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Introduction

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<p><span>Introduction</span></p>

<p><span>The main priority for business owners and managers is the daily operation of their business. Such issues as sales, production, cost control, quality control, on-time delivery, customer services, employee relations, and other issues consume maximum time, mental concentration, and attention. As such, life insurance for businesses provides an invaluable benefit: it allows business owners and managers to focus on these primary concerns by managing risks and offering protection against a variety of anticipated and unexpected contingencies. For example, business insurance can protect against property and casualty losses, litigation, business interruption from natural causes, labor issues, disability, death, etc.</span></p>

<p><span>Business life insurance also ensures a successful continuation of the business and protects invested time and assets. Planning for the continuation of the business is always associated with how that business entity has been structured: is the business a sole proprietorship, a partnership, a corporation, or a limited liability company? The answer to this question dictates how the company manages risks in terms of human capital, or what will and may happen to the business, to the investors, to the employees, and to the families of the employees in the event of death. Prudent business owners and managers plan for these contingencies.</span></p>

<p><span>In light of these considerations, this course thoroughly analyzes the problems common to all of these business structures and compares the specific problems they encounter. This content is especially tailored for insurance agents, financial planners, advisors, CPAs, and other financial professionals who serve the business community as advisors.</span></p>

<p><span>The chapter summaries provided below identify the scope for this book and describe the type of information you can expect to find in each chapter:</span></p>

<p><span><strong>Chapter 1, Introduction to Business Insurance,</strong> identifies the advantages and disadvantages of the four types of business structures: sole proprietorships, partnerships, corporations, and limited liability companies.</span></p>

<p><span><strong>Chapter 2, The Sole Proprietorship,</strong> addresses specific liabilities for sole proprietorships, as well as their tax issues, factors for continuing a sole proprietorship, legal implications, and many other attributes that distinguish them from the other types of business structures.</span></p>

<p><span><strong>Chapter 3, The Partnership,</strong> identifies when and how a partnership is formed and explores the types of partnerships that can be established, the duties of partners, tax issues of partnerships, events occurring when a partner dies, and many other characteristics of partnerships.</span></p>

<p><span><strong>Chapter 4, The Corporation,</strong> describes the fundamental characteristics of corporations, including the ways in which a corporation is formed and approved, the types of corporations, property rights, liabilities, and the reasons for liquidating a corporation..</span></p>

<p><span><strong>Chapter 5, The Limited Liability Company,</strong> explains the tax implications for LLCs, the benefits in establishing a family LLC as opposed to a family limited partnership, and the LLC's effects on business planning.</span></p>

<p><span><strong>Chapter 6, Other Uses of Life Insurance in Business,</strong> discusses the advantages/disadvantages of key person insurance, split-dollar plans, Section 162 Executive Bonus plans, deferred compensation arrangements, and corporate-owned life insurance.</span></p>

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<div style="margin-left:auto;"><span>1.</span><span>1 - </span><span>Introduction to Business Insurance</span>

<p><span>A business enterprise can be operated or conducted under various structures, the selection of which the owner or owners must determine. Naturally, all forms of business structures have their own advantages and disadvantages. Therefore, it is important for the insurance or financial professional to understand the distinctions between the various business forms and the consequences of a particular business structure. This chapter introduces you to these four forms of business structures and describes their advantages and disadvantages.</span></p>

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<div><span>1.</span><span>2 - </span><span>Types of Business Structures</span>

<p><span>The four principal types of business structures are</span></p>

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<ul>

<li><span>sole proprietorships,</span></li>

<li><span>partnerships,</span></li>

<li><span>corporations, and</span></li>

<li><span>limited liability companies.</span></li>

</ul>

<p><span>Selecting one of these forms of business is one of the first decisions a business owner or owners must make. Although this decision is usually based on advice or counsel from an attorney or a CPA, each legal structure must be carefully considered to determine which structure best suits the goals and objectives of a particular business venture and the goals and objectives of its owners. Let's examine the positive and negative aspects of each structure.</span></p>

<span>The Sole Proprietorship</span>

<p><span>The sole proprietorship is the simplest, most efficient, and flexible form of business enterprise. While it is not unusual for a business to start as a sole proprietorship and then later to develop into a partnership or corporation, the sole proprietorship is nonetheless the most prevailing form of small business organizations.</span></p>

<p><span>Sole proprietorships are owned by one individual, usually the business owner, who makes all of the business decisions. Easing this process is the fact that setting up a sole proprietorship does not require much formal organizational or legal procedures.</span></p>

<span>Advantages of the Sole Proprietorship</span>

<p><span>A sole proprietorship as a business structure has the following advantages:</span></p>

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<li><span><strong>simplicity</strong>—Establishing a sole proprietorship requires less formality and fewer legal requirements. It needs little government approval or formal organizational procedures. Further, sole proprietorships are not required to get a separate tax identification number or to file separate taxes.</span></li>

<li><span><strong>sole ownership of profits</strong>—The sole proprietor is not required to share profits with anyone. This is a unique advantage when comparing the sole proprietorship to the other business structures.</span></li>

<li><span><strong>flexibility</strong>—A sole proprietor and single owner is able to make decisions quickly and to respond swiftly to business needs. New opportunities and new areas of business can be quickly acted upon, unhampered by having to consult with others.</span></li>

<li><span><strong>freedom</strong>—The simplicity of the sole proprietorship allows relative freedom from bureaucracy, government control, and special taxation issues. The sole proprietor can schedule hours of business operations as well as personal time that best suits his or her needs and objectives.</span></li>

</ul>

<span>Disadvantages of the Sole Proprietorship</span>

<p><span>Disadvantages of the sole proprietorship as a business structure are the following:</span></p>

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<li><span><strong>liability</strong>—The sole proprietor has full responsibility and complete liability for all of the obligations of the business. This includes debt, payables, and judgments.</span></li>

<li><span><strong>losses</strong>—While the sole proprietor is entitled to all of the profits, he or she must also bear all of the losses. Profits and losses are usually cyclical, and the sole proprietor must prepare in years of profit for those years of losses.</span></li>

<li><span><strong>less available capital</strong>—As a rule, the sole proprietor has less available capital and options in which capital can be obtained. The sole proprietor is likely to experience some difficulty in establishing long term financing, which may be needed to expand his or her business. Personal credit history and personal assets are always at risk in securing capital needs.</span></li>

<li><span><strong>instability</strong>—Business succession planning for the continuation of the sole proprietorship at the death of the owner is severely limited. In fact, a sole proprietorship is usually terminated at the death of the owner. In addition, unexpected contingencies and external factors have much greater impact on this form of enterprise.</span></li>

<li><span><strong>tax benefits</strong>—The sole proprietor does not enjoy some of the tax benefits that a corporation form of enterprise does, especially in the area of employee benefit planning and advanced planning strategies.</span></li>

</ul>

<span>The Partnership</span>

<p><span>By definition of the Uniform Partnership Act (UPA), a partnership is "an association of two or more persons to carry on as co-owners of a business for profit." A partnership is a contractual relationship between the persons who have combined their property, talents, labor, and skills in an enterprise for the purpose of joint profit. The concept of a partnership is very broad-it can be a syndicate, pool, joint venture, or other unincorporated organization through which any business is conducted, as long as it is not a corporation, a trust, or a sole proprietorship.</span></p>

<p><span>Following are some of the specific characteristics of a partnership.</span></p>

<span>Partnership Characteristics</span>

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<ul>

<li><span>The partnership's formation requires the participation of two or more competent parties.</span></li>

<li><span>The partnership is an unincorporated association of persons, as distinguished from a corporation.</span></li>

<li><span>The partnership is established by the voluntary contract of the parties, as distinguished from a corporation, which is created by law.</span></li>

<li><span>The partnership's capital is established by contributions from each person's property, capital, talents, labor, or skill.</span></li>

<li><span>The partnership's business is transacted by the parties as principals, each of whom is a co-owner.</span></li>

<li><span>The partnership's purpose is to "carry on" a business for the monetary gain of the members, as distinguished from charitable, educational, religious, social, or other similar purposes.</span></li>

<li><span>The partnership can have general partners, limited partners, or family partners.</span></li>

</ul>

<span>Advantages of the Partnership</span>

<p><span>The advantages to a partnership as a form of business entity are the following:</span></p>

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<li><span><strong>additional human resources</strong>—The success or failure of the partnership is not solely dependent on one single individual. The skill, talent, and labor of each partner contribute to the benefit of the partnership.</span></li>

<li><span><strong>ease of formation</strong>—Although the procedures for forming a partnership are slightly more extensive than that of forming a sole proprietorship, establishing the partnership requires less formalities and expenses when compared with the requirements for creating a corporation.</span></li>

<li><span><strong>additional sources of capital</strong>—The partnership depends on the resources of two or more individuals.</span></li>

<li><span><strong>flexibility</strong>—A partnership can be more flexible in the decision making process than a corporation.</span></li>

<li><span><strong>freedom</strong>—The partnership has relative freedom from government regulation and special taxation when compared to a corporation.</span></li>

<li><span><strong>sharing of losses</strong>—The individuals in the partnership can share losses incurred in the operation of the partnership.</span></li>

