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Archives for August 2019

Limited Liability Companies (LLCs)

August 30, 2019 by John Sanchez

Limited Liability Companies (LLCs)

Limited Liability Companies (LLCs)

What is a Limited Liability Company?
A limited liability company (LLC) is a business entity organized in the United States under state law. Unlike a partnership, all of the members of an LLC have limited personal liability for its debts. Depending on elections made and the number of owners, an LLC may be classified for federal income tax purposes as a partnership, corporation, or an entity disregarded as separate from its owner.
This information applies to LLCs in general, and different rules may apply to special situations, including banks, insurance companies, or nonprofit organizations that are LLCs. Check your state’s requirements.

Forming an LLC
Choose a business name. Your business name must be different from any existing LLC in your state, it must indicate that it is an LLC, and must not include words restricted by your state.

File the Articles of Organization. The articles of organization is a document that is filed with your Secretary of State that makes your LLC a legal entity and includes information such as your business name, address, names of members, and your resident agent. There is usually a filing fee.

Create an Operating Agreement. Most states do not require operating agreements, but they are highly recommended, especially for multi-member LLCs. The operating agreement structures your LLC’s finances and organization, and provides rules and regulations for its operation. Sometimes tax treatment can be dictated by a written operating agreement. Default tax rules of multimember LLCs will split income and expenses evenly, unless otherwise noted in an operating agreement.

Hold and document annual member meetings. If the operating agreement requires an annual meeting, these meetings must be held and documented. Failure to adhere to provisions in the operating agreement and other formalities could result in loss of liability protection for your LLC.

Apply for an EIN. An employer identification number (EIN) is a nine-digit number assigned by the IRS used to identify the tax accounts of employers and certain others who have no employees. If you will hire employees or have an LLC with multiple members, you need to apply for an EIN. See IRS Form SS-4, Application for Employer Identification Number, or apply online at www.irs.gov.

Limited Liability Companies (LLCs)

Classification of an LLC
Default classification rules. An LLC with at least two members is classified as a partnership for federal income tax purposes. An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes). See Single Member LLCs—Disregarded Entities, below.
Elected classification. If an LLC does not choose to be classified under the above default classifications, it can elect to be classified as an association taxable as a corporation or as an S corporation. After an LLC has determined its federal tax classification, it can later elect to change that classification. See IRS Form 8832, Entity Classification Election.

LLCs Classified as Partnerships
Ifan LLC has at least two members and is classified as a partnership, it generally is subject to the same filing and reporting requirements as partnerships. For certain purposes, members of an LLC are treated as limited partners in a limited partnership. For example, LLC members are treated as limited partners for purposes of material participation under the passive activity limitation rules.

Change in default classification. If the number of members in an LLC classified as a partnership is reduced to only one member, it becomes an entity disregarded as separate from its owner. However, if the LLC has made an election to be classified as a corporation and that elective classification is in effect at the time of the change in membership, the default classification as a disregarded entity will not apply. Other tax consequences of a change in membership, such as recognition of gain or loss, are determined by the transactions through which an interest in the LLC is acquired or disposed of.

Single Member LLCs—Disregarded Entities
If an LLC has only one member and is classified as an entity disregarded as separate from its owner, its income, deductions, gains, losses, and credits are reported on the owner’s income tax return. For example, if the owner of the LLC is an individual, the LLC’s income and expenses would be reported on the following schedules filed with the owner’s Form 1040.

• Schedule C, Profit or Loss from Business (Sole Proprietorship),
• Schedule E, Supplemental Income and Loss, or
• Schedule F, Profit or Loss From Farming.

Employment tax and certain excise taxes. If the LLC pays wages to employees, employment taxes must be reported and paid in the name and EIN of the LLC rather than in the name and EIN of the single member owner. The single-member LLC is also required to use the LLC’s name and EIN to register for certain excise taxes.

Self-employment tax. An individual owner of an LLC treated as a disregarded entity is not an employee of the LLC. The owner is subject to self employment tax on the net earnings in the same manner as a sole proprietorship.

