Insurance-Only LLCs: A Versatile Option for Business Continuation Planning

Looking beyond trusteed buy-sell agreements

by James Magner, JD, CLU, ChFC

Mr. Magner, JD, CLU, ChFC, is a consultant with the Business Resource Center for Advanced Sales at The Guardian Life Insurance Company of America. Prior to joining Guardian, he was General Counsel for a national broker dealer/brokerage general agency, and previously worked as an Attorney-Advisor in the Internal Revenue Service’s Office of Chief Counsel in Washington, D.C. He can be reached at

Transition planning for multiple-owner businesses can be a delicate science, one that must take the personalities and preferences of several individuals into account when creating a business continuation agreement that is fair to all parties while remaining focused on keeping the enterprise viable. For some time, the trusteed buy-sell agreement has been the gold standard of business continuation planning, finding favor among advisors over redemption agreements, where the business is the owner and beneficiary of the life insurance policies, and cross-purchase agreements, where each business owner is the owner and beneficiary of a policy on the other business owners.

There are good reasons for this: Trusteed buy-sell agreements have many advantages, which I’ll outline below. At the same time, there have always been a few persistent questions about the efficacy of this approach, which the astute planner must consider before recommending it. Recently, another technique, the so-called ‘insurance only’ Limited Liability Company (LLC), employed for many years in wealth transfer and non-qualified fringe benefit situations- has received attention as a viable solution for many business continuation cases.

Pluses and Minuses of Trusteed Buy-Sell Agreements

Trusteed buy-sell agreements have a number of features that make them attractive, the most prominent of which is the fact that the trustee is required to purchase only one policy per business owner. In most cases, centralized management of a large block of policies is preferable to each insured having to own and maintain multiple policies on his or her partners, as with cross-purchase agreement. And, unlike redemption agreements, the Alternative Minimum Tax (AMT) typically is not an issue when life insurance is trust-owned; there also may be a degree of creditor protection afforded to the insureds from trust-owned life insurance.

Despite these advantages, for planners who like to be able to put the planning tools they implement into discrete boxes, the trusteed buy-sell agreement presents its own set of definitional challenges. Is it really a legitimate trust arrangement, with perhaps the client’s attorney or CPA acting as a trustee on behalf of the beneficiary/insureds?  Or, is it more in the nature of an escrow arrangement, with the escrow agent acting on behalf of the principal/insureds? This isn’t merely an academic question: The extent to which insureds exercise control over the trustee/escrow agent/policy owner has a direct bearing on the incidents of ownership-estate tax inclusion issue.

Trusteed buy-sell agreements come in two flavors: business-sponsored, where the entity establishes the trust for the benefit of the business owners, and individual-sponsored, where the insured/business owners establish the trust. In particular, entity-sponsored trusts can pose difficult income tax issues.

Whenever life insurance is owned by someone other than the insured in so-called third party ownership arrangements, complications arise. In the case of trusteed buy-sell agreements, cost allocation can get tricky when there are significant disparities in age and underwriting classifications. The mechanics of how premiums are funded can be another challenge, although executive bonus or split dollar arrangements usually work.

But, perhaps the most troubling aspect of working with trusteed buy-sell agreements is the fact that the transfer-for-value (TFV) issue at the first death has forced planners to either find a partnership exception to the transfer for value rule, or simply unwind the agreement after the first owner’s death and start over again. Although there is no physical transfer of the policies owned by the trustee at the first death, the deceased owner’s interest in the policies on the other owners’ lives shifts to the surviving owners pro rata, which can create a TFV problem. When one factors in lurking issues about income tax and estate tax inclusion, it makes sense to at least consider substituting insurance-only LLCs for trusteed buy-sell agreements in certain cases.

The New Kid on the Business Transition Planning Block

As I noted in the introduction, over the past ten years, special purpose, insurance-only LLCs have been used in both the wealth transfer and non-qualified fringe benefits markets. More recently applied to business continuation situations, such a vehicle will operate somewhat similarly to a trusteed buy-sell agreement, but with important differences.

The buy-sell insurance LLC involves three moving parts: 1) the LLC used to own the life insurance; 2) the actual buy-sell agreement; and 3) the operating entity. The buy-sell insurance LLC is similar to a trusteed cross-purchase arrangement in that the LLC is the applicant, owner and beneficiary of the life insurance policies.