</ul>

<span>Disadvantages of the Partnership</span>

<p><span>The disadvantages to a partnership as a form of business entity are the following:</span></p>

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<li><span><strong>unlimited liability of at least one partner</strong>—A partner is responsible for the full amount of business debts, even though he or she may exceed that individual's total investment. This liability extends to all of the partner's assets, including home, auto, bank accounts, property, etc.</span></li>

<li><span><strong>instability</strong>—Eliminating a partner for any reason, voluntary or involuntary, including by death, automatically dissolves the partnership.</span></li>

<li><span><strong>funding</strong>—It is relatively difficult to obtain large sums of capital in a partnership, including long-term financing.</span></li>

<li><span><strong>binding</strong>—All of the partners are bound by the acts of the other partners.</span></li>

<li><span><strong>disposal</strong>—Disposing of the partnership interests can be difficult, especially if a specific arrangement for this purpose does not exist.</span></li>

</ul>

<span>The Corporation</span>

<p><span>A business can be operated in an unincorporated form, such as a sole proprietorship or a partnership, or the business can be operated in an incorporated form, such as a corporation. The corporation is the most complex of these three business forms, and is defined as "an artificial being, invisible, intangible, and existing only in contemplation of the law." A corporation is considered a distinct legal entity, that is, separate and apart from the individuals who own it.</span></p>

<span>Corporation Characteristics</span>

<p><span>A corporation can be characterized as "a group of one or more persons acting as a group and with vested personality by the policy of the law."</span></p>

<p><span>A unique feature of the corporation is its ability to exist for an indefinite time. Under most state statutes, a corporation must state its period of duration in its "Articles of Incorporation," but its duration can be stated as "perpetual." This is a distinct advantage over the sole proprietorship and partnership business forms. Moreover, a corporation cannot be terminated by any change, removal, or death of an owner stockholder.</span></p>

<p><span>A corporation is usually formed by the authority of the state government. Corporations that do business in more than one state must comply with each of the individual state laws, and these can vary considerably.</span></p>

<p><span>Additionally, corporations can be divided into two broad categories:</span></p>

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<li><span><strong>public</strong>—A public corporation is a governmental body, for example, a state or political subdivision of a state.</span></li>

<li><span><strong>private</strong>—A private corporation is one that is created for commerce; it can have various characteristics of distinction with regard to stock or non-stock entities, religious, charitable, etc.</span></li>

</ul>

<p><span>Corporations can elect how they want to be treated tax-wise. For example, a corporation can elect to be a non-profit; a "C" corporation; or a "Subsection S" corporation, all of which dictate their own tax status.</span></p>

<span>Advantages of the Corporation</span>

<p><span>The advantages to a corporation as a form of business entity are the following:</span></p>

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<li><span><strong>limited liability</strong>—Unless otherwise noted, the liability of the owner-stockholder is limited to his or her amount of investment. Liability can be extended in cases where the owner-stockholder exercises a guarantee to a corporate note or credit line, or in cases where the owner-stockholder may have participated in fraudulent activity.</span></li>

<li><span><strong>transfer of ownership</strong>—Ownership can be transferred without affecting the ongoing operation of the business.</span></li>

<li><span><strong>separate entity</strong>—A corporation has status and is recognized as a separate entity, separate from the stockholder owners.</span></li>

<li><span><strong>stability</strong>—A corporation is relatively permanent in the sense that it continues to exist and to conduct business in the event of disability, illness, death, or any other condition that could impact an owner-stockholder. This is not true of a sole proprietorship or a partnership form of business.</span></li>

<li><span><strong>ease of securing capital</strong>—A corporation can secure large amounts of capital by issuing stock and long-term bonds. Long-term financing can also be secured by taking advantage of corporate assets.</span></li>

<li><span><strong>centralization of management</strong>—Owner-stockholders have supervised control of centralized management when they hire officers and managers. Owner-stockholders can also serve as officers, managers, or both.</span></li>

<li><span><strong>the availability of expertise and skills</strong>-A corporation can rely upon the expertise and the skills of many people.</span></li>

</ul>

<span>Disadvantages of the Corporation</span>

<p><span>The disadvantages to a corporation as a form of business entity are the following:</span></p>

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<li><span><strong>limitations</strong>—Some activities are limited by the corporation's charter and by various state laws.</span></li>

<li><span><strong>management</strong>—A corporation has a more complex management structure than that of a sole proprietorship or partnership. Management decisions must go through a structured process.</span></li>

<li><span><strong>manipulation</strong>—Minority stockholders can sometimes be exploited.</span></li>

<li><span><strong>regulation</strong>—Corporations are extensively regulated at the state and federal levels.</span></li>

<li><span><strong>expense</strong>—Forming and maintaining a corporation have greater expenses when compared with a sole proprietorship or a partnership.</span></li>

<li><span><strong>taxation</strong>—A corporation has more taxation oversight, in which corporate income or profit are income taxed, as well as individual salaries and dividends. Even under a Subsection S election, distributions of income in the form of profits and salaries must be treated with care.</span></li>

</ul>

<span>The Limited Liability Company (LLC)</span>

<p><span>The limited liability company was first established in 1977 in the State of Wyoming and is now adopted by statute in all 50 states and the District of Columbia. This form of business offers owners the limited liability advantage that the C corporation also offers. LLCs also offer tax and management advantages as offered with a partnership. Because the state statutes are not uniform, this business form is best suited for business activity that can be confined to one or two states.</span></p>

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<span>1.</span><span>3 - </span><span>Factors Influencing the Choice of Business Structure</span>

<p><span>The major factors that must be considered when determining the business structure to best suit the needs of a particular business are</span></p>

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<li><span><strong>nature of business activity</strong>—The amount of risk and potential liability of the activity that the business will engage in.</span></li>

<li><span><strong>number of owners</strong>—A one-owner business can choose any of the business structures to set up business. However, if the business will have more than one owner, the sole proprietorship is not an option.</span></li>

<li><span><strong>capital needs</strong>—This factor is a major influence in selecting a business structure.</span></li>

<li><span><strong>ownership involvement</strong>—In selecting a business structure, the parties involved must consider in what capacity the owner(s) will be involved. Will the owners be passive and only provide working capital for an interest in ownership? Or will the owners be actively engaged in daily operations?</span></li>

<li><span><strong>size and complexity of business</strong>—Smaller, first-time businesses may begin as a sole proprietorship and then change to a partnership or corporation.</span></li>

<li><span><strong>tax bracket and income source of individual owners</strong>—New businesses may have losses in the early years of start-up. A review of these losses may be viewed by an owner as a positive inducement for taking the risk of a new business.</span></li>

<li><span><strong>federal and state income tax laws</strong>—Deciding on a business structure must consider current laws and the fact that these laws are continually changing. Certain business structures are more heavily impacted by these evolving tax laws.</span></li>

<li><span><strong>federal and state regulations</strong>—Business activity, which is to be confined to a local geographic area, may find an advantage in one form of business structure over another. A business activity that covers multiple states may prefer a different structure.</span></li>

</ul>

<p><span>As you can see, each type of business structure has its own set of concerns and implications for how a business operates. In the remaining chapters of the book, we will examine each type of business structure in detail.</span></p>

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<span>2.</span><span>1 - </span><span>The Sole Proprietorship</span>

<p><span>The sole proprietorship is the most common form of business structure. It is a one-owner unincorporated business that has specific liabilities, tax issues, factors for continuing the business, legal implications, and many other attributes distinguishing it from the other types of business structures. This chapter examines these attributes in detail. First, let’s consider how a sole proprietorship is formed.</span></p>

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<span>2.</span><span>2 - </span><span>How a Sole Proprietorship is Formed</span>

<p><span>A single owner who has the required components to operate a particular business forms the sole proprietorship. The owner must obtain any required licenses or permits; commonly the owner files the name of the business as a d/b/a, (Doing Business As:____). Filing regulations varies by state, but it is common for the name of the business to be filed with a local government office. The sole proprietorship is not required to obtain an income tax identification number (I.D. number), because all business profits and losses belong to the owner’s individual social security (income tax) number.</span></p>

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<span>2.</span><span>3 - </span><span>The Rights of a Sole Proprietor</span>

<p><span>Sole proprietors have the same rights of dominion and control over their business assets that they have over their personal assets. Business and personal assets are not separated, because sole proprietors can keep, use, destroy, sell, exchange, barter, or otherwise dispose of their property as they choose. The only exception is if these actions infringe on the rights of others or violate regulatory laws.</span></p>

<p><span>Further, establishing a sole proprietorship does not create any new property rights, consequences, or asset-ownership exchange. In a legal sense, the assets of the business remain the personal assets of the owner. Any changes made with respect to a sole proprietor’s personal property when he or she spends money for the purchase of inventory, premises, furniture, or other necessary business property, are economic or financial changes rather than legal changes of property rights.</span></p>

<p><span>The sole proprietor can establish how and when the business operates and when to be open or closed. Moreover, the sole proprietor determines his or her time off according to personal preferences or obligations, and determines the pay scale for any employees.</span></p>

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<span>2.</span><span>4 - </span><span>The Liabilities of a Sole Proprietor</span>