Taxpayer identification number. For all income tax purposes, a single-member LLC classified as a disregarded entity must use the owner’s Social Security Number (SSN) or EIN. This includes all information returns and reporting related to income tax.

LLCs Classified as Corporations
An LLC with either a single member or more than one member can elect to be classified as a corporation rather than be classified as a partnership or disregarded entity under the default rules. An LLC classified as a corporation is subject to the same filing and reporting requirements as a corporation. The
entity may elect to be treated as an S corporation if it otherwise qualifies.

C corporation. If the entity is treated as a C corporation, it is taxed on its taxable income and distributions to members are includible in each member’s gross income to the extent of the corporation’s earnings and profits (double taxation).

S corporation. If the entity elects to be an S corporation, the corporation is generally not subject to an income tax. The income, deductions, gains, losses, and credits of the corporation pass through to the members.

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Filed Under: Business Tagged With: Corporations, Limited Liability Companies, Partnerships

Financial Planning Guide

August 30, 2019 by John Sanchez

Financial Planning Guide

Personal Financial Planning

Budgeting
Steps to managing income and expenses include:
• Be realistic when making a budget.
• Identify monthly outflows as living expenses, savings, and discretionary.
• Estimate low for income.
• Estimate high for expenses.
• Track every expense.
• Track income and expenses monthly and review periodically.
• Save for large purchases.
• Save first.
• Budget for fun.

Education Funding
Several tax advantages are available to help save for education expenses.
• Savings bond interest may be tax free if used for qualified education expenses.
• Coverdell education savings accounts (ESAs) provide tax-deferred growth and tax-free distributions for qualified education expenses.
• Qualified tuition programs (529 plans) provide taxfree distributions for qualified tuition expenses.
• A gift of low-basis stock allows the individual’s child to sell the stock and use the proceeds to fund education expenses. This is beneficial when the individual is in a higher tax bracket and the student is in a lower tax bracket. Kiddie tax rules may apply.
• Roth IRAs can be used as a savings vehicle for education purposes. Contributions are removed from a Roth IRA without tax or penalty. Parents and grandparents fund the Roth IRA with the intention of removing the contribution and gifting that amount to the student.

If the student does not go to college, or has the costs covered by other means, the contributions can stay in the Roth IRA without concern for tax or penalty.
• Cash-value life insurance can also be used as a funding mechanism for college expenses.

Insurance
The purpose of insurance is to transfer the risk of loss to a third party to prevent catastrophic financial loss should that risk become a reality. For this reason, people choose to insure the larger risks and take on the smaller potential losses at their own risk.
• Liability insurance protects from financial loss due to specific incidents that create a liability. Automobile and homeowner insurance are examples of insurance that provide liability protection.
• Health insurance provides financial protection from medical costs associated with illness and/or injury.
• Disability insurance provides for income replacement in the event a person is unable to work due to injury or illness.
• Long-term care insurance protects financial assets and income in the event a person is confined to a long-term nursing home or needs in-home care for an extended period of time.
• Life insurance provides for an immediate lump-sum amount of money in the event of the insured’s death.
The purpose of life insurance is to provide income replacement in the event the income earner dies.

 Planning Tip: Individuals may want to ask their insurance agent about purchasing umbrella liability protection.
The cost is typically economical and it can provide additional protection from a liability loss.
Tax-savings tips

Financial Planning Guide

Investment Planning

Stocks, bonds, money markets, mutual funds, commodities, real estate, and options are the most common types of investments. Most financial professionals will recommend diversifying an investment portfolio across the different spectrum of investments. Investors need to be aware of the risks involved with any investment.
• Market risk. This is the risk that the value of the investment will be below the purchase price when or if it needs to be sold.
• Inflation risk. If the increase in value of an investment is less than the increase in the inflation rate, the future purchasing power will be less.
• Liquidity risk. Not all investments can be sold at a moment’s notice. Some investments do not have a marketplace where they can be sold.
• Interest rate risk. If an individual buys an interestbearing investment and interest rates go up, the current investment value can decrease.
• Tax risk. Buying and selling repeatedly for a profit will lead to taxable gains. The tax paid presents a risk to the investment value.
• Political risk. Specifically, when investing globally, political changes within a country can decrease investment values.
• Currency risk. Fluctuations in world currencies will cause investment values to rise or fall, independent from the true value of the investment.

