Accounting
Buy-sell agreements and their tax and insurance considerations for surviving partners
There are two significant reasons for a client to have an updated and funded buy-sell agreement. One is to allow the surviving partner to maintain sole control of the business if one of the owners or partners were to die prematurely or become disabled.
The other is to provide an immediately available sum of tax-free dollars to pay the deceased partner’s family for their share of the business or practice. A written agreement would establish an updated value of the business, how much money the deceased’s partner’s family would receive, over what period of time and most importantly, where the funds needed to pay the deceased partner’s family would come from.
Having discussed the value, terms, mechanics and funding beforehand would not only provide for an orderly transition of the business but also avoid unnecessary disputes settled by costly litigation.
Doing so would also prevent key people, employees, vendors and customers from leaving the business, thereby maintaining the full value of the business or practice for the surviving partner and their family. Lastly, a properly drafted, funded and annually updated valuation of the business could peg the value of a business for estate tax purposes.
There are basically three types of buy-sell agreements: cross-purchase, stock redemption, and wait and see. For the purposes of this article, we’ll focus on the two most popular: the cross-purchase and stock redemption. The wait and see has components of both types of agreements but doesn’t require a decision until death occurs. The cross-purchase agreement is an agreement made directly between the partners of a business or practice. Each partner is the owner, beneficiary and premium payor of the other partner’s life Insurance policy. As always, there are benefits and detriments to any planning options and the cross-purchase is no exception.
In a cross-purchase agreement, the distinct tax benefits to the surviving partner are that at their subsequent death, their family would receive a step up in basis to the current value of the business. For example, if a business is initially valued at $1million and then over 20 years later it’s worth $3 million, there would be no capital gains tax at the subsequent death of the surviving partner on the $2 million gain as the surviving partner in a cross-purchase agreement would receive a stepped-up basis at death to the $3 million.
One of the detriments of such an agreement is that the value of the personal shares of the business are subject to the claims of the creditors. In addition, if there are three partners, there could be as many as six life insurance policies required, and 12 policies if there were four partners involved. That aside, there would be disparities as to the cost of a particular amount of life Insurance coverage for a partner in their 60s in excellent health, as opposed to a partner in their 70s in not such good health. Equalizing the individual costs for a business or practice with four or more partners could be an administrative burden.
The second type of a buy-sell agreement is called a stock redemption. In this type of an agreement the mechanics work differently. Instead of the partners owning the policies on each other’s lives, paying for one another’s premiums and being each other’s beneficiary, the business is the owner, premium payor and beneficiary of each partner’s policy. This type of arrangement makes the administration easier and equalizes the different policy charges as well as reduces the number of policies required to provide the insurance coverage for several partners. It also shields the value of the shares of the business from personal creditors.
However, the detriment to that type of an agreement is severe in that at the death of a partner there is no step up in basis in the value of the business for the surviving partner’s family at their passing. Using the prior example, if the initial value of the business or practice was $1 million and then over 20 years later, upon the death of the first partner, the value of the business was determined to be $3 million, the estate of the surviving owner would be required to pay a capital gains tax of $2 million with a basis of $1million rather than the $3 million it would have been with a cross-purchase agreement.
The Supreme Court ruling on June 6 in the case of
Buy-sell agreements frequently utilize life insurance to provide the funding mechanism for payment of the purchase price upon death, disability, retirement or a specifically mentioned triggering mechanisms outlined in the buy-sell agreement such as divorce, unresolvable differences or bankruptcy. This source of funding is designed to have the surviving partner receive the tax-free death benefit in the most tax efficient manner, which would then be used to purchase the shares of the deceased partner from their family.
Since we’ll be focusing on the use of four different types of life insurance, a brief explanation of each type of life insurance policy that could be used is in order. Term life insurance can be purchased with a five- to 40-year term of coverage where the death benefit, the premium and the duration of coverage are all guaranteed. Term insurance provides a death benefit only and is the most popular and least expensive type of coverage simply because the coverage contractually ceases to exist at the ages of 80 to 82. As a result, only 2% of term insurance coverage is ever paid out as a death benefit. However, for business owners who intend to retire or sell their business or practice before the age of 80, and only want to be protected in the event of death, term insurance is a good choice. Since a disability is more likely to occur than a premature death, it’s a good idea to address a disability by funding it with a disability buyout policy.
If one wants to guarantee their coverage beyond age 82, they can utilize a guaranteed universal life insurance policy, which for a higher annual premium can guarantee the death benefit, cost and duration of coverage up to age 120. It should be noted that the longer one wants their coverage guaranteed to last, the higher the cost.