<p><span>Sole proprietors have many liabilities. They are personally liable for all the debts, taxes and liabilities of the business. This includes claims made against them, any claims made against employees acting within the course and scope of their employment, and any property claims made in regard to default of care and service. In addition, sole proprietors are personally liable for such things as business property leases, vehicles, lines of credit, installment debts, and any other expenses incurred in doing business. This liability belongs solely to the owner, is unlimited and unshared, and encumbers all of his or her assets.</span></p>

<p><span>In the event of the death of the sole proprietor, business liabilities and personal liabilities are the same. All property not expressly exempted by state statute can be used in the payments of all debts; business debts need not be paid from business assets, and personal debts need not be paid from personal assets. Any assets held in or attributed to the estate of the deceased sole proprietor, including that of life insurance proceeds by rights of policy ownership, are used to address all claims and liabilities.</span></p>

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<span>2.</span><span>5 - </span><span>Tax Issues of a Sole Proprietorship</span>

<p><span>In a sole proprietorship, the business does not pay taxes as an entity. Rather, the owner reports and pays taxes on the profits of the business on his or her own individual tax return. No other tax return is required. If the sole proprietor sells his or her business, the profits of the sale go directly to the sole proprietor.</span></p>

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<span>2.</span><span>6 - </span><span>The Termination of a Sole Proprietorship</span>

<p><span>The termination of a sole proprietorship can occur by a voluntary act or from causes beyond the control of the owner, such as retirement, bankruptcy, or death.</span></p>

<p><span>Sole proprietors can cease the operation of the business at any time. However, they must fulfill any outstanding commitments and must liquidate the assets of the business. They can also sell the business to someone else, to a partnership, or to a corporation. Sole proprietors can also acquire additional owners by forming a partnership or corporation.</span></p>

<p><span>In the event of the death of a sole proprietor, the sole proprietorship simply ends. It does not have a legal entity distinction separate from that of the proprietor as an individual. Sole proprietors who want their business to continue beyond death can leave the remaining assets to anyone they choose after discharging the debts and obligations of the business and personal estate. They can leave the assets to a beneficiary, who can do with the assets what he or she wishes, or they can choose to leave the business to a beneficiary with the stipulation that the business continue to operate as it had been operating.</span></p>

<span>Effects of Terminating a Sole Proprietorship</span>

<p><span>Some potential damaging effects of terminating the proprietorship upon the death of the proprietor are</span></p>

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<li><span><strong>effect on general economy</strong>—Business units such as proprietorships, partnerships, and corporations contribute to and sustain their communities. Whether the company is large or small, the economic strength of the community is weakened when a business goes out of business.</span></li>

<li><span><strong>employees</strong>—Most sole proprietorships have employees whose livelihoods depend on the business. When the business terminates, these jobs are destroyed, usually with financial loss to the employees, their families, and to the community.</span></li>

<li><span><strong>disruption of income to the family</strong>—The income of the sole proprietor depends on the profits of the business. This income provides for the proprietor’s living expenses and those of his or her family. In the event of death, this income abruptly ceases, except for the completion of any contractual obligations, which may need to be fulfilled by the proprietor’s personal representative. Further, profits no longer exist, and the flow of funds to the family is halted.</span></li>

<li><span><strong>shrinkage of assets</strong>—The personal representative has the duty to convert the assets of the estate into cash. In the event the deceased proprietor leaves a will, the personal representative must convert all personal property into cash, except for that which is specifically bequeathed or permitted by will or consented to by the heirs.</span></li>

<li><span>However, this duty, even though directed or permitted, can be accomplished only to a limited degree in many cases. A considerable amount of cash may be required to pay final expenses, taxes, executor’s fees, legal fees, probate charges, and personal and business debts. Often the personal representative must liquidate the assets of the business for cash, which usually results in severe losses. Accounts receivable typically cannot be fully collected. The forced sale of inventory is often made at reduced prices, and equipment is frequently sold at a great sacrifice. Rarely does a single buyer purchase the proprietorship business, thereby reducing these sacrificial losses. Only when the sole proprietor has established during his or her lifetime an effective plan for the continuation of his or her business can this devastation be avoided.</span></li>

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<p><span>With proper planning, the sole proprietor can create a plan for the continuation of his business, enabling him to pass along to his heirs the true value of what had been created.</span></p>

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<span>2.</span><span>7 - </span><span>The Death of a Sole Proprietor</span>

<p><span>The death of the sole proprietor creates an immediate problem in that business operations must cease entirely until the probate court appoints an administrator. Until that time, no one has the legal authority to act.</span></p>

<p><span>This sudden interruption of business continuity could become a costly period of time. Some probate courts promptly appoint a temporary administrator, giving him or her the authority to keep the proprietorship business in operation until the regular personal representative qualifies.</span></p>

<span>If the Proprietor Leaves a Will</span>

<p><span>If the proprietor leaves a valid will, his or her executor, administers the business property and obligations in accordance with the will’s terms. If the proprietor does not leave a will, an administrator is appointed to manage the affairs in accordance with applicable probate and intestate laws.</span></p>

<p><span>With or with out a will, the personal representative (executor or administrator) is required to</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span>take possession of and inventory all of the deceased proprietor’s property;</span></li>

<li><span>conserve the property;</span></li>

<li><span>convert the property into cash, excepting real property, property, property specifically bequeathed by will, and items the heirs agree to accept, unless these items are required for the payment of debts;</span></li>

<li><span>pay the debts and obligations of the deceased; and</span></li>

<li><span>distribute the remainder to those who are entitled to it.</span></li>

</ul>

<p><span>Exceptions to these rules are made under certain circumstances. Examples of such circumstances are:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span>special will provisions of the business;</span></li>

<li><span>special statutes authorizing a limited continuation of the business beyond the owner’s death; and</span></li>

<li><span>a business continuation agreement.</span></li>

</ul>

<span>If the Proprietor Does Not Leave a Will</span>

<p><span>When a person dies, his or her property, including the person’s business, must be collected. After debts, taxes, and expenses are paid, the remaining assets are distributed to the deceased’s beneficiaries stipulated in the will. However, if the deceased has not prepared a will, or if a will is determined to be invalid, the state graciously makes a will for the deceased. In either of these cases, the deceased is said to have died “in testate.” The intestacy laws of the state in which the deceased was domiciled at the time of his or her death dictate how to distribute the person’s assets; provisions are made for the spouse, children, etc. Some states may show preference to the surviving spouse, while other states may show preference to minor children.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>8 - </span><span>The Personal Representative</span>

<p><span>In most instances, when a person dies owning property of any value, including a business, it is necessary to appoint someone to administer the estate. This person, acting on behalf of the deceased, is called the personal representative. The personal representative can be an individual, a bank or trust company, an attorney, or a combination of any of these.</span></p>

<p><span>The title and the duties of the personal representative depend on the method by which this person is selected or appointed, which depends on the circumstances involved and specific state statutes. For example, if the deceased business owner does <strong>not </strong>leave a valid will, then the personal representative is appointed by the Probate Office or the Register of Wills Office in the state or county of the deceased’s residence; the state or county will have jurisdiction over the deceased’s estate. When the personal representative must be appointed, he or she is called an <strong>administrator</strong>. If the deceased business owner does have a valid will, then a person or an institution is specifically named to act on the deceased’s behalf. This named personal representative is known as the <strong>executor</strong>.</span></p>

<p><span>State statutes typically stipulate the person who can serve as the administrator for a person who dies in testate. Usually this person is the spouse or an adult child. If no one with a close relationship is available, the court can appoint someone unknown to the deceased and unfamiliar with his or her affairs. State statutes hold the personal representative to the standard of care of a “reasonable, prudent individual” under all circumstances.</span></p>

<p><span>In addition, the personal representative is required to perform all duties with discretion. He or she can hire others to do only ministerial duties, but the personal representative must act as a prudent person in both what he or she does and in whom he or she hires. In fact, the personal representative can be held accountable for hiring someone not suited for the job. Unfortunately, what seems prudent to the personal representative when performing his or her tasks is not always seen in the same light to the beneficiaries. The can cause problems for the estate as well as for the surviving business operations.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>9 - </span><span>Probate Issues</span>

<p><span>Probate means, “to prove.” The probate process</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span>is the legal activity of proving the validity of a will and the competence of the deceased to make that will;</span></li>

<li><span>refers to the procedure by which the personal representative is appointed to handle the affairs of the deceased;</span></li>

<li><span>refers to the entire process of settling an estate;</span></li>

<li><span>incorporates the legal process of changing ownership of assets that were in the name of the deceased to those who are to be the new owners of the assets according to the provisions of the will or state statutes.</span></li>

</ul>

<p> </p>

<span>2.</span><span>10 - </span><span>Ways to Transfer Property at Death</span>

<p><span>There are four ways to transfer property at death:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span>probate</span></li>

<li><span>a contractual arrangement, such as life insurance, where the promise involves a contractual provision for a named beneficiary upon death;</span></li>

<li><span>joint ownership, where upon the death of one of the joint owners, the jointly held property is passed on to the other joint owner;</span></li>

<li><span>a living trust where, during lifetime, assets are placed in the trust, with provisions of how the assets are to be administered for the benefit of the beneficiaries of the trust.</span></li>