Income Tax Planning

In addition to the economic logic that a financial transaction must have, it is important to evaluate the tax consequences of those transactions. Basis and Holding Period Knowing the basis and holding period in advance of a transaction can prevent costly tax consequences. Selling highly-appreciated assets will increase the amount of tax owed. Selling investments that are below basis can provide tax benefits by allowing a dollar-for-dollar reduction against capital gains. In addition, individuals are allowed to write off investment losses in excess of

gains up to $3,000 per year. Any amount not used can be carried forward to future tax years.

Example: Val owns the following shares of stock.

Val wants to make a $5,000 charitable donation by selling stock and contributing the cash to charity. If she sells both stocks and donates the proceeds, she will generate a taxable capital gain of $1,000 and take a charitable deduction of $5,000. Instead of selling both stocks, Val could gift stock A to the charity, along with the proceeds from the sale of stock B. Her tax result would be a capital loss of $2,000 from the sale of stock B and a charitable deduction of $5,000 ($4,000 FMV of stock A, plus $1,000 proceeds from the sale of stock B). She thus avoids paying tax on the $3,000 appreciation on stock A while achieving the same charitable deduction.

Annuity or Life Insurance Exchanges
A life insurance or annuity contract can be exchanged to a different life insurance or annuity contract without the exchange becoming taxable. Limitations may apply.

Early Retirement
Early retirees (before age 59½) are allowed to take distributions from retirement plans and avoid the 10% additional tax. In order to do so, they must follow certain rules.
• Distributions must be taken at least annually in substantially equal amounts.
• Distribution amounts are determined by life expectancy of the recipient.
• Distributions must be taken for a minimum of five years beginning with the year of the first distribution. If, at the end of the five years, the recipient has not yet attained the age of 59½, he or she must continue the distributions until attaining age 59½.

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Filed Under: Business Tagged With: Education Funding, Financial Planning, Financial Planning Guide, Planning Tips

Marketing Your Business

August 30, 2019 by John Sanchez

Marketing Your Business

Marketing Your Business

In order to be successful in marketing, you’ll need to follow a few simple steps.
1) Define your target market.
2) Identify the products and/or services that meet your customers’ needs.
3) Define the offer for your product and/or services.
4) Advertise your product and/or services.

General Ideas

• Engage in at least one marketing activity every day.
• Determine a percentage of gross income allotted to spend annually on marketing.
• Set annual marketing goals. Review and adjust quarterly.
• Carry business cards with you at all times.

Marketing Communications

• Develop an online marketing strategy. There are many opportunities for developing customer relationships through blogs, social media sites, and other vehicles. If you are not familiar with online marketing techniques, consult with experts or use online business advice sites such as entrepreneur.com.
• Publish a newsletter for customers and prospects (it doesn’t have to be fancy or expensive).
• Create giveaways such as calendars or posters for your customers to keep your name in front of them.
• Print a slogan and/or one-sentence description of your business on letterhead, fax cover sheets and invoices.
• Create a signature file to be used for all your email messages. It should contain contact details, including your website address and key information about your

company that will make the reader want to contact you.
• Include testimonials from customers in your literature.
• Remember to keep your message consistent in all communications.

Media Relations

• Upload helpful videos relating to your product or service to video sharing websites.
• Write a column for the local newspaper, local business journal, or a trade publication.
• Publicize your 500th client of the year (or other notable milestone).
• Create an annual award and publicize it.
• Get public relations and media training.
• Create your own TV program on your industry or your specialty. Market the show to your local cable station or public broadcasting station as a regular program, or see if you can air your show on an open access cable channel.

Customer Service and Customer Relations

• Return phone calls promptly.
• Set up an email system to easily respond to customer inquiries.
• Get a memorable phone number, such as 1-800-WIDGETS.
• Obtain a memorable URL and email address and include them on all marketing materials.
• Take clients out to a ball game, show, or another special event—or just send them two tickets with a note.
• Send handwritten thank you notes.
• Send birthday cards and appropriate seasonal greetings.

