Partnerships and LLC's are one of the most prominent types of business entities. Since the advent of the Limited Liability Partnership (LLP) and Limited Liability Company (LLC), which both may be considered partnerships for tax purposes, the number of companies that have either been formed or converted to partnerships is significant.

  One advantage to a business being a bona fide partnership is the flexibility available in the use of life insurance for business planning needs. This flexibility is due to exceptions awarded to bona fide partnerships in the transfer-for-value rule. The transfer-for-value rule provides that if a policy, or any interest in a policy, is transferred for valuable consideration, the death benefit proceeds will generally be exempt from federal income taxes only to the extent of the consideration paid by the transferee and net premiums paid by the transferee after the transfer unless the transaction falls within an exception to the rule. Two of the exceptions to the transfer-for-value rule are a transfer to a partnership in which the insured is a partner or a transfer to a partner of the insured.

  An important aspect of the business planning is having a properly structured buy-sell agreement in place. Business partners often use life insurance policies as the funding vehicle for a buy-sell agreement. Many times, however, the partners are hesitant to hold a policy on the lives of each other. A strategy that may allow the partners to fund a buy-sell agreement with policies owned by the insured on their own lives is the Insured Controlled Cross Purchase.

  In a traditional cross purchase, the participants own policies on lives other than their own. The insured controlled cross purchase design, as opposed to a traditional cross purchase, may permit for the funding of a cross purchase buy-sell agreement and accumulation of policy cash value for use by the insured. First, the partners purchase a life insurance policy on their own lives. Then, through a personal split dollar arrangement, the partners endorse a portion of, or all of, the death benefit above cash value to each other. The non-owner of the policy pays for the Reportable Economic Benefit (REB) cost on their portion of the death benefit, which the owner of the policy will have to recognize as taxable income, and the owner of the policy pays the rest of the premiums. If a partner dies, the non-owner of the policy will receive their portion of the death benefit, which will be applied towards the purchase of the decedent's business interest. Prior to death, the policy owner has access to any available policy loans and withdrawals. If the buy-sell agreement is no longer needed, the split dollar agreement can be terminated and each partner retains the policy on his or her own life.

  The prirmary tax issue with this design is the transfer-for-value rule. The personal split dollar agreements would usually be considered a transfer-for-value. The consideration that causes the design to be a transfer-for-value is the reciprocal promise to name each other as beneficiary for the death benefit above cash value. Thus, without one of the exceptions to the transfer-for-value rule, the personal split dollar plan would create taxable income to the surviving partner. One exception to the transfer-for-value rule, however, is a transfer to a partner of the insured. If the personal split dollar design is implemented and the partners are not partners in a bona fide partnership, the death benefit above basis will be income taxable.

  Due to the transfer-for-value issue, the insured controlled cross purchase design should only be used with partners in partnerships. The partnership however, need not be related to the split dollar arrangement. Therefore, if shareholders in a corporation are also partners in a partnership (or can create a bona fide partnership), the transfer-for-value exception may apply even if the buy-sell agreement is for the corporation.

The insured retains control over his or her own policy, including any available cash value.

There is no need to swap policies if the buy-sell agreement is terminated.

The purchasing partner may receive a step-up in basis in the partnership interest they acquire.

If the buy-sell is no longer needed, the parties may terminate the split dollar agreements and continue to own policies on their own lives.

The Business Planning Group
3186 Eaglecrest Lane, Clinton WA 98236
Phone: 206-255-5700     Fax: 206-260-2721