</ol>

<p> </p>

<span>2.</span><span>11 - </span><span>Preplanning</span>

<p><span>Continuing or disposing of a sole-proprietorship as part of an estate has many complex issues. To help ease this burden and to give guidance to the personal representative, preplanning is essential. For example, the sole proprietor may have arranged to sell his or her business or may have created a business succession plan for new management. Because an active business is extremely difficult to administer, planning for the disposition of the business greatly simplifies the personal representative’s role.</span></p>

<p><span>One possibility of preplanning the disposition is to arrange for <strong>a buy and sell agreement</strong>. This agreement provides that upon the sole proprietor’s death, the buyer is obligated to purchase the business interest for a specified sum. The personal representative is then obligated to sell to the designated buyer the business interest for that specified amount. Under such an arrangement, the personal representative need only transfer the deceased’s business interest to the new owner.</span></p>

<p><span>Many other issues could arise after the death of a business owner, which also emphasize the importance of preplanning. For example, if the deceased has a valid will that provides for the business to be left to multiple beneficiaries, one of the beneficiaries may want to sell the business while the other does not. Or perhaps they all want to sell the business, but cannot agree on how to do it or cannot agree on the value of the business. Perhaps they want to operate the business, but disagree on how to proceed. If a business is to survive its owner or to provide the desired amount of cash and value to the estate, these issues must be discussed, resolved, and planned for during the lifetime of the sole proprietor as part of the business planning and estate planning process.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>12 - </span><span>Continuation of the Business</span>

<p><span>Upon the death of a sole proprietor, it is unlikely that the business will be able to continue operating. However, someone must be responsible to handle or to terminate the work in progress, to pay outstanding bills and wages, to collect outstanding receivables, and to make other decisions that involve closing the business.</span></p>

<p><span>As previously mentioned, a business is one of the most difficult assets to administer in an estate. Following are some of the areas of difficulty that the personal representative must address:</span></p>

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<p> </p>

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<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span><strong>emotional involvement</strong>—The emotional involvement of the family, employees, and customers does not lend itself to rational decision-making.</span></li>

<li><span><strong>lack of liquidity</strong>—Frequently, most of the assets are tied up in the business and cash is not available to pay expenses. In addition, credit cannot usually be extended, nor are temporary cash advances available.</span></li>

<li><span><strong>lack of marketability</strong>—Finding a viable market for the business upon the death of the sole proprietor is difficult. Business assets are generally depressed in value because of the restrictions of negotiation and time frames.</span></li>

<li><span><strong>lack of diversification</strong>—In a sole proprietorship, the business generally represents the largest asset of wealth or value in the estate.</span></li>

</ul>

<span>Continuing the Business without Authority</span>

<p><span>Upon the death of the sole proprietor, the personal representative immediately takes possession of the business assets. In some cases, the personal representative may decide to continue the operation for the benefit of the heirs or the estate without authority to do so.</span></p>

<p><span>The unauthorized continuation of a sole proprietorship business by a personal representative, especially one who is unfamiliar with the business, often results in reduced or lost estate values. The the personal representative is fully liable for these negative consequences.</span></p>

<p><span>In addition, the personal representative must make other decisions, such as whether to carry on the business (with authority to do so), to sell the business, which assets to hold or sell, what rate of return to seek on investments, and what the most prudent method is to handle all estate assets. These activities can generate complaints by heirs, and such complaints can escalate into lawsuits against the personal representative.</span></p>

<p><span>If the personal representative can be shown to have not acted reasonably or in the best interests of the estate, he or she can be held personally liable for any mistakes made in administering the deceased’s estate.</span></p>

<p><span>To make matters worse, determining whether a continuation is authorized is very difficult. For example, while personal representatives have the duty to conserve the estate’s assets, they are also penalized if they continue the business without authority; sometimes the heirs request that the personal representative continue the business and give their consent to this. However, such continuation is not considered “authorized.” Minor heirs can never consent, as they are legally incapable of giving their permission. However, if all of the heirs are of age, competent, and the consent is unanimous, then the personal representative can continue the business. If profits result, the obligation of the personal representative to turn the profits over to the heirs remains the same. However, if losses are sustained, the consenting heirs have surrendered their right to hold the personal representative liable.</span></p>

<p><span>Although the personal representative may be relieved of liability of losses to consenting heirs, he or she may still be personally liable for any obligations entered into on behalf of the business. If assets of the business are sufficient, the personal representative may use them to cover the obligations. However, if assets become exhausted, creditors could hold the personal representative liable.</span></p>

<p><span>Sometimes an heir without authority continues the business of the deceased. Even if the heir is acting in good faith and believes he or she is proceeding in the best interests of the estate, the personal representative, not the heir, is still liable for all debts of the business.</span></p>

<span>Continuing the Business with Authority</span>

<p><span>If the personal representative has obtained unanimous consent from the heirs of the estate to continue the business, then he or she is not held liable for any losses incurred while doing so.</span></p>

<p><span>In most states, authority can be granted to the personal representative to temporarily run a business. Continuation of the business under the authority of a state statute is likely to allow continuance for only as long as is necessary to finalize the affairs of the business. A written court order is the safest authority for continuing a business after the death of the sole proprietor, but it does not allow the business to be run indefinitely.</span></p>

<p><span>Some statutes allow for the continuation of a business for the purpose of its sale as a going concern during the normal period of estate administration. A few states permit an extension until the sale of the business is made, but there are qualifying guidelines. If the personal representative carries on the business beyond the term provided by the statutes, he is carrying on the business without authority and could be held liable for losses.</span></p>

<span>Paying Heirs and Creditors with Estate Assets</span>

<p><span>The next issue to examine is the priority of creditors over the heirs. Creditors of the estate are entitled to be paid out of the estate assets before the heirs are paid out of the same. To facilitate this, the personal representative must conserve the estate assets and apply them to the payment of creditor claims against the estate. If debts are unpaid to the creditors, the creditors of the continued business may hold the personal representative liable. However, when these creditors consent to the continuation of the business after the proprietor’s death, they are essentially consenting also to the creation of new debts. The estate creditors are allowing their claims to be subordinated to those of the new creditors.</span></p>

<span>Summarizing Continuation Plans</span>

<p><span>As this chapter has so far shown, the need and value of a business continuation plan is invaluable in the event of death for the owner of a sole proprietorship. The existence of a business continuation plan can help to avoid loss for the estate, the heirs, and the employees. In addition, the business continuation plan can provide for liquidity, control, and a smooth transition for the personal representative. No matter how capable and well intentioned the personal representative may be, a plan created and implemented by the business owner will function more effectively</span></p>

<p><span>Because closing a business immediately upon the death of its owner is not desirable or necessarily efficient, a plan must be in place for the continuation of the proprietorship and controllable options.</span></p>

<span>Use of Will Provisions for the Continuation of the Business</span>

<p><span>By the use of the sole proprietor’s will, he or she can authorize the continuance of the business for any of the following purposes:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span>to enable inventory of goods on hand to be sold in the ordinary course of trade instead of piecemeal (where goods auctioned or sold individually to bidders in a forced sale environment). This provision in the will authorizes the continuation of the business until the inventory, stock, or merchandise on hand can be disposed of in the ordinary course of the trade. This provision is necessary as the state statutes are exceedingly narrow regarding this issue. This provision also helps to minimize or even to avoid the losses that can follow the immediate closing of a business upon the death of the owner and the piecemeal selling of inventory. However, this provision does not create the most desirable option, because the value of both the good will and the going concern of the enterprise will be lost.</span></li>

<li><span>to afford the personal representative an opportunity to sell the business as a going concern during the normal period of estate administration. This provision directs the personal representative to continue the business until he or she can sell it as a going concern during the normal period of estate administration. While this provision is an improvement over the first option listed, it may still be unsatisfactory, because a buyer who is willing to offer an adequate price may not be found during the period of estate administration.</span></li>

<li><span>to enable the business to be sold as a going concern, regardless of whether an advantageous sale can be made during the normal period of estate administration. Sometimes the sole proprietor provides in his or her will for the continuation of the business by his or her personal representative “until the business can be advantageously sold as a going concern.” The problem with this approach is that if the sole proprietor has not made sufficient capital available to pay all taxes, administration expenses and debts, final expenses, and other estate-related costs, as well as those cash needs required due to the continuation of the business, the personal representative will have a difficult time continuing the operation of the business.</span></li>

</ul>

<p><span>Although life insurance can be used as a method of providing for these cash needs, this option should only be proposed if the sole proprietor is satisfied that no better options are available and if a personal representative is willing and competent to operate the business until it can be advantageously sold—the executor must be willing to run the business. Unfortunately, securing a competent personal representative is frequently difficult, because this person must step in at a moments notice and carry on a business that is the result of the particular abilities and personality of the deceased.</span></p>

<p><span>Even in the best of circumstances, the business may at risk of continuing at a loss. Experience and familiarity with the business operations do not eliminate that risk, because other numerous factors can affect a business that a personal representative may not be able to control.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span>to keep the business in tact and to provide a source of income until a member of the family can take it over. The sole proprietor may want to leave his business to a child or children. Moreover, he or she could provide in his or her will that the personal representative continue the business until it can be turned over to the child or children. Many hazards are involved in such a provision.</span></li>