Tax-savings tips

Marketing Your Business

• Create an area on your website specifically for your customers.
• Redecorate your office or location where you meet with your clients.
• Distribute advertising specialty products such as pens, mouse pads, or mugs.
• Mail bumps—mail photos, samples or other innovative items to your prospect list. (A mail bump is anything that makes the envelope bulge and makes the recipient curious about what’s inside!)
• Consider non-traditional tactics such as bus backs, billboards, and popular websites.
• Consider placing ads in your newspaper’s classified section.
• Code your ads and keep records of results.

Marketing Performance

After implementing a marketing program, it is important to understand its impact on your business. Each program should have performance standards to compare with actual results. Researching industry norms and past performances will help to develop appropriate standards. Audit your company’s marketing performance at least quarterly, if not monthly.

Marketing Tips

• The most important order you ever get from a customer is the second order.
• Understanding and adapting to consumer motivation and behavior is not an option. It is an absolute necessity for competitive survival.
• A well-designed catalog mailed to a qualified response list will probably bring a one percent response.
• Processing and fulfillment costs incurred from the time an order arrives until it is shipped should be kept below $10 an order.
• The two most common mistakes companies make in using the phone is failing to track results and tracking the wrong thing.

• Marketing activities should be designed to increase profits, not just sales.
• It costs five times as much to sell a new customer as an existing customer.
• Selling what your customers need, instead of what they want, can lead to failure.
• Don’t think that product superiority, technology, innovation or company size will sell itself.
• Don’t neglect or ignore your current customers while pursuing new ones.
• People don’t buy products, they buy the benefits and solutions they believe the products provide.
• The average business never hears from 96% of its dissatisfied customers.
• Fifty percent of those customers who complain would do business with the company again if their complaints were handled satisfactorily.
• It is estimated that customers are twice as likely to talk about their bad experiences as their good ones.
• Marketing is everyone’s business, regardless of title or position in the organization.
• Get to know your prime customers—the 20% of product users who account for 80% of the total consumption of that product class.

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Filed Under: Business Tagged With: Marketing, Marketing Tips, Media Relations

College Financial Aid Planning

August 30, 2019 by John Sanchez

College Financial Aid Planning

College Financial Aid Planning

Individuals who want to attend college but cannot afford the costs outright must find alternative funding through various types of financial aid. Many factors affect eligibility for federal financial aid; therefore, all students should apply for financial aid every year even if they think they do not otherwise qualify.

FAFSA. The Free Application for Federal Student Aid (FAFSA) is the first step in the financial aid process. Students use the FAFSA to apply for federal student aid, such as grants, loans, and work-study.
The FAFSA must be submitted for each year the student wants financial aid.

Income tax return. If the student (or parents) needs to file an income tax return with the IRS, it is recommended that it is completed before filling out the FAFSA.

Expected Family Contribution. The questions on the FAFSA are required to calculate the student’s Expected Family Contribution (EFC). The EFC measures the student’s family’s financial strength and is used to determine the student’s eligibility for federal student aid. The EFC is split between an expected amount contributed from the student (usually more) and an expected amount being contributed from the parents.

Student Aid Report. A student’s EFC will be listed on their Student Aid Report (SAR). The SAR summarizes the information submitted on the student’s FAFSA.

Financial need. Financial need is the difference between the EFC and the college’s cost of attendance (which can include living expenses), as determined by the college. The college will use the student’s EFC to prepare a financial aid package to help meet financial need.

Need analysis formula. To determine financial need, a need analysis formula measures the parents’ and student’s assets and income. Assets are measured as follows:
• Assets in the student’s name are assessed at a maximum rate of 20%, whereas parents’ assets are assessed at a maximum rate of 12%.
• The assets of other children are not considered by the need analysis formula.
• Specific types of property (automobiles, computers, furniture, books, clothing and school supplies, boats, and appliances) do not count as assets.
• Retirement funds and pensions are generally not considered assets.
• Annuities and life insurance policies are generally not considered assets.
• Small businesses owned and controlled by the student’s family are excluded as assets. However, a partnership where the family owns 50% of the business is not excluded.
• Consumer debt (such as a credit card balance) is not counted against assets and income.
• Only debt secured by property (mortgage on home or business loan for equipment) is counted against assets and income.