For those business owners and partners of a practice that want to utilize life insurance for its living benefits as well as its death benefit, they can use a whole life policy with a guaranteed premium and tax- free death benefit, based on a fixed return. Another option would be a variable life policy. This type of policy’s return is based on the returns of the stock market and is not guaranteed but may provide a higher or lower return. In either case, in addition to having provided an income tax-free death benefit during the partner’s working years, the policy could have accumulated a significant build-up of tax deferred internal cash value. Then at retirement (beyond age 59 and a half) when the death benefit is no longer needed, the partners could begin withdrawing the policy’s cash value to supplement their retirement on a 100% tax-free basis, utilizing a strategy of loans and withdrawals that never have to be paid back as long as the policy survives the insured. This and other split-dollar arrangements (such as premium sharing) are an extremely popular strategy for those businesses with an adequate cash flow. This is known as a private pension. or supplemental owners retirement plan.
Similar steps can also be taken to ensure a key employee remains in the business during any such turbulent times by providing them with a deferred compensation plan. Such a plan can merely provide a death benefit only using simple term insurance, or arrangements can be made to use a whole life or variable life insurance policy that in addition to providing a death benefit, also accumulates cash value on a tax-deferred basis. This accumulation can, upon the key person’s retirement, be used to supplement their income with tax-free distributions, but only if they fulfill their end of the bargain, i.e., remaining at their place of business for a specified number of years set at the owner’s discretion. This strategy is commonly called a supplemental executive retirement plan.
The Financial Accounting Standards Board met this week to discuss its projects on accounting for transfers of cryptocurrency assets and enhancing the disclosures around certain digital assets, such as stablecoins.
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During Wednesday’s meeting, FASB’s board made certain tentative decisions, according to a
At a future meeting, the board plans to consider clarifying the derecognition guidance for crypto transfer arrangements to assess whether the control of a crypto asset has been transferred.
FASB also began deliberations on the
The board decided to provide illustrative examples in Topic 230, Statement of Cash Flows, to clarify whether certain digital assets such as stablecoins can meet the definition of cash equivalents. It also decided to include the following concepts in the illustrative examples:
- Interpretive explanations that link to the current cash equivalents definition;
- The amount and composition of reserve assets; and,
- The nature of qualifying on-demand, contractual cash redemption rights directly with the issuer.
FASB plans to clarify that an entity should consider compliance with relevant laws and regulations when it’s creating a policy concerning which assets that satisfy the Master Glossary definition of the term “cash equivalents“ will be treated as cash equivalents.
“I agree with the staff suggestion to look at examples,” said FASB vice chair Hillary Salo. “From my perspective, I think that is going to help level the playing field. People have been making reasonable judgments. I agree with that. And I think that this is really going to help show those goalposts or guardrails of what types of stablecoins would be in the scope of cash equivalents, and which ones would not be in the scope of cash equivalents. I certainly appreciate that approach, and I think it has the least potential impact of unintended consequences, because I do agree with my fellow board members that we shouldn’t be changing the definition of cash equivalents, and it’s a high bar to get into the cash equivalent definition.”
“I’m definitely supportive of not changing the definition of cash equivalents,” said FASB chair Richard Jones. “I believe that’s settled GAAP in a way, and we’re not really seeing a call to change it for broader issues. I am supportive of the example-based approach. The challenge with examples, though, is everybody’s going to want their exact pattern, but that’s not what we’re doing.”
The examples will explain the rationale for how digital assets such as stablecoins do or do not qualify as cash equivalents and give a roadmap for other types of digital assets with varying fact patterns to be able to apply.
“We really don’t want to be as a board facing a situation where something was a cash equivalent and then no longer is at a later date,” said Jones. “That’s not good for anyone, so keeping it as a high bar with certain rigid criteria, I think, is fine.”
Stablecoins are supposed to be pegged to fiat currencies such as U.S. dollars and thus provide more stability to investors. “In my view, while a stablecoin may meet the accounting definition established for cash equivalents, not every one of those stablecoins in the cash equivalent classification represents the same level of risk,” said FASB member Joyce Joseph.
She noted that the capital markets recognize the distinctions and have established a Stablecoin Stability Assessment Framework to evaluate a stablecoin’s ability to maintain its peg to a fiat currency. Such assessments look at the legal and regulatory framework associated with the stablecoin, and provide investors with information that could enable them to do forward-looking assessments about the stability of the stablecoin.
“However, for an investor to consider and utilize such information for a company analysis the financial statement disclosures would need to include information about the stablecoin itself,” Joseph added. “In outreach, the staff learned that investors supported classifying certain stablecoins as cash equivalents when transparent information is available about the entities at which the reserve assets are held. Therefore, in my view, taking all of this into consideration a relevant and informative company disclosure would include providing investors with the name of the stablecoin and the amount of the stablecoin that is classified as a cash equivalent, so investors can independently assess the liquidity risks more meaningfully and more comprehensively by utilizing broader information that is available in the capital markets and its emerging information.”