</ul>

<p><span>To enable the personal representative to hold the business assets in tact during the period of administration of the estate and to continue the business successfully, the sole proprietor must provide sufficient capital available to pay all taxes, administration expenses and debts, final expenses, and other estate-related costs, and must provide those cash needs required for the continuation of the business.</span></p>

<p><span>In addition to selecting a competent personal representative who is willing to stay on the job as an operating trustee, possibly over a period of years, the sole proprietor must also select a contingent trustee who is equally competent and is willing to step in without prior notice and continue the business in the event of the death, disqualification, or renunciation of the original executor.</span></p>

<p><span>In most situations of this type, the time between the death of the sole proprietor and the time when the business can be turned over to the designated child or children could be several years. Nonetheless, the personal representative must run the business successfully over a period of time to turn over anything of value. Further, the risk of business evolution and change must be contemplated when considering such a provision. These changes may render the business’s product or service inefficient or outdated.</span></p>

<p><span>Yet another hazard in making a will provision to continue a business until a relative can assume operations is that under the estate laws of most states, a surviving spouse is entitled to a specific minimum share of the deceased’s estate. If a lesser portion is given to the spouse in the will, the spouse can “elect against the will” to receive the full share of the estate, despite the provisions of the will. This right cannot be denied, unless the surviving spouse has formally waived the right.</span></p>

<p><span>For example, a sole proprietor with a wife, a son, and a daughter would probably not want to leave the business, which could represent the bulk of his estate, to his son at the expense of his wife and daughter. Even though this arrangement meets only the minimum requirements of the estate law, it could happen.</span></p>

<p><span>A better option is if this sole proprietor considered purchasing additional assets, such as life insurance, to equalize the allocation of estate assets. In most states, however, life insurance proceeds to a surviving spouse are not counted in calculating the minimum share of the deceased’s property to which the spouse is legally entitled. The surviving spouse must waive statutory rights as part of such a plan, or the insurance proceeds he or she stands to receive must be made payable to the sole proprietor’s estate.</span></p>

<p><span>A more elaborate arrangement could be added to the plan, including the creation of a living insurance trust. With a living insurance trust, an irrevocable life insurance trust (ILIT) is created and is executed immediately. The insurance policy is owned by and is payable to the trust, and the amount of the policy is equal to the value of the sole proprietorship business. In addition, a testamentary trust must be a part of the plan. The will provides for the continuation of the business by the executor under the testamentary trust until the child is ready to take over the business. Until that time, the net income from the business and from the insurance trust is paid to the members of the family according to the stipulations of the will and trust documents.</span></p>

<p><span>When the child is ready to take over the business, the trustee transfers it to him or her. At this point, the insurance trust can be terminated, with the funds divided between the surviving spouse and the other children, or the trust can be continued for their benefit. These documents must be drawn to include alternative provisions for disposing of the business in the event that</span></p>

<ul>

<li>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span>it cannot be operated profitably;</span></li>

<li><span>the child that was to receive the business dies; or</span></li>

<li><span>the child decides to pursue a different career.</span></li>

</ul>

</li>

</ul>

<p><span>By using suitable will provisions, an insurable sole proprietor can distribute equal values of the assets by purchasing an appropriate amount of life insurance while at the same time preserving the legacy of his or her business.</span></p>

<p><span>The success of such a plan ultimately depends upon the ability of the personal representative to conduct the business in a profitable manner between the time of death of the sole proprietor and the time when the heir(s) can assume the operations of the business. Unfortunately, sole proprietors often delegate this complex task to someone who lacks the necessary ability or experience. Even an otherwise competent person can prove to be an amateur in a particular business. A plan of this nature should only be entrusted to a professional trustee or to an individual who possesses the necessary qualifications and who is willing to assume the responsibility. Even when such a person can be found, he or she is subject to the personal risks of death and disability over time. To offset this risk, a professional corporate trustee can be used.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span>to allow the personal representative to use his or her discretion in disposing of the business given the circumstances. By making such a provision in his or her will, the sole proprietor must carefully describe the assets that are held in the bequest. He or she must state whether the personal representative is to pay the business debts from these assets. Preferably, life insurance should be provided to pay these debtors, as well as other obligations of the estate.</span></li>

</ul>

<p><span>Moreover, the sole proprietor must make certain that this provision of his or her will cannot be circumvented by other beneficiaries of the estate. To satisfy the legal requirements of minimum estate share distribution, the sole proprietor should secure sufficient additional life insurance for his or her spouse. He or she must also make sure that creditors will not circumvent this provision of the will, which can erode estate assets if not properly documented and if proper life insurance funding is not provided.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>13 - </span><span>Disposing of the Business</span>

<p><span>Better solutions exist for disposing of the business in the event of the sole proprietor’s death. These solutions are the living trust and selling the business, which are described in the following sections.</span></p>

<span>Using a Living Trust</span>

<p><span>A revocable living trust document may be changed or revoked by the sole proprietor at any time. The agreement allows the sole proprietor, during his lifetime, to familiarize the trustee with the operations of the business. It has the added advantage of relieving the sole proprietor of some of the burdens of sole management.</span></p>

<p><span>However, if the arrangement is going to be in effect for any length of time, there may be difficulty in finding a trustee capable and willing. A corporate trust may be engaged, but these often require that the business be incorporated. Trustee fees are significant consideration, and a trustee may insist on very broad powers.</span></p>

<span>Selling the Business</span>

<p><span>Issues to consider when the sole proprietor decides to sell the business are the following:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

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<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span>What is the overall financial condition of the business?</span></li>

<li><span>What is the condition of the physical assets of the business, and do they need repair or replacement?</span></li>

<li><span>What are the current and potential liabilities of the business?</span></li>

<li><span>Can the direction of the business be controlled?</span></li>

<li><span>Can the business survive under someone else’s direction?</span></li>

<li><span>Is there reliable management, such as a manager or other employees, who can step in and replace the owner?</span></li>

<li><span>How is the value of the business impacted if the sole proprietor were no longer running the business?</span></li>

<li><span>Can the business be sold, and to whom, and at what price?</span></li>

<li><span>How will current economic conditions affect the price of the business?</span></li>

</ul>

<span>The Buy-Sell Agreement</span>

<p><span>Sole proprietors can arrange to sell their business from their estate to a designated buyer with a buy-sell agreement. A buy-sell agreement is a binding contract for the buyer to purchase the business as a “going concern” and is triggered upon the death of the sole proprietor or some other event, such as retirement, as stated in the agreement. Upon the death of the sole proprietor, the buy-sell agreement obligates the buyer to purchase the business from the estate, and requires the estate to sell the business to that buyer.</span></p>

<p><span>In this sense, a buy-sell agreement between a sole proprietor and the person who buy’s the business upon the sole proprietor’s death establishes a pre-arranged market for the business. To be valid, the buy-sell agreement must contain an agreed upon price or a definite formula for valuation. This formula is then applied at the time of the sole proprietor’s death to determine the price for the buy-sell agreement. Further, the agreement must ensure that the purchaser has the money to pay the price in full or nearly in full at the sole proprietor’s death.</span></p>

<p><span>Therefore, preplanning requires a search for a logical successor to the sole proprietorship business. When this person or entity is found, a buy-sell agreement can be arranged. Without a pre-arranged plan, the business that a sole proprietor has worked so hard to establish will likely close its doors, be exposed to losses, or suffer diminished value in the event of the sole proprietor’s death. In the due course of administering the estate, assets are typically sold for only a fraction of their former worth, when they were assets of a profitable and going concern. Even with the best of intentions, if the sole proprietor provides in his or her will for the continuance of the business until it can be sold as a going concern, problems are often encountered before a buyer can be located.</span></p>

<span>Benefits of the Buy-Sell Agreement</span>

<p><span>By using a buy-sell arrangement, the business continues uninterrupted, which benefits the buyer, the heirs of the estate, and the community. For example, through a buy-sell agreement, the buyer acquires the sole proprietorship as an actively operating business. When the buy-sell agreement is properly arranged, it includes financing the purchase price; the sole proprietor’s estate receives the full value of the business in cash. The buyer can therefore afford to pay its going concern value. Consequently, the deceased sole proprietor’s estate suffers no losses because of forced liquidation.</span></p>

<p><span>Upon the sale of the sole proprietorship, taxes are due, and the balance can be placed in investments that are suitable for the surviving spouse and children.</span></p>

<span>Parties to the Buy-Sell Agreement</span>

<p><span>The most likely place to begin looking for a prospective buyer for a sole proprietorship is among the current employees of the sole proprietorship. Typically, one or more individuals have the ability and ambition, are familiar with the business, and may have already wondered what would happen to them, their jobs, and their families in the event the owner dies. Perhaps an employee or employees would welcome the opportunity to become the successor to the business.</span></p>

<p><span>In the case of small business operations where the sole proprietor may not have an employee who is capable or willing to succeed him or her, the sole proprietor may have to search elsewhere to find such a person and bring this person into the business. Discussing such arrangements with other business owners may be advantageous for the sole proprietor in some circumstances. These potential buyers could be competitors, vendors, or businesses that see the benefit of expanding their products or services through such an arrangement.</span></p>

