential legal documents to include with proper planning is a well-drafted buy-sell or shareholder agreement, and it is a good place to start the succession-planning​​ process.

These agreements customarily include stock purchase or redemption options in the event of a shareholder’s death. The decision of how to structure such a transaction is frequently overlooked, but there are various options that can impact funding, asset protection and present drastic tax differences determined by its basic structure.

Curtis Walther headshot
Curtis C. Walther, Marquette 2019, is with
von Briesen & Roper, s.c. in Milwaukee, where he practices in the firm’s Business Practice Group.

Thomas W. Moniz headshot

Thomas W. Moniz
Marquette 2009, is a shareholder with
von Briesen & Roper, s.c. in the Business Practice and Nonprofit and Tax Exemption groups.

Taxation of Redemption versus Cross-purchase

Many buy-sell agreements require the corporation to redeem all of a deceased shareholder’s stock upon their death. This basic structure can often present a missed opportunity to provide a tax benefit to the remaining shareholders.

In a redemption structure, the corporation will reserve the purchased stock as treasury stock, but it will not provide any meaningful benefit to the remaining shareholders from a tax perspective.

In comparison, a cross-purchase structure provides the remaining shareholders with a cost basis in the purchased shares. This difference can result in substantial tax differences when the remaining shareholders in turn sell their stock due to this cost basis.

Often, the redemption is the default structure, because the corporation typically will have better access to credit and liquidity to fund the purchase compared to the individual shareholders. Additionally, the corporation enjoys limited liability and asset protection that the individual shareholders do not.

However, these downsides to the cross-purchase can be mitigated to achieve the tax benefits with proper planning.

Funding with Life Insurance

To alleviate concerns on liquidity and access to credit, it is common for businesses to fund the redemption structure with life insurance proceeds.

The preferred structure (redemption versus cross-purchase) should be coordinated with the underlying policy provide the purchaser with the proceeds from such policies. It may also provide a particularly beneficial source of liquidity for single-owner businesses who designate a key employee as a beneficiary to purchase the owner’s equity upon their death.

If the corporation is the beneficiary of such life insurance policies on an employee-shareholder, Internal Revenue Code (I.R.C.) section 101(j) would apply and needs appropriate planning. The section 101(j) requirements include notice and consent requirements for the employee and annual Form 8925 filing requirements for the corporation.

Unless these requirements are satisfied, the life insurance proceeds are includible in gross income to the beneficiary. The proceeds, provided that these requirements are satisfied, are generally not taxable. Assuming proper planning, this source of funds provides an effective means of funding buy-sell obligations upon the death of a shareholder.

Exposure to Creditors and Third Parties

From an asset-protection standpoint, it typically is the best option to have the life insurance proceeds payable to the corporation to fund a stock redemption transaction to enjoy limited liability benefits.

While it may present a less favorable tax outcome as to the purchaser, the risk of an individual shareholder exposing the life insurance proceeds to individual creditors is often an unacceptable level of risk. Indeed, with buy-sell obligations and insurance proceeds that may reach several million dollars, there may be a very low tolerance for susceptibility to a shareholder’s personal creditors.

However, there may be an approach that could provide the benefits of a cost basis from a cross-purchase and also the limited liability protection of the redemption.

Separate Limited Liability Company for Asset Protection

Instead of corporate or shareholder ownership, there is another hybrid approach that involves the formation of a separate limited liability company. The LLC would be formed solely for the purposes of holding the life insurance policies and would be the beneficiary of all life insurance policies that are used to fund the individual shareholders’ buy-sell obligations. The equity ownership of the LLC would mirror that of the operating corporation and each shareholder would be required to contribute capital from time to time to fund the life insurance premiums.

This structure provides a better alternative to both the corporate and individual ownership of the life insurance from an asset protection standpoint since it is isolated from both the corporation’s operating liabilities and also the individual shareholders’ personal liabilities.

Taxation of Life Insurance Partnership

The key to the effectiveness in this life insurance LLC structure is I.R.C. section 704​​​(b).

Instead of allocating the life insurance proceeds to each partner’s capital account on a pro rata basis, the LLC’s operating agreement would include a special allocation provision. Capital contributions from each partner would be required in proportion to their equity ownership to fund the life insurance premiums​, but only for life insurance policies that do
not insure their life. The life insurance proceeds, when received, would be specially allocated to the surviving partners in proportion to their relative (i.e., excluding the deceased member) equity ownership.

The LLC would then be required to distribute the insurance policies consistent with the partner’s positive capital account balances, and first to the partners to whom the life insurance proceeds had been specially allocated.

Once distributed, the partners would use the proceeds to fund the mandatory cross-purchase obligation under the buy-sell agreement of the operating corporation. In this manner, the surviving shareholders would obtain a cost basis in the purchased stock, while having a controlled and limited exposure to personal creditors or the corporation’s operating liabilities.

Finally, the LLC would redeem the deceased partner for the amount of their positive capital account balance. To the extent that amount exceeds the LLC’s remaining cash, it would trigger a mandatory capital contribution by the surviving partners.

Despite being held in a relatively inactive LLC with which the partners are not employed, the employer-owned life insurance provisions in section 101(j) would still apply under the common control rules in I.R.C. section 101(j)(3)(B)(ii), and should be complied with.

This article was originally published on the State Bar of Wisconsin’s
Taxation Law Section Blog. Visit the State Bar
sections or the
Taxation Law Section webpages to learn more about the benefits of section membership.