Such information could include the issuer, reserves, governance and management, she noted, so investors would get a more holistic look at the risks that holding the stablecoin would entail for a given company.
The board decided to require all entities to disclose the significant classes and related amounts of cash equivalents on an annual basis for each period that a statement of financial position is presented.
Entities should apply the amendments related to the classification of certain digital assets as cash equivalents on a modified prospective basis as of the beginning of the annual reporting period in the year of adoption.
FASB decided that entities should apply the amendments related to the disclosure of the significant classes and amounts of cash equivalents on a prospective basis as of the date of the most recent statement of financial position presented in the period of adoption.
The board will allow early adoption in both interim and annual reporting periods in which financial statements have not been issued or made available for issuance.
FASB also decided to permit entities to adopt the amendments to be illustrated in the examples related to the classification of certain digital assets as cash equivalents without the need to perform a preferability assessment as described in Topic 250, Accounting Changes and Error Corrections.
The board directed the staff to draft a proposed accounting standards update to be voted on by written ballot. The proposed update will have a 90-day comment period.
Senators introduced several pieces of tax-related legislation this week, including measures aimed at improving customer service at the Internal Revenue Service, cracking down on tax evasion and curbing the carried interest tax break, in addition to efforts in the House to repeal the Corporate Transparency Act.
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Senators Bill Cassidy, R-Louisiana, and Mark Warner, D-Virginia, teamed up on introducing a bipartisan bill, the
The bill would establish a dashboard to inform taxpayers of backlogs and wait times; expand electronic access to information and refunds; expand callback technology and online accounts; and inform individuals facing economic hardship about collection alternatives.
“Taxpayers deserve a simple, stress-free experience when dealing with the IRS,” Cassidy said in a statement Wednesday. “This bill makes the process quicker and easier for taxpayers to get the information they need.”
He also mentioned the bill during a
“I’m happy to meet with the team … and do all I can to make it as good as you want it to be,” said Bisignano.
“My bill would equip the IRS with the legislative mandate to create an online dashboard so that taxpayers can monitor average call wait time and budget time accordingly,” said Cassidy. He noted that the bill would allow a callback for taxpayers that might need to wait longer than five minutes to speak to a representative, and establish a program to identify and support taxpayers struggling to make ends meet by providing information about alternative payment methods, such as installments, partial payments and offers in compromise.
“I know people are kind of desperate and don’t know where to turn for cash, so I think this could really ease anxiety,” he added. “This legislation is bipartisan and is likely to pass this Congress.”
Cassidy and Warner
“Taxpayers shouldn’t have to jump through hoops to get basic answers from the IRS — and in the last year, those challenges have only gotten worse,” Warner said in a statement. “I am glad to reintroduce this bipartisan legislation on Tax Day to ease some of this frustration by increasing clear communication and making IRS resources more readily available.”
Stop CHEATERS Act
Also on Tax Day, a group of Senate Democrats and an independent who usually caucuses with Democrats teamed up to introduce the Stop Corporations and High Earners from Avoiding Taxes and Enforce the Rules Strictly (Stop CHEATERS) Act.
Senate Finance Committee ranking member Ron Wyden, D-Oregon, joined with Senators Angus King, I-Maine, Elizabeth Warren, D-Massachusetts, Tim Kaine, D-Virginia, and Sheldon Whitehouse, D-Rhode Island. The bill would provide additional funding for the IRS to strengthen and expand tax collection services and systems and crack down on tax cheating by the wealthy.
“Wealthy tax cheats and scofflaw corporations are stealing billions and billions from the American people by refusing to pay what they legally owe, and far too many of them are getting a free pass because Republicans gutted the enforcement capacity of the IRS,” Wyden said in a statement. “A rich tax cheat who shelters mountains of cash among a web of shell companies and passthroughs is likelier to be struck by lightning than face an IRS audit, and Republicans want to keep it that way. This bill is about making sure the IRS has the resources it needs to go after wealthy tax cheats while improving customer service for the vast majority of American taxpayers who follow the law every year.”
Earlier this week. Wyden also
The Stop CHEATERS Act would provide the IRS with additional funding for tax enforcement focused upon high-income tax evasion, technology operations support, systems modernization, and taxpayer services like free tax-payer assistance.
“As Congress seeks ways to fund much-needed policy priorities and address our growing national debt, there is one common sense solution that should have unanimous bipartisan support: let’s enforce the tax laws already on the books,” said King in a statement. “Our legislation will make sure the IRS has the resources it needs to confront the gap between taxes owed and taxes paid – while ensuring that our tax enforcement professionals are focused on the high-income earners who account for the most tax evasion. This is a serious problem with an easy solution; let’s pass this legislation and make sure every American pays what they owe in taxes.”