Planning Strategies 

Income Strategies
• Avoid selling items that will produce a capital gain during the base year (first year of financial aid application) because capital gains are treated like income.
• Avoid taking money out of a retirement fund to pay for educational expenses. In general, retirement funds are not counted as an asset in the need analysis formula. However, if distributions are made, this converts

College Financial Aid Planning

a sheltered asset into an included asset. Therefore, it is more beneficial to spend down cash in a bank account first.
• Reduce parents’ income to increase eligibility for financial aid when parents’ AGI is close to $50,000. If the parents’ AGI is under $50,000, then the family may qualify for the Simplified Needs Test (SNT) which disregards assets when determining the EFC.

Asset Strategies
• Avoid saving money in the student’s name. Assets should be saved in the parents’ name because parents’ assets are assessed at a much lower rate for determining need (12% for parent versus 20% for student).
• A section 529 college savings plan saved in the parents’ name has minimal impact on financial aid eligibility, and one owned by a grandparent has no impact on the student’s eligibility.
• Avoid paying the student a salary from the family business.
• Spending down the student’s assets, preferably within the first year, before using any parent asset will leave the family with the most money left over after graduation.
• Put parent assets in the name of another sibling not in college because assets of other children are not considered by the need analysis formula.
• Buy necessary purchases prior to applying for financial aid. Specific types of property (automobiles, computers, furniture, books, clothing and school supplies, boats, and appliances) do not count as assets.
• Grandparents who wish to pay for college should pay money directly to the school to avoid increasing parental or student assets by giving money to them outright. Or, if the grandparents wait until the child has graduated, they could pay off the student loans instead.
• Make maximum contributions to retirement funds because these assets are not considered by the needbased formula.
• Buy life insurance policies or tax-deferred annuities because these assets are not considered by the needbased formula.

Consumer Debt
Paying off credit card debt and automobile loans will increase eligibility for financial aid by reducing available cash.

Mortgage Debt
To maximize eligibility for financial aid, reduce cash and other assets by prepaying mortgage debt. In addition, parents could take out a home equity line of credit each year to pay for the student’s school expenses. Interest payments would be tax deductible and the loan would reduce assets considered by the need-based formula.

Change in Financial Circumstances
A student should contact his or her financial aid office if the student or his or her family has unusual circumstances that should be taken into account in determining financial need. Some examples of unusual circumstances are unusual medical or dental expenses or a large change in income from last year to this year.

Non-Federal Assistance
Information about other non-federal assistance may be available from foundations, religious organizations, community organizations, and civic groups, as well as organizations related to a student’s field of interest, such as the American Medical Association or American Bar Association. Check with the parents’ employers or unions to see if they award scholarships or have tuition payment plans.

Independent Status
If a student is considered an independent, he or she does not have to include any parental income or assets on the FAFSA application. A student is considered an independent if he or she:
• Gets married before submitting the FAFSA.
• Attains age 24.

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Filed Under: Business Tagged With: Asset Strategies, Consumer Debt, Mortgage Debt, student aid

Early Retirement Distributions — SEPP

August 30, 2019 by John Sanchez

Early Retirement Distributions — SEPP

 Early Retirement Distributions
You may choose, or be forced into choosing, early retirement. Retirement before age 59½ may create income challenges. You are not yet eligible to receive retirement benefits from Social Security. You may or may not have a monthly pension to generate income.

In many situations, you will need to generate income from your assets. Often, most of your assets in a retirement plan through a 401(k) plan at your employer or in an individual retirement arrangement (IRA). Withdrawals of earnings and pre-tax contributions are subject to ordinary income tax. In addition, you may be subject to the 10% early withdrawal penalty tax on distributions taken before you reache age 59½.

Tax Summary
• Withdrawals of earnings and pre-tax contributions
from an IRA are subject to ordinary income tax.
• Unless an exception applies, taxable withdrawals
from an IRA prior to age 59½ are subject to a 10% early withdrawal penalty.
• If you take a series of substantially equal periodic payments from an IRA, you are not subject to the 10% additional tax.