Whenever life insurance is owned by someone other than the insured in so-called third party ownership arrangements, complications arise.

The death of an insured triggers two purchases: The LLC first redeems the membership interest from the deceased member’s estate and then, once the life insurance proceeds are allocated and distributed to the surviving members, they use the proceeds to purchase the interest the deceased owned in the operating entity. Potential AMT exposure is avoided and, so long as the LLC elects to be taxed as a partnership, all TFV issues appear to be off the table.

However, there is one important caveat: the Internal Revenue Service’s recent ‘no-rule position’ on TFV and insurance-only LLCs. It stipulates that when ‘substantially all of the organization’s assets consist or will consist of life insurance policies on the lives of the members,’ advisors may be asked to provide ‘comfort’ against IRS scrutiny. While some may speculate that the very name ‘insurance-only’ may be a red flag inviting regulatory scrutiny, thus far the IRS appears to be fair and even generous to taxpayers in its private rulings on TFV issues, finding exceptions in a variety of fact patterns.

Regarding the issue of creditor protection, it’s important to consider the policy’s cash surrender value and its death proceeds. While the insureds are alive and the policies are in the LLC, a charging order is the best remedy judgment creditors may obtain against an insured member when the LLC is domiciled in states that limit creditors to charging orders. Advisors in states that permit judicial foreclosure sales and broad charging orders may do well to recommend another vehicle for their business continuation clients. In addition, state exemption statutes, which can be all over the map, should be reviewed. While most state exemption statues provide protection against the insured’s creditors, a few exempt the death proceeds from the beneficiary’s creditors.

Here’s my final piece of advice with respect to relevant laws in your state: Once the entity is up and running, it’s important to adhere to all formalities required under state law, such as annual reports.

Now for the Nuts and Bolts

Once you’ve established that the legal and regulatory environment in your clients’ state is favorable to implementing a buy-sell insurance LLC, there are a number of nuts-and-bolts planning issues that advisors must consider, including whether it should be member-managed or manager-managed, for example, and how valuation of membership interest is spelled out in the LLC operating agreement.

And then there’s the decision on how the premiums will be paid. Although term insurance can be used as the funding vehicle, especially in those cases where the need is short-term and/or cash is scarce, permanent life insurance is usually the more appropriate choice to meet the business partners’ objectives. There are many ways paying the premium can be achieved.

If cash flow is sufficient, the business can use an executive bonus plan to pay the premiums directly to the insurance carrier. If underwriting issues result in large premium differentials, it may be preferable for records purposes to have the operating business bonus the necessary cash directly to the members to allow them to make capital contributions to the LLC.

Where the operating business is a closely-held pass-through entity, loan covenants may prevent large outflows of cash that would be required to fund an executive bonus plan. A split-dollar arrangement may be an attractive option, as the collateral assignment interest will be reflected as an asset on the entity’s balance sheet. Alternatively, an income-producing asset in the LLC's hands could generate a substantial portion of the cash flow required to pay premiums.

As with TFV issues, there is a caveat related to how the IRS defines split-dollar arrangements that should factor into any decisions related to establishing a buy-sell insurance LLC. Currently, the IRS has reserved the right to exert possible future guidance with regard to ‘life insurance contracts owned by partnerships.’ For planners looking to draw parallels between the IRS’s definitions of ‘owners’ and ‘non-owners’ on one hand, and LLCs and their members on the other, the regulations don't offer much clarity. Under the IRS's split-dollar regulations, the person named as the policy owner of the contract is deemed the owner of the contract, and a non-owner is any person, other than the owner of the contract, that has any direct or indirect interest in the contract. Although the LLC is merely ‘warehousing’ the coverage (the buy-sell provisions are typically contained in a separate document), LLC members have many premium payment options that may prevent the entity itself from being deemed a split-dollar ‘arrangement’ in the IRS’s eyes.

With their flexibility and durability ideal for many types of business continuation scenarios, insurance-only LLCs have emerged as a worthy alternative to the long-favored trusteed buy-sell agreements. However, as with all advanced planning techniques, there can be unintended legal and regulatory consequences, at both the federal and state level. Therefore, it is vitally important to engage appropriate tax and legal resources to help you make the best possible recommendation to your clients.