Carried interest
Wyden, King and Whitehouse also teamed up on another bill Thursday to close the carried interest tax break for hedge fund managers that
Carried interest is a form of compensation received by a fund manager in exchange for investment management services, according to a
Under the bill, the
“Our tax code is rigged to favor ultra-wealthy investors who know how to game the system to dodge paying a fair share, and there is no better example of how it works in practice than the carried interest loophole,” Wyden said in a statement. “For several decades now we’ve had a tax system that rewards the accumulation of wealth by the rich while punishing middle-class wage earners, and the effect of that system has been the strangulation of prosperity and opportunity for everybody but the ultra-wealthy. There are a lot of problems to fix to restore fairness and common sense to our tax code, and closing the carried interest loophole is a great place to start.”
Repealing Corporate Transparency Act
The House Financial Services Committee is also planning to markup a bill next Tuesday that would fully repeal the Corporate Transparency Act, which has already been significantly
If enacted, the repeal would eliminate beneficial ownership reporting requirements, removing a transparency measure designed to help law enforcement and national security officials identify who is behind U.S. companies.
“This repeal would turn the United States back into one of the easiest places in the world to set up anonymous shell companies, something Congress worked for years to fix,” said Erica Hanichak, deputy director of the FACT Coalition, in a statement. “These entities are routinely used to facilitate corruption, financial crime, and abuse. Rolling back the CTA doesn’t just weaken transparency, it signals to bad actors around the world that the U.S. is once again open for illicit business.”
The Internal Revenue Service rarely penalizes taxpayers who have high balances in foreign bank accounts and fail to file the proper forms, according to a new report.
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The
Taxpayers with specified foreign financial assets that meet a certain dollar threshold are also required to report the information to the IRS by filing Form 8938. Failure to file the form can result in penalties of up to $60,000. However, TIGTA’s previous reports have demonstrated that the IRS rarely enforces these penalties.
The IRS created an Offshore Private Banking Campaign initiative to address tax noncompliance related to taxpayers’ failure to file Form 8938 and information reporting associated with offshore banking accounts, but it’s had limited success.
Even though the initiative identified hundreds of individual taxpayers with significant foreign bank account deposits who failed to file Forms 8938, the campaign only resulted in relatively few taxpayer examinations and a small number of nonfiling penalties. The campaign identified 405 taxpayers with significant foreign account balances who appeared to be noncompliant with their FATCA reporting requirements.
The IRS used two ways to address the 405 noncompliant taxpayers: referral for examinations and the issuance of letters to them.
- 164 taxpayers (who had an average unreported foreign account balance of $1.3 billion) were referred for possible examination, but only 12 of the 164 were examined, with five having $39.7 million in additional tax and $80,000 in penalties assessed.
- 241 noncompliant taxpayers (who had an average unreported account balance of $377 million) received a combination of 225 educational letters (requiring no response from the taxpayers) and 16 soft letters (requiring taxpayers to respond). None of the 241 taxpayers were assessed the initial $10,000 FATCA nonfiling penalty.
“While taxpayers can hold offshore banking accounts for a number of legitimate reasons, some taxpayers have also used them to hide income and evade taxes,” said the report.
Significant assets and income are factors considered by the IRS when assessing whether taxpayers intentionally evaded their tax responsibilities, the report noted. Given the large size of the average unreported foreign account balances, these taxpayers probably have higher levels of sophistication and an awareness of their obligation to comply with the law.
TIGTA believes the IRS needs to establish specific performance measures to determine the effectiveness of the FATCA program. “If the IRS does not plan to enforce the FATCA provisions even where obvious noncompliance is identified, it should at least quantify the enforcement impact of its efforts,” said the report. “This will ensure that IRS decision makers have the information they need to determine if the FATCA program is worth the investment and improves taxpayer compliance.
TIGTA made three recommendations in the report, including revising Campaign 896 processes to include assessing FATCA failure to file penalties; assessing the viability of using Form 1099 data to identify Form 8938 nonfilers; and implementing additional performance measures to give decision makers comprehensive information about the effectiveness of the FATCA program. The IRS disagreed with two of TIGTA’s recommendations and partially agreed with the remaining recommendation. IRS officials didn’t agree to assess penalties in Campaign 896 or with implementing performance measures to assess the effectiveness of the FATCA program.
“From our perspective, TIGTA’s conclusions regarding IRS Campaign 896 are based, in part, on a misguided premise and overgeneralizations, including the treatment of ‘potential noncompliance’ as tantamount to ‘egregious noncompliance’ that warrants a monetary penalty without contemplating the variety of justifications that may exempt a taxpayer from having to file Form 8938,” wrote Mabeline Baldwin, acting commissioner of the IRS’s Large Business and International Division, in response to the report.
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