Take-Away: With some of the changes resulting from the 2017 Tax Act, there could be more use of limited liability companies (LLC) in estate plans. One change is that the federal alternative minimum tax is repealed for C corporations, which may cause some businesses to consider incorporation. With many taking a second look at incorporation, that may also warrant a second look at the use of an LLC’s instead of a cross-purchase funding arrangement among business owners to implement a buy-out on one owner’s death, disability or retirement.

Background: Suppose a business owner visits you to discuss the implications of the 2017 Tax Act on his/her estate and business planning. The obvious first topic of conversation is the possible incorporation of their business to take advantage of the 21% income tax rate. Another obvious topic will be qualifying for the IRC 199A deduction. But other changes in the Tax Act may also be relevant to the business owner, such as how business buy-outs are financed and used if there is less exposure to federal estate taxes (at least through 2025.)

Cross Purchase Agreements: Many small businesses use cross-purchase life insurance arrangements to facilitate the purchase/redemption of a business owner’s interest in the business on the owner’s death. Years ago it was thought appropriate for the business itself to own life insurance policies on each of its owners. But then came the increases in the alternative minimum tax imposed on the business which made it expensive for the business to own the life insurance policies on the lives of its owners, because the death benefit paid to the business entity on the death of one owner, which was intended to then be used by the business to redeem the deceased owner’s interest in the business, exposed the business to the alternative minimum tax. That change in the tax law then forced many business owners to shift away from entity owned life insurance policies on owners’ lives to cross-purchase arrangements, where each business owner owned a life insurance policy on the lives of all of the other business owners, in order to avoid triggering the alternative minimum tax of the business. But purchasing a life insurance policy on each of the other business owners (the intent being to use the death benefit to then purchase directly the decedent’s interest in the business, instead of a redemption of the decedent’s interest by the business itself) was expensive with multiple policies required to be purchased, and sometimes problematic if an owner withdrew from the business and he/she wanted to own the life insurance policies the other owners held on his/her life. In short, cross-purchase arrangements were better than entity redemption arrangements from an income tax perspective, but the cross-purchase arrangement brought its own set of practical and administrative problems.

LLC’s: An LLC created under the Uniform Limited Liability Company Act permits the creation of an LLC for any lawful purpose. [In contrast, for example, a partnership formed under the Uniform Partnership Act must be formed as a business for profit.] As a result, special purpose LLCs have proliferated in recent years for many uses such as owning private jets, yachts, and luxury homes. Yet another special purpose use of an LLC is that it can now be used in lieu of the more cumbersome cross-purchase arrangements by the owners of small businesses.

Benefits of LLC Owned Life Insurance: Using an LLC to own life insurance on the lives of the owners of a business provide several benefits. Assume a closely held business with 5 separate owners:

  • Alternative Minimum Tax Avoidance: If the business does not own the life insurance on the life of one of its owners, it will not receive the death benefit and thus the alternative minimum tax (before its repeal) faced by the business will be avoided if it had directly received the death;
  • Number of Life Insurance Policies: Under a cross-purchase arrangement, each owner must purchase a life insurance policy on the life of the other 4 owners. That requires the purchase of 20 separate life insurance policies. With an LLC ownership arrangement, only 5 life insurance policies are required to be purchased and held by the LLC.
  • Centralized Policy Ownership: Administration is much easier if the LLC owns 5 life insurance policies, as opposed to five different owners of 4 separate life insurance policies. The manager of the LLC can properly assure the timely payment of the 5 insurance premiums. The LLC manager will also be the party who files the claim for the death benefit and then uses that death benefit that it receives to purchase the business interest held by the deceased business owner or his/her estate. The death benefit does not get derailed if it is paid to the individual business owners, or the proceeds are applied for other emergent purposes.
  • ‘Stray’ Life Insurance Policies: With the cross purchase arrangement, upon the deceased owner’s death, part of his/her estate will consist of the 4 life insurance policies that he/she owned on the surviving business owners’ lives. It is possible that the deceased owner’s estate will pass those 4 insurance policies onto his/her heirs who are not involved with the business, but who will gain a windfall if one of the other business owners later dies. With the LLC ownership arrangement, the LLC will continue to own and control the 4 life insurance policies which will remain in place owned by the LLC for their intended purpose- to finance the buyout of a deceased or retiring business owner.
  • Retiring Owner: If one of the owners decides to retire, the LLC can distribute the life insurance policy on his/her life to that retiring business owner, which can then be used for his/her own estate planning purposes, or if it is a cash surrender type of insurance policy, the policy’s cash surrender value can possibly supplement the retiree’s income through policy loans. The distribution to the retiring business owner should not result in a taxable event under the partnership taxation rules that normally  applied to an LLC.
  • Flexibility: Capital contributions do not necessarily have to be equal or pro rata among the LLC members (i.e. the business owners.) Consequently, there can be flexibility in owner contributions to the LLC. Similarly, allocations of income and expenses of the LLC do not have to be pro-rata based upon their business ownership percentages, so long as these allocations made by the LLC have ‘substantial economic effect.’
  • ‘Incidents of Ownership:’ If the LLC is manager-managed by an individual or entity, the members will not have any ‘incidence of ownership’ of the policies on their death. [IRC 2042.] The LLC, not the individual member, owns and controls the life insurance policy, which means that the death benefit will not be taxed in the deceased owner’s estate. Treasury has held in a private letter ruling that an insured LLC member will not possess an incidence of ownership over a life insurance policy that is owned by an LLC life insurance ownership arrangement, so long as: (i) the LLC manager is independent, and (ii) the insured LLC member cannot exercise any control over the life insurance policy. [PLR 200747002.]
  • Limited Estate Inclusion: While the life insurance LLC ownership of the life insurance policies will avoid inclusion of the death benefit in the decedent’s taxable estate under IRC 2042 (i.e. there is no incidents of ownership held by the decedent that warrants inclusion of the death benefit in the owner’s taxable estate) some death benefit will be indirectly included in the decedent-member’s taxable estate through application other sections of the Tax Code, primarily the decedent’s ownership of the LLC membership interest. But that LLC membership interest will be subject to valuation adjustments (discounts) due to the lack of control and marketability of the minority LLC units owned by the decedent-member. In short, a much smaller amount will be included in the deceased member’s taxable estate.
  • Caution: The IRS concluded long ago that a partnership (or LLC taxed as a partnership) could be created solely for the purpose of owning insurance. [PLR 9309021, March 5, 1993.] That said, the anti-abuse rules [Treas. Reg. 1.701-2] were created to eliminate the use of a partnership when the principal purpose of the partnership is to reduce substantially the partners’ aggregate federal tax liability in a manner that is inconsistent with subchapter K of the Tax Code. In order to avoid running afoul of these anti-abuse rules, the LLC should probably have some other business purpose besides owning life insurance, e.g. a pooled investment fund which is accessed by the manager and used to pay the policy premiums.

Conclusion: If a business owner wants to talk about the implications of the new Tax Act on his/her business and existing estate plans, it will be important to cover the new tax rates imposed on C corporations, the repeal of the alternative minimum tax, the possible eligibility for the IRC 199A deduction. But you may also encourage the business owner to take a look at any existing cross-purchase agreements that are currently in place to fund a buy-out should the owner die. The benefits of an LLC manager managed LLC to hold the existing life insurance on the owners’ lives should be brought to the owner’s attention, due primarily to the simplicity and ease if offers to manage and control far fewer life insurance policies.