Tax Planning Strategy
One strategy to generate income from retirement accounts if you are under age 59½ is to take periodic distributions from those accounts. If structured properly, the 10% additional tax will not be assessed on the distributions. You can take distributions from various retirement accounts such as 401(k) plans, 403(b) plans, and IRAs.

Substantially Equal Periodic Payments (SEPP)
The Internal Revenue Code allows you to take withdrawals from retirement accounts without incurring the 10% penalty. To do so, very specific rules need to be followed.
• The payments made to you from the IRA are based on one of three calculation methods.
• The payments must be made to you at least annually during the payment years. Payments can be made more frequently, such as monthly, but the total for each year during the SEPP period must meet the payment calculation result for the year or years during the SEPP.
• Payments must be made for a period of at least five years or until the taxpayer reaches age 59½, whichever is later.

Example: Fred, age 52, establishes a SEPP from his IRA. He must continue to take withdrawals until he reaches age 59½. If he discontinues or changes his SEPP withdrawals at any time before he reaches age 59½, the current year withdrawal is subject to the additional 10% tax. In addition, the SEPP withdrawals for previous years are retroactively subject to the additional 10% tax. If, however, Fred begins SEPP withdrawals at age 58, he must continue the withdrawals to age 63 to comply with the 5-year withdrawal requirement.

Calculation Method
Payments are considered to be substantially equal periodic payments if they are made in accordance with one of the three calculation methods allowed.
1) Required minimum distribution method. Under this method, the account balance, the number from the life expectancy table, and the resulting annual payment amount is re-determined each year.

Early Retirement Distributions— SEPP

2) Fixed amortization method. The annual payment for each year is determined by amortizing in level amounts the account balance over a specified number of years determined using a life expectancy table and a chosen interest rate. Under this method, the annual payment is determined once for the first distribution year and the annual payment is the same in each succeeding year.
3) Fixed annuitization method. The annual payment for each year is determined by dividing the account balance by an annuity factor that is the present value of an annuity of $1 per year beginning at the taxpayer’s age and continuing for the life of the taxpayer. The annuity factor is derived from a mortality table and a chosen interest rate. Under this method, the annual payment is determined once for the first distribution year and the annual payment is the same amount in each succeeding year.

One-Time Change to Required Amount
If you begin distributions in a year using either the amortization method or the annuitization method you may in any subsequent year switch to the required minimum distribution method to determine the payment for the year of the switch and all subsequent years. The change in method will not be treated as a modification. Once a change is made, the required minimum distribution method must be followed in all subsequent years until the required number of years under the plan have been met.

Changes to Account Balance
No other contributions or distributions can be taken from the account being distributed from during the SEPP period. This includes nontaxable transfers in or out of the account.
Example: Susan establishes a SEPP distribution from her IRA. Two years later, at age 53, she takes on a new job and wants to make contributions to an IRA with her newly earned income. Susan cannot contribute to the IRA that is making her SEPP distribution. Susan can establish a new, separate IRA account that she can make contributions to.

Depletion of Account Value
If, as a result of following an accepted method of determining SEPP withdrawals, your IRA assets are exhausted, you will not be subject to the additional income tax of 10%. The resulting cessation of payments will not be treated as a modification of the series of payments.
Example: Dick established a SEPP distribution plan at age 54 that required him to take a distribution amount of $25,000 each year. He invested aggressively in his SEPP account and, due to distributions and declines in the stock market, the value of his account was down to $15,000 when Dick took his distribution at age 58. Because the account has been depleted, none of the amounts distributed through the SEPP plan in prior years is subject to the 10% additional tax. In addition, the $15,000 distribution at age 58 is not subject to 10% additional tax. Also, because the account has been depleted, he will face no tax consequences for not being able to take a distribution at age 59.

Possible Risks
• The rules for distributions using the Internal Revenue Code provide very little flexibility. Once the distribution begins, taxpayers need to exert extreme caution in making any changes to the distribution amount and frequency.
• You need to document the calculations used to determine the distribution, as well as any change in distribution. Tax courts have consistently assessed the 10% additional tax for taxpayers who could not substantiate the distributions were, in fact, based on SEPP calculations.