<p><span>Sometimes buy-sell agreements are arranged between family members. The Internal Revenue Service very closely scrutinizes these arrangements to determine if they are actually bona fide business agreements or whether they are simply designed to transfer ownership of the property to family members for less than a fair valuation. Legislation has been enacted to prevent these interfamily arrangements when they are designed to pass business wealth through artificially low price valuations, or through impractical terms in the agreement.</span></p>

<p><span>Generally, a buy-sell agreement carries no weight in setting the tax value for transfer tax purposes between family members. For a buy-sell arrangement to qualify as a bona fide agreement between family members, the IRS specifies the following three requirements:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span>The agreement must be part of a bona fide business arrangement.</span></li>

<li><span>The agreement must not be a device to transfer the property to members of the deceased’s family for less than full and adequate consideration in money.</span></li>

<li><span>The terms of the agreement must be comparable to similar arrangements entered into by persons in other transactions. This is sometimes referred to as an “at arms length” transaction.</span></li>

</ol>

<span>Contents of the Buy-Sell Agreement</span>

<p><span>A competent attorney must create the buy-sell agreement, which has the following three elements:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span>The sole proprietor binds his or her estate to sell the enterprise to the purchaser upon the sole proprietor’s death. Likewise, the purchaser binds himself or herself to buy the business upon the death of the sole proprietor.</span></li>

<li><span>A life insurance policy is described as part of the agreement. The amount of the death benefit represents the predetermined value of the business.</span></li>

<li><span>The sole proprietor binds himself or herself to provide a “first right of refusal” to the purchaser should the sole proprietor determine to sell his or her business while living. This event may be triggered by illness, disability, or retirement. The arrangement for purchase can be negotiated or established, and can include terms of financing or payments. This provision is designed to protect the purchaser.</span></li>

</ol>

<p><span>Naturally, no two agreements for the purchase and sale of a sole proprietorship are exactly alike. However, in addition to the three elements stated previously, some common components of an agreement are</span></p>

<p> </p>

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<ul>

<li><span>a specific formula for valuating the business at the time of the sole proprietor’s death;</span></li>

<li><span>an agreement concerning the assets and liabilities of the business;</span></li>

<li><span>the purchaser’s commitment to purchase and maintain life insurance on the life of the sole proprietor to finance the purchase of the business;</span></li>

<li><span>a commitment that the purchaser will assume all business debts, or a portion thereof;</span></li>

<li><span>a provision for the ownership and control of the life insurance policy;</span></li>

<li><span>a commitment for the time and manner of paying any balance of the purchase price that exceeds the amount of the insurance proceeds, and a commitment to dispose of any insurance proceeds that exceed the purchase price. Both provisions anticipate a possible change in the price of the business upon valuation by formula;</span></li>

<li><span>a provision for disposal of the life insurance policy if the agreement is terminated during the lifetime of the parties or upon the death of the purchaser;</span></li>

<li><span>a granting of power of attorney to the purchaser by the sole proprietor to continue the business without interruption; and</span></li>

<li><span>provisions for altering, amending, or terminating the agreement.</span></li>

</ul>

<span>Validity of the Buy-Sell Agreement</span>

<p><span>Courts compel performance of the buy-sell agreement. For example, the parties are required to purchase and sell the business when a buy-sell contract is in force according to the terms of the contract; the non-performing party cannot simply pay a judgment for monetary damages for breach of contract.</span></p>

<span>Financing the Buy-Sell Agreement</span>

<p><span>The purchaser can carry life insurance on the life of the sole proprietor in the amount of the purchase price of the business. This assures all parties of the agreement that the cash needed to fulfill the obligations will be available when needed. Life insurance is also the most convenient and practical method of financing the purchase. Other methods of financing the business are not as practical or efficient. For example, rarely does an employee or a prospective buyer have the sufficient capital to pay cash for the business at the exact time of the sole proprietor’s death. Excluding the use of life insurance, the following three other methods are often used to finance the purchase of the business:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span>using savings to pay the purchase price;</span></li>

<li><span>paying the purchase price in installments over time after the death of the sole proprietor;</span></li>

<li><span>borrowing the money at the time of death of the sole proprietor.</span></li>

</ol>

<p><span>The obvious problem with using savings to pay for the purchase price is that the time of death of the sole proprietor is an unknown. Because death is an uncontrolled event, the buyer has no guarantee that the required funds will be available when needed.</span></p>

<p><span>Through life insurance, the premium payments become a method of saving for the purchase price. The advantage is that an untimely death is unlikely to occur and to disrupt the savings process. The effect of this type of financing arrangement is essentially to establish an advance installment plan to pay for the purchase price. The premiums can be semi-annual, quarterly, or even monthly payments. These installment payments stop at the death of the sole proprietor, when the financing plan becomes completed.</span></p>

<p><span>Using this advanced method of financing the purchase price compound interest favors the purchaser, because he or she is purchasing, in effect, a large capital asset of death benefit proceeds for pennies on the dollar. Conversely, using a purchase arrangement sometimes calls for installment payments after the sole proprietor dies; this arrangement has compound interest essentially working against the purchaser. The purchaser is, in effect, paying more than the purchase price of the business because of the added interest in the installment agreement.</span></p>

<p><span>Installment arrangements also jeopardize the estate, because making installment payments on the estate depends on the capability of the new business owner to continue the business profitably. This prospect is even more difficult, because the purchaser has increased his or her expenditures with the new debt obligation of these payments.</span></p>

<p><span>The only completely satisfactory method of financing the buy-sell agreement is when the purchaser carries life insurance on the life of the sole proprietor. This arrangement guarantees that the sole proprietor’s estate receives the full value for the business in cash upon the death of the sole proprietor. From the sole proprietor’s perspective, an enormously complex estate problem has been solved. From the purchaser’s perspective, upon the death of the sole proprietor, the purchase price is due. This automatically cancels all future installment payments and places the required funds into the purchaser’s hands.</span></p>

<span>Benefits of the Insured Buy-Sell Agreement</span>

<p><span>Financing a buy-sell agreement with life insurance has many benefits for all parties involved. First, for the purchaser, the future capital requirements are ensured. If the purchaser is an employee or group of employees, funding the buy-sell agreement with life insurance ensures that the business continues operations, that the employees have a job, and that the purchaser has ownership of a going business.</span></p>

<p><span>Although the primary objectives of an insured buy-sell agreement are realized at the death of the sole proprietor, the following are other advantages that emerge during the sole proprietor’s lifetime:</span></p>

<p> </p>

<p><strong>corporation</strong></p>

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<p> </p>

<p> </p>

<ul>

<li><span><strong>Business is stabilized. </strong>Because the future of the sole proprietorship has been addressed, customers and vendors may be more readily obtained and retained. Conditions for establishing vendor and operational credit lines will be more favorable. Moreover, employees are likely to feel more secure and to contribute at a higher level to a stable organization. All these features can add profitability to existing business operations.</span></li>

<li><span><strong>A savings medium provided to the purchaser. </strong>Each premium payment represents an investment immediately put to work for the purchaser at compound interest. The life insurance has a cash value component that increases with each premium paid.</span></li>

<li><span><strong>The sole proprietor’s burden is relieved. </strong>If the purchaser in the buy-sell agreement is an employee or group of employees, they will be more unlikely to leave the business or to establish a competing business. Further, they will likely be more eager to assume additional responsibilities in the operations of the business. This allows the sole proprietor to focus on other business-related matters or to slow down in his or her business activities without sacrificing business responsibilities.</span></li>

</ul>

<p><span>Benefits for the <strong>heirs </strong>of the estate are the following:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span><strong>The estate receives payment for the full value of the sole proprietorship.</strong>Using the insured buy-sell agreement guarantees that the estate receives the full value of the sole proprietorship, in cash, immediately after the death of the sole proprietor.</span></li>

<li><span><strong>The estate can be settled promptly. </strong>With an insured buy-sell agreement, the sole proprietorship is quickly disposed of for its full value. Then the personal representative can administer the balance of the estate promptly, efficiently, and economically. Further, by establishing the value of the business, the estate can be settled promptly. Cases are common where estate settlements stretch for 5 to 8 years because of an IRS challenge that is less than $100.</span></li>

<li><span><strong>The surviving heirs are relieved of business worries. </strong>The surviving spouse and children are protected under an insured buy-sell agreement. They need not depend on the personal representative to get the highest value for business-related assets, nor must they depend on the new owner to provide future income to the family.</span></li>

</ul>

<span>Provisions in the Buy-Sell Agreement</span>

<p><span>Each sole proprietorship differs from every other; therefore, each buy-sell agreement must be adapted to fit a particular situation. However, certain elements and provisions must be present in all insured buy-sell agreements, which are</span></p>

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<p> </p>

<ul>

<li><span><strong>the parties to the agreement</strong>—The necessary parties are the sole proprietor and the purchaser. Sometimes a trustee who is an impartial third party acts as custodian and beneficiary of the life insurance policies during the lifetime of the sole proprietor. The trustee’s responsibility is to supervise the purchase of the business upon the sole proprietor’s death. In community property states, the spouse of the sole proprietor should be a party to this agreement.</span></li>

