Insurance Concepts You’ll Need To Sell To High Net Worth Individuals and Business Owners

Presented to:
CPS/Arizona Insurance Services
3420 East Shea Blvd, #152
Phoenix, AZ 85028

September 13, 2006

Buy — Sell Agreements

 Providing for the Three D’s: Death, Disability & Divorce

 Objectives of a B-S agreement: Price, terms, money

  1.  The key points in reaching these objectives:
  2. Providing a guarantee that their interest in the business will be purchased at a fair price
  3.  Creating an immediately available source of funds for the purchase
  4.  Ensuring that the owners’ interest will be promptly sold to the other owners, to the company or a combination of the two with a minimum of disruption
  5.  Guarantees a purchaser for what could otherwise be a hard-to-sell asset (ie, what outsider would want to buy into the company?).
  6.  Avoids a possible dissolution and liquidation of the company if the remaining owners can’t or won’t come up with funds to buy out the decedent’s share of the business. The company will continue to exist and hopefully thrive as will its employees.
  7.  If done correctly, establishing a value of the owners’ interest for estate tax purposes

The Three D’s – Death
This is the least complicated scenario from a planning standpoint


  • Typically this is determined in one of several ways. The ideal methods is to have an annual review by the owners of the company’s financials and have them agree on a fair market value(FMV) for their respective shares for the next year. However, this requires a degree of diligence and dedication seldom seen, so this seldom happens.
  • The second method, probably the most widely used by my clients, is to hire an appraiser when the proposed ownership transfer is about to occur and use that value. This allows for flexibility but it is an unknown number.
  • A third method is to use a formula, usually a multiple of some sort. Like three times gross revenues or five times net income. This gives us a semi-firm and predictable number but it may not equate to FMV. Gross revenues are not necessarily profits and simply because revenues are up does not mean that profits have increased. And how is net income defined? The most commonly used definition is EBIDTA – Earnings Before Interest, Depreciation, Taxes and Amortization – which focuses on the operating income of a company: cash revenue and receivables less operating expenses.
  • A fourth method – and a sure sing of amateurs or DIYers – is a multiple of book value. This tells you nothing about the FMV of the company. Most of the mass market, fill-in-the-blank forms use this formula. Stay away from anyone using this.


  • So you have a price. Now, when will it be paid. Always avoid an installment plan if possible. What happens if the remaining owners fall behind in their payments? What if there is outright default? Too may times, the family ends up holding these businesses years later. They never wanted or knew anything about the business when times were good and now they are getting it dumped in their laps when it is a mess.
  • Nevertheless, a common term is equal monthly payments for 60 months. But can the business generate the cash flow to pay this off? Especially with the decedent no longer working at the company? Wouldn’t the family prefer to be completely rid of the business and vice versa? What about the simmering animosity of the remaining owners are convinced they overpaid for the business (which they almost always do)?


  • This is where the insurance agent looks like a savior. The purchase price gets paid immediately and painlessly. The decedent’s family is flush with cash. The remaining owners get to bid the spouse and kids a not-so-fond farewell. The company survives because it is not saddled with additional debt to pay off the family.
  • A very misunderstood concept is how the policies funding the BS agreement should be titled. This can be done in two ways – a cross-purchase or redemption. In a cross-purchase agreement, each owner owns the policy on the other owner’s life and uses the death benefit to purchase the other owner’s interest. This is the preferred method for tax purposes because this increases the purchasing owner’s basis (cost) in his ownership interest, thereby minimizing the capital gain on a subsequent sale. And, often, this basis has been increased using tax-free insurance dollars (if no transfer-for-value rules apply).
  • But cross-purchase agreement get very messy of there are more than two owners. In that setting, a redemption agreement is used. Here, the company owns and is the beneficiary of the policies and uses the death benefit to purchase (called a redemption) of the decedent’s share. The downside from a tax standpoint is that does not increase the basis of the remaining owners. Plus there can be tricky attribution rules if the remaining owners are family members, the dreaded alternative minimum tax (AMT) may apply if the business is a C corporation and a majority shareholder may have the death benefit included in his estate for estate tax purposes.

The Three D’s: Disability

  • Rather than dying, an owner suffers a stroke and can no longer work.
  • The same issues exist as with death but with two added factors. One is how to define disability – exactly how bad must the owners physical or mental condition be? The other factor is how long must it last. Most owners insist that the disability last for at least six months before the owner can be forced out.
  • As with the death situation, insurance can solve many of these problems.

The Three D’s: Divorce — Getting Rid of the Ex-Spouse

  • Unfortunately, no easy out with insurance on this one.
  • The problem is that, for most business owners, nearly all of their net worth is tied up in the business. Yet, in a community property state like Arizona, each spouse has a one-half share in the owner’s interest in the business. None of the owners want a troublesome ex-spouse owning a share of the business. Usually, the owners pledge that they will do their best to make sure they retain full ownership interest in the business in the event of a divorce. Or the other owners may be able to force the divorcing owner to sell his/her interest.

Irrevocable Life Insurance Trusts

A great technique that can result in huge estate tax savings. But a huge malpractice trap if overlooked, as it often is.

Key points of an ILIT:

  1.  Removes the death benefit from the decedent’s estate for estate tax purposes
  2.  Little or no gift tax incurred upon creation of the trust or paying for premiums in subsequent years.
  3.  Preserves the income-tax-free nature of the death benefit
  4.  If done correctly, provides a ready and immediate sources of funds to pay taxes, debts and expenses of the decedent’s estate
  5.  Creates a “Symington” trust for subsequent generations.

Malpractice traps of an ILIT

  1.  If not done, then death benefit is included in the estate, which could be taxable at a 47% rate.
  2.  No control by creator (grantor) of the trust. The grantor must put space between himself and the trust – cannot be a trustee or beneficiary, cannot later amend the trust to change either of these and assets of the trust cannot be used to pay of the grantor’s obligations, to include the support of dependents.
  3.  If an existing policy is transferred into the ILIT, the insured must live for three years or it is included in the estate. And there may be a transfer-for-value issue. Always best to have the ILIT own the policy at the outset – have the trust exist first, then purchase the policy, not the other way around. So coordinate with the estate planning lawyer BEFORE the policy is purchased.
  4.  Best to name children or other family member, but not the spouse, as beneficiaries. If the non-insured spouse is named, the policy could be included in that spouse’s estate under several theories, mainly via community property law or section 2036 of the Internal Revenue Code. A great vehicle for second-to-die policies if only children are named as beneficiaries.
  5.  Crummey powers. Each beneficiary must be put on notice of a withdrawal right, usually of the amount of money contributed to pay the premiums. Best to do this annually and in writing, but neither is required.
  6.  GST. The generation-skipping transfer tax will apply to any gifts to grandchildren.       This is an additional tax that is imposed on what is left after the estate tax has been paid. It generally has the same exemption amounts as the estate tax (ie, $2M for 2006) and the tax rate for 2006 is 31.9%.

Creditor Protection of Life Insurance

A gift in 2005 from the Arizona legislature to the insurance industry, apparently their response to the favorable ruling by the Arizona Supreme Court in the case of May v. Ellis, 208 Ariz 229 (2004), that held that insurance policies are protected from creditors of probate estate. The 2005 legislation increased creditor protection of life insurance policies and annuity contracts by amending ARS 20-1131 and 33-1126. The $25,0000 cap has been eliminated for policies and annuities that are at least two years old and name a family member as beneficiary. Protection includes cash surrender values. Exemption does not apply to policies or annuities that were pledged as collateral.