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Helms - Buy-Sell Lessons Learned

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					                                   ADVISOR UPDATE I July 2010


                     Buy-Sell Lessons Learned
A recent Indiana court case reinforces the need to
                                                              FOR MORE INFORMATION
“close the loop” on ownership of life insurance
policies funding a buy-sell arrangement when the                        Rick Helms
need for such coverage ends.                                      RVP – Life Distrubution

                                                                       704-904-2492
Introduction
                                                                   Britnee Scharnhorst
Many buy-sell agreements use life insurance policies
                                                                   Sr. Internal Wholesaler
to fund buy-out obligations created by the death of a
business owner. Most of these policies are owned by                800-654-4278 x64962
either the business or its owners. Occasionally, they are
owned by a trust, an LLC, or a partnership. Each of
these ownership alternatives may be appropriate when
properly aligned with the overall buy-sell plan design.

A strong majority of buy-sell agreements reviewed by our Advanced Solutions Team, however, fail to
address disposition of life insurance policies acquired for purposes of the buy-sell agreement when the
buy-sell insurance need ends. A recent Indiana state court case, Hilliard v. Jacobs, 916 N.E. 2d 689,
points out the importance of providing for disposition of buy-sell life insurance policies when they are no
longer needed to fund a buy-sell arrangement.

                                        Hilliard v. Jacobs Case
In Hilliard, two business owners each owning a one-half interest in an LLC, acquired life insurance on
each other to fund a cross-purchase buy-sell agreement. Subsequently, the two owners sold their
business to a third-party. At that time, each owner held a $2,500,000 policy on the life of the other
owner.

After sale of the business was completed, Hilliard requested an exchange of policies. Jacobs refused
and continued to pay premiums on the policy he owned. Hilliard brought suit requesting that the policy
either be transferred to him or cancelled, asserting that Jacobs no longer held an insurable interest in
Hilliard’s life. The Court rebuffed this claim by indicating that Indiana law did not require the presence of
a continuing insurable interest.
It is not clear from the facts of the case if either Jacobs or Hilliard knew that Hilliard might be in poor
health. Obviously, a change in an insured’s health after a life insurance policy is originally issued may
make the policy much more valuable.

The Indiana court addressed many procedural issues raised during the case which took seven years to
resolve. Hilliard died before the case ended and his wife, in the role of testamentary trustee, was
substituted for the original plaintiff.

The narrative of the case indicates that the owners had two opportunities to address final disposition of
their life insurance policies prior to the lawsuit. Their first opportunity was the buy-sell agreement. A
second opportunity arose through a settlement agreement entered into at the time the company was
sold. The purpose of this settlement agreement was to resolve all outstanding claims between the
owners. Neither document addressed disposition of the life insurance policies they owned on each other.

                                 Suggested Best Practices for Advisors
Well-drafted buy-sell agreements should address disposition of life insurance policies when the need for
coverage ends. There are several fact patterns which eliminate the need for life insurance coverage.
Two examples are sale of the entire business to a third-party or, termination of the insured’s relationship
as a business owner for any reason such as retirement, disability, sale to a third-party, or a dispute
among owners. Death of an insured/business owner may also be an event which creates the need to
adjust life insurance policy ownership.

As indicated by the Hilliard case, it may be very important, particularly if an insured experiences a
change in health, to consider including language which gives an insured the opportunity to acquire
ownership of a life insurance policy on his or her life which was intended for buy-sell funding purposes.
Buy-sell agreement language granting such purchase rights also may be provided to family members of
the insured or a trust created by the insured for the benefit of family members. The following purchase
rights are those most often addressed:

     1.   An unrestricted right to purchase any policies on the insured’s life upon termination of his or her
          ownership interest in the business for any reason other than death.


          Where company-owned policies are present, and the buy-sell plan design calls for the company
          to acquire or redeem an owner’s business interest, the agreement could require that any
          company-owned policies be transferred to the departing owner as partial payment for his or her
          business interest.

     2.   An unrestricted right to purchase any policies on the insured’s life before such policies may be
          surrendered for their cash value, sold, or otherwise conveyed by the company or other business
          owners, to anyone other than the insured.

     3.   An unrestricted right to purchase any policies on the insured’s life upon the death of the policy
          owner.

Policy transfers under any of the above provisions should be carefully reviewed for potential violations of
the transfer for value rule. Under this rule, transfers for valuable consideration may cause taxation of
death proceeds in excess of cost basis as ordinary income. Certain exceptions to the rule may be
available, such as a transfer to the insured or to a trust created by the insured which is a grantor trust for
income tax purposes.

Transfers of a life insurance policy between a business and one of its owners must use the policy’s “fair
market value” to establish a monetary value for purposes of the transaction as indicated in Revenue
Procedure 2005-25. Failure to use the policy’s “fair market value” in such transactions may result in
imputed income to the business owner.

A schedule or exhibit identifying all life insurance policies acquired for buy-sell purposes should be
attached to the buy-sell agreement to avoid issues in identifying policies that are part of the buy-sell
arrangement. This schedule should also be maintained to reflect any subsequent material changes in
these policies or policy ownership, changes in company ownership, or the addition/termination of any
policies.




                                                 WE’LL GIVE YOU AN EDGE®

Principal National Life Insurance Company and Principal Life Insurance Company, Des Moines, Iowa 50392-0001, www.principal.com
                                                                                                                    ®
Principal National (except in New York) and Principal Life are issuing companies of the Principal Financial Group .
While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to
provide general information about the subject matter covered and is provided with the understanding that The Principal is not rendering
legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code.
You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and
requirements.

                               For producer and advisor information only – not for use in sales situations.
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posted:7/23/2010
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