<li><span><strong>the purpose of the agreement</strong>—The insured buy-sell agreement should contain a statement of purpose. It should identify the sole proprietorship, identify the status of the purchaser (employee or otherwise), and state that the intent of the parties is to sell and to purchase the business upon the death of the sole proprietor, carrying the life insurance for that purpose.</span></li>

<li><span><strong>description of the assets and liabilities of the sole proprietorship</strong>—These descriptions should be accurate and sholuld carefully define the exact assets and liabilities that comprise the agreement.</span></li>

<li><span><strong>the “first-offer” commitment</strong>—The agreement should contain a provision stating that if the sole proprietor wants to dispose of the business during his or her lifetime, that he or she must first offer it to the purchaser at the contract price.</span></li>

<li><span><strong>the commitment to sell and buy</strong>—The agreement must clearly acknowledge that the estate of the deceased sole proprietor is required to sell the business at the price stipulated in the agreement, and that the purchaser is required to buy the business at that price.</span></li>

<li><span><strong>the purchase price and the valuation formula</strong>—Designating the purchase price to be paid for the business can be done in several ways. The parties must decide whether the purchase price of the business includes all or certain assets, good will, or the responsibility for debts. Sometimes the purchase price is fixed in advance, although the parties may agree to revise this figure periodically. Such revisions of price can be scheduled annually or at other specified times, such as every two or three years. The advantages of this provision are</span>

<p> </p>

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<ul>

<li><span>the amount of the purchase price must be clear and unambiguous;</span></li>

<li><span>the sole proprietor, knowing exactly how much his or her estate will receive, can plan for the welfare of his or her family; and</span></li>

<li><span>the purchaser, knowing exactly what amount is necessary for the purchase, can keep the purchase price fully insured.</span></li>

</ul>

</li>

</ul>

<p><span>Because of the changes in asset values or changes in the net worth of the business, several revisions may be necessary. A clause is typically provided stating that the price is valid for one year from the last time of valuation. If a longer period passes, then the purchase price is fixed by an alternative method.</span></p>

<p><span>In addition, a valuation formula should be specified in the agreement. A simple formula fixes the purchase price at the book value shown at the time of purchase. If the death of the sole proprietor is the triggering event for the sale, this provision should state that the book value to be used is the value as-of the date on which the sole proprietor dies, or the value as-of the date on which the last financial statement of the business was issued before the sole proprietor died. If the date of death is used, the provision should specify who is to make the audit and appraisal. Often, this provision specifies on what basis to value the various classes of property among the assets; for example, raw materials, finished goods, etc.</span></p>

<p><span>A formula can also be applied for valuing “good will.” Sometimes the agreement stipulates that good will should be determined by CPAs who are experienced in that type of business enterprise. A frequently used formula averages the net earnings over a period of years. Two items are subtracted from this figure:</span></p>

<ul>

<li>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span>the sum that represents reasonable compensation for the personal services of the sole proprietor; and</span></li>

<li><span>the reasonable percentage of the book value representing interest on the proprietor’s capital.</span></li>

</ol>

</li>

</ul>

<p><span>The resulting amount is multiplied by a stated figure, such as 3, 5, or 7, depending on the nature and stability of the business.</span></p>

<p><span>Another way of valuing a business in a buy-sell agreement is that at the sole proprietor’s death, a panel of three appraisers determines the value. One appraiser is to be appointed by the personal representative of the deceased sole proprietor, one by the purchaser, and the third by the two appraisers already appointed.</span></p>

<p><span>The formula of valuing a business should be the one best suited for the business, and it should be fully understood and agreed to by all parties.</span></p>

<p> </p>

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<ul>

<li><span><strong>the financing of the buy-sell agreement with life insurance</strong>—The agreement should contain a clause relating to the purchase and use of the life insurance policy. Often the policy is applied for after executing the buy-sell agreement or during the final draft of the agreement. Therefore, the policy is often referred to as an “attached exhibit.” In addition, the clause should state that the purpose of the policy is to provide capital for the purchase of the business, whether such capital results from the death proceeds or from the cash value. The purchaser is to be credited when the payment is made to the estate.</span></li>

<li><span><strong>provisions for adding, substituting, or withdrawing policies</strong>—As an ongoing business, the value of the sole proprietorship can change after the buy-sell agreement has been executed. Consequently, the amount of life insurance should also be changed. The agreement should provide for the addition, substitution, or withdrawal of policies by the action of all parties.</span></li>

<li><span><strong>provisions relating to business debts</strong>—Upon the death of the sole proprietor, the personal representative is held accountable for the assets of the estate. He or she must collect and conserve the assets and apply them to payment of all debts, both business and personal. The personal representative must then see that all remaining property of the estate is distributed to those who are entitled to it.</span></li>

</ul>

<p><span>If the business assets are sold on a “gross” basis to the purchaser (gross being the total value of all assets with no adjustment for debt or other encumbrances), then a provision referring to the payment of all business debts in the agreement is unnecessary. Such debts are paid by the personal representative along with all other debts of the deceased. However, if the business assets are sold on a “net” basis to the purchaser, then the buy-sell agreement must contain a provision requiring the purchaser to assume and to pay all business debts. (The net value makes the adjustment to debt and other encumbrances.) .</span></p>

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<ul>

<li><span>In either case, both the purchaser and the estate must have protection that such debts will be satisfied by the obligating party and that a release of these debts has been verified.</span></li>

<li><span><strong>provisions for uninterrupted continuance</strong>—The buy-sell agreement should provide that, upon the death of the sole proprietor, the purchaser immediately takes possession of the sole proprietorship business and continues its operations while the purchase is in process.</span></li>

</ul>

<p><span>To effect this provision, a broad power of attorney can to be used. This power of attorney gives the purchaser the power to conduct the business during the sole proprietor’s lifetime as well, if the sole proprietor’s consents. Further, the sole proprietor’s personal representative can revoke such power when the agreement is finalized or if and when the agreement fails to be completed.</span></p>

<p><span>This section of the buy-sell agreement should also state that the sole proprietor’s personal representative is “held harmless” while the purchaser is operating under the power of attorney provision. Holding the personal representative liable for the actions of the purchaser is unfair, as well as any negative impact on the business that may occur.</span></p>

<p> </p>

<p> </p>

<p> </p>

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<ul>

<li><span><strong>provisions for amending, revoking, or terminating the agreement</strong>—Events that amend, evoke, or terminate the agreement include the bankruptcy of either party, the termination of employment if the purchaser is an employee, the death of the purchaser before completing and executing the buy-sell agreement, or the sale or liquidation of the business by the sole proprietor.</span></li>

<li><span><strong>provision to bind the heirs</strong>—The buy-sell agreement must specifically bind the estate and the heirs of the deceased sole proprietor to fulfill the terms of the agreement.</span></li>

</ul>

<span>Adjustment to the Buy-Sell Agreement</span>

<p><span>In some circumstances, the amount of insurance proceeds can differ from the purchase price because of the business valuation at the time of purchase. However, the buy-sell agreement should contain provisions if this occurs. For example, if the value of the business changes when the purchaser buys the business (during the lifetime of the sole proprietor), then the valuation sets the price stipulated in the buy-sell agreement. Typically, if the business value upon the death of the sole proprietor is less than the insurance proceeds, the purchase price is the amount of the insurance proceeds. However, a provision can offer certain adjustments to the purchase price if the value of the business is much less than the insurance proceeds. A percentage range is usually stated.</span></p>

<p><span>Conversely, if the value of the business exceeds the insurance proceeds, the balance can be paid in a variety of ways. If the balance is small, the purchaser should be able to pay it in cash when the assets are transferred. But if the balance is large, payments can be established through interest-bearing notes that are secured by the assets of the business, or through personal assets of the purchaser.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>14 - </span><span>Paying Insurance Premiums</span>

<p><span>The purchaser is typically obligated to pay the premiums for the insurance that is carried on the life of the sole proprietor. This is because the purchaser receives the proceeds from the policy to pay for the business. These premium payments are often viewed as advance installment payments for the future purchase of the business. If the purchaser is an employee or group of employees, the premiums can be paid through payroll deductions, ensuring the sole proprietor that the policy is kept current.</span></p>

<p><span>In certain situations where the employee-purchaser does not earn sufficient income to pay the required premiums, the employee’s income can be increased enough so that he or she can afford to pay the premium obligations. This arrangement is desirable because an employee-purchaser is the logical party to the buy-sell agreement. Moreover, the sole proprietor and his or her heirs greatly benefit from this buy-sell arrangement, primarily because of the increased value that the employee-purchaser brings to the business.</span></p>

<p><span>The sole proprietor can also assume part of the premium payments through a split-dollar plan. A split-dollar plan requires the parties to agree on how to split or share the dividends of the policy, which are the premiums, cash values, and death benefits. Variations to a split-dollar plan are many, and the method selected should be one that best fits the situation. A split-dollar arrangement does require additional documentation—that of the split-dollar agreement. The purchaser or a trust must own the policy. In addition, care should be taken so that the maximum tax and estate advantages are secured.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>15 - </span><span>Control Over the Insurance Policies</span>

