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Utilizing Special Purpose LLCs for Effective Buy-Sell Agreements

A well-designed buy-sell agreement is a crucial component for businesses aiming to secure a smooth transition of ownership in the face of unforeseen events. Traditionally, buy-sell agreements have been designed as either cross-purchase agreements or stock redemption plans, each with their own benefits and drawbacks depending on the specifics of a given business. However, one innovative approach increasingly gaining traction among financial experts is the use of Special Purpose LLCs (Limited Liability Companies) to effectively structure buy-sell agreements.

The Impact of Connelly vs. US Case Ruling

Connelly vs. United States serves as a looming deterrent to many advisors and business owners using stock redemption buy-sell agreements for closely held businesses. In June 2023, a three-judge panel in the Eight Circuit of the U.S. Court of Appeals ruled that life insurance proceeds that were originally earmarked to redeem the stock of a deceased shareholder “were simply an asset that increased shareholders’ equity,” and should be included in the valuation of the business for buy-out purposes. The ruling imposed a significant tax liability on the deceased shareholder’s estate that may have been avoided through proper adherence to an existing buy-sell agreement between the decedent and his brother who was the other shareholder.

Prior to the Connelly decision, the prevailing case regarding the administration of life insurance proceeds and its impact on the value of a business for estate tax purposes was Estate of Blount v. Commissioner, which established that the value of a company would not be increased by the value of the death benefit of life insurance when its purpose is to provide liquidity to a company to redeem a decedent’s ownership interest.

Given that the appraisal requirements and valuation methodology within buy-sell agreements are often disregarded by business owners, this case highlights the enormous hidden dangers within stock redemption agreements for closely held businesses. It also emphasizes the importance of considering alternative structures, such as Special Purpose LLCs, to avoid potential tax pitfalls.

Why Special Purpose LLCs

Much like a stock-redemption plan, the centralized ownership and administration of the life insurance policies purchased to fund the buy-sell is a key advantage of employing Special Purpose LLCs. Taken a step further, the capital contributions from the business partners into the Special Purpose LLC can be designed to smooth out any uneven life insurance premiums amongst the business partners caused by differences in age, gender or health status. Additionally, a properly structured Special Purpose LLC can shield assets from the personal liabilities of individual members. This added protection can prove invaluable, especially in industries prone to litigation or economic volatility.

Importantly, the Special Purpose LLC delivers a cost basis step-up to the purchasing party upon buyout triggered by the death of an owner, much like in a cross-purchase arrangement. This strategy helps the successor owners reduce capital gains taxes upon the potential future sale of the business.

Finally, and of critical importance given the Connelly rulings, the Special Purpose LLC can serve to ensure the death benefit proceeds identified for share redemption of a deceased owner are never included in the valuation of the business for buy-sell purposes.

Establishment and Ownership Structure:

To harness the full benefits, business owners should consult with a tax professional who can help with properly structuring the Special Purpose LLC. Some key details for the managing member of the LLC to keep in mind before and after a partner’s passing are:

  • The LLC should be established as a partnership for tax purposes and, ideally, the ownership percentages will mirror those of the operating company.
  • The partnership should issue a Promissory Note to the deceased owner’s estate for the payment of the buy-out price.
  • The partnership will file to “terminate the tax year” as an accounting strategy.
  • New tax year for the LLC begins after death with the remaining living partners as sole owners.
  • The LLC receives the life insurance proceeds and increases the remaining owner’s cost basis.
  • The partnership repays the outstanding promissory note to the deceased owner’s estate.

Special Purpose LLCs present a powerful solution for business owners seeking to design more effective buy-sell agreements. With tax benefits, creditor protection, and greater valuation certainty this innovative approach offers a robust option for those looking to secure their business legacy and financial future. We urge business owners to review existing buy-sell agreements (or operating agreements) with their advisors on a regular basis and abide by the stated terms and conditions in order to avoid unintended consequences.

Connelly v. US:

Estate of Blount v. Commissioner:

Neither MML Investors Services nor any of its subsidiaries, employees or agents are authorized to give legal or tax advice. Consult your own personal attorney, legal or tax counsel for advice on specific legal and tax matters. CRN202605-5951311

Approval # CRN202302-278300