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Filed Under: Business Tagged With: 401(k) plan, Early Retirement Distributions, SEPP, Tax Planning Strategy

Buy-Sell Agreements

August 30, 2019 by John Sanchez

Buy-Sell Agreements

Buy-Sell Agreements
Buy-sell agreements are usually part of a succession plan put in place to protect the financial interests of the owners of closely held companies and their heirs and to protect the company’s stability in case of a major event. Funding buy-sell agreements is frequently accomplished using insurance policies under (1) a cross purchase agreement, or (2) a stock redemption agreement.

Cross purchase agreement. Each owner of the company takes out, and is beneficiary of, an insurance policy
on each of the other owners. In the event of an owner’s death, the other owners use the insurance proceeds to buy out the decedent’s ownership share in the company from the decedent’s beneficiaries.

Stock redemption agreement. The company takes out life insurance policies on each of the owners. When an owner dies, the company buys out the deceased owner’s interest.

Valuation. Valuation of a company can change significantly in a relatively short time. The buy-sell agreement should be flexible in its ability to accurately reflect changes in value.

In a cross purchase agreement, the company has no interest in the decedent’s life insurance proceeds, whereas in a stock redemption, the interest is included with the value of the business. Typically, the redemption price of a stock redemption includes a portion of the life insurance proceeds.

Buy-Sell Agreements

Example #1: Abe and George each own 50% of Cherry Tree Inc., a C corporation. The company is currently valued at $250,000. Under a cross purchase agreement, Abe takes out, and is beneficiary of, a $125,000 life insurance policy on George. George takes out a similar policy on Abe. The cross purchase agreement is structured so that additional policies can be taken out over time as the value of the company increases. George dies and Abe collects $125,000 in tax-free proceeds from the life insurance policy. Under the terms of the cross purchase agreement, George’s beneficiaries are required to sell his interest in the company to Abe for $125,000. Since the basis of George’s interest is stepped up to FMV on the date of death, George’s beneficiaries do not realize taxable income.
After the transaction, Abe owns 100% of the company.
George’s beneficiaries receive $125,000 cash, which is not
taxable to them.

Example #2: Assume the same facts as Example #1, except the buy-sell agreement is funded by a stock redemption agreement. Cherry Tree Inc. takes out, and is beneficiary of, a life insurance policy on Abe in the amount of $125,000, and a similar policy on George. When George dies, Cherry Tree Inc. receives $125,000 in life insurance proceeds. The proceeds are not taxable to Cherry Tree Inc., but the $125,000 in life insurance proceeds do increase the corporation’s earnings and profits (E&P) so the amounts will be taxable if distributed to shareholders as dividends. Cherry Tree Inc. uses the proceeds to purchase George’s ownership interest from his beneficiaries. George’s ownership interest was stepped up at his date of death so his beneficiaries do not realize taxable income on the transaction. Abe now owns 100% of the outstanding stock of the corporation.

Insurance. There are several other insurance policies which should be considered by every business owner.

Key person life insurance. Many business owners are required to sign personal guarantees to secure business debt. In the event of an owner’s death, these debts will remain and, if unpaid by the business, will become the responsibility of the owner’s heirs. By taking out life insurance on the owner, proceeds can be used to retire the debt. The proceeds can also be used to fund the search for a replacement to the deceased business owner or to fund obligations to the owner’s spouse, such as continuing medical insurance coverage or salary payments. The premium payments by the business are not deductible, and the proceeds from the policy are not taxed as income.

Disability insurance. Disability insurance protects the earnings of employees and business owners by providing a stream of payments when a disability resulting in the loss of ability to work occurs.

Professional liability insurance. Professional liability insurance provides coverage for claims arising from professional error or malpractice. It is most commonly used by physicians, attorneys, architects, and accountants. The costs of this coverage are deductible to the business owner and augments the liability protection of incorporating.

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Filed Under: Business Tagged With: Buy-Sell Agreements, Cross purchase agreement, Insurance, Stock redemption agreement, Valuation

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