<p><span>The buy-sell agreement should specify who has ownership rights to the insurance policies during the lifetime of the sole proprietor. The purchaser should own the policy; however, certain situations require that a sole proprietor involve a trustee. If the trust is to be the owner of the policy, provisions protecting the rights and equity (cash value ownership) of the purchaser should be in place. If the sole proprietor shares the insurance policy under a split-dollar arrangement, he or she may be a collateral assignee to the policy.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>16 - </span><span>Beneficiary Arrangements</span>

<p><span>The buy-sell agreement should contain a provision for naming the beneficiary of the insurance policies. If the agreement has a third-party trustee, then the trustee is named as the beneficiary. The agreement is drawn up as a trust indenture (a binding contract of representation), and the provisions follow the general buy-sell agreement modified by the trust provisions. These provisions specify that the trustee is the beneficiary custodian of the policies. If ownership rights in the policy are given to the trustee, then the agreement outlines the conditions under which the trustee can exercise these rights.</span></p>

<p><span>When the sole proprietor dies, the trustee collects the insurance proceeds and supervises the purchase and sale of the sole proprietorship. If the sole proprietor owns the policy, then the value of the death benefit proceeds can be subject to estate taxation, even though the insurance company did not pay the proceeds directly to the estate. If a trust is not involved with the policies, then the purchaser is the logical beneficiary, as he or she is the one who created the fund. The purchaser generally retains ownership of the policy.</span></p>

<p><span>The insurance proceeds are paid to the purchaser, and he or she holds title to the proceeds. The sole proprietor’s representative, who is obligated to sell and transfer the deceased sole proprietor’s business to the purchaser, holds title to the assets of that business. Each party holds title to something of value and is obligated to exchange something of value with something of equal value from the other party.</span></p>

<p><span>If the buy-sell agreement does not have a trustee, then the sole proprietor’s estate can be designated as the beneficiary of the policy. However, this arrangement is not conducive, because it creates an imbalance between the estate and the purchaser—the estate now holds title to both the insurance proceeds and the business assets. Other problems created by this arrangement are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

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<p> </p>

<ul>

<li><span>the insurance proceeds and the assets of the business are exposed to the claims of creditors;</span></li>

<li><span>the insurance proceeds are now subject to estate taxation. Placing the insurance in a taxable status by making it payable to the estate increases the likelihood of a controversy;</span></li>

<li><span>the insurance proceeds with the assets of the business increase the value of the estate two-fold, because the asset value of the business is duplicated;</span></li>

<li><span>transfer of title of the business assets may have to occur through another document, such as a will. This creates doubt as to whether the insurance proceeds are included in the purchaser’s cost basis for the assets acquired from the deceased.</span></li>

</ul>

<p> </p>

<span>2.</span><span>17 - </span><span>Disposing of Insurance if the Agreement is Terminated</span>

<p><span>If the parties terminate the buy-sell agreement, the cash value of the policy belongs to the owner of the policy. If the purchaser is the owner of the policy, he or she can use those cash values to recover the cost of premiums by surrendering the policy. If a trust has ownership rights in the policy, provisions should allow the party who paid the premiums to use the cash values to recover premium payments.</span></p>

<p><span>The possibility always exists that the purchaser dies before the sole proprietor. In this event, the agreement automatically terminates. If the purchaser is more than one individual, such as a group of employees or an entity, provisions allow for the agreement to continue. However, if the purchaser is one individual, then the buy-sell agreement should provide that the sole proprietor can elect to purchase the insurance on his or her life from the estate of the deceased purchaser at the policy’s cash value.</span></p>

<p><span>Simultaneous with setting up the buy-sell agreement, the sole proprietor can take out an insurance policy on the life of the purchaser. The amount of the policy should be at least equal to the amount of the probable shrinkage that would occur in the value of the business upon eventual liquidation, should the purchaser die first. Using this plan, the sole proprietor purchases, owns, and pays for the insurance policy and is its beneficiary. In the event the sole proprietor dies first, the estate can use the purchaser’s life insurance as collateral for any balance due on the purchase of business assets the purchaser makes, should the value of the business exceed the insurance proceeds of the buy-sell agreement. In the event of the purchasers’ death after the buy-sell agreement has been drawn, the heirs receive the insurance proceeds as payment for any unpaid balance owed under the arrangement. Once the business has been paid for in full, the purchaser can then buy the insurance policy on his or her life for its cash value from the heirs of the deceased sole proprietor.</span></p>

<p><span>This arrangement also benefits purchasers in that when they obtain ownership of the policy on their life from the heirs of the deceased sole proprietor, they can use the policy in a new buy-sell agreement with another party, therefore protecting their heirs in the same manner. This protects purchasers if any health changes occur that could affect the rating or issuance of a policy.</span></p>

<p> </p>

<p> </p>

<span>2.</span><span>18 - </span><span>Tax Issues</span>

<p><span>With an insured buy-sell agreement, life insurance premiums are not a deductible expense to the premium payer. If the sole proprietor pays insurance premiums on behalf of an employee purchaser, then the sole proprietor can deduct the amount as wages to the employee. This amount becomes taxable income to the employee purchaser but is not deductible as premiums.</span></p>

<p><span>The Internal Revenue Code provides that life insurance proceeds are not taxable income. For estate tax purposes, the basis of a deceased’s property is its fair market value at death or on the valuation date. Therefore, the sale of capital assets of a sole proprietorship at death results in little or no taxable gain or loss.</span></p>

<p><span>However, uncollected accounts receivable of the sole proprietorship are treated as income, and they do not receive a “stepped up” basis at his or her death. (A “stepped up” basis means the asset owned by the deceased receives a new “cost” basis, which is the actual value of that asset as of the date of death.) If these accounts receivable are sold by the estate, any gain over uncovered costs is considered ordinary income to the estate. Often, the accounts receivable are purchased at a discount, allowing for the possibility of shrinkage in the collection process.</span></p>

<p><span>The federal estate law specifically states the circumstances under which life insurance proceeds are considered taxable or nontaxable to the estate of the insured. Therefore, if the insurance proceeds are nontaxable, the sole proprietorship business is generally taxed at the value stated in the buy-sell agreement. This is true if the purchaser paid for or owned the insurance and the purchaser or trustee acting for the purchaser is the beneficiary.</span></p>

<p><span>On the other hand, if the insurance is arranged in a taxable way, then the insurance proceeds must be included in the taxable estate. Ownership of the insurance, or any rights of ownership, is the deciding factor in bringing the insurance proceeds into the estate. Therefore, if the sole proprietor has any rights of ownership, the insurance proceeds are brought into the estate.</span></p>

<p><span>Should the parties terminate the buy-sell agreement, the cash value of the policy belongs to the owner of the policy. If the purchaser is the owner of the policy, he or she can use those cash values to recover the cost basis of premiums paid by surrendering the policy. If the cash values exceed the purchaser’s cost basis, he or she must pay taxes on the gain upon surrendering the policy.</span></p>

<p> </p>

<p> </p>

<p> </p>

<span>3.</span><span>1 - </span><span>The Partnership</span>

<p><span>If a person is contractually part of a partnership, then he or she must thoroughly understand all of the details and legal considerations impacting partnerships. Further, he or she must understand the problems that can arise when developing a satisfactory plan for the continuation of a partnership business.</span></p>

<p><span>This chapter begins by identifying when and how a partnership is formed and explores the types of partnerships that can be established, the duties of partners, tax issues of partnerships, events occurring when a partner dies, and many other characteristics of partnerships. By understanding the concepts in this chapter, you will have a thorough knowledge of not only what constitutes a partnership but also what the legal issues are. First, let’s begin with a simple definition.</span></p>

<p> </p>

<p> </p>

<span>3.</span><span>2 - </span><span>Defining a Partnership</span>

<p><span>The Uniform Partners Act (UPA) defines a partnership as “an association of two or more persons to carry on as co-owners of a business for profit.” However, understanding partnerships and the relationship of the partners goes far beyond this simple concept.</span></p>

<p><span>Some attributes of a partnership are the following:</span></p>

<p> </p>

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<p> </p>

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<p> </p>

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<p> </p>

<ul>

<li><span>Two or more owners.</span></li>

<li><span>The existence of a partnership is largely based on the principles of contract law.</span></li>

<li><span>A partnership is a voluntary and concentual arrangement between partners and is based on a written or verbal agreement. Anyone who has legal capacity can enter into a partnership, and the purpose of the partnership must be legal; that is, partnerships obviously cannot conduct illegal activity.</span></li>

<li><span>The principal evidence that a person is a partner in a partnership business is the receipt of a share of the profit or loss of the business.</span></li>

<li><span>Wages, annuities, interest on a loan, etc., do not constitute evidence of partnership for the individual.</span></li>

<li><span>Partnerships can be reconstituted, unlike corporations. A partnership that is reconstituted is reformed rather than dissolved at the end of the fixed term.</span></li>

</ul>

<p><span>In addition to understanding what qualifies as a partnership, recognizing a non-legitimate partnership is also important. Lawful partnerships, like any other business form, can be legitimately used to limit or to reduce tax obligations in some circumstances. However, partnerships are particularly vulnerable to being ruled invalid by the Internal Revenue Service if they are unreal or simulated relationships designed primarily to lower tax liability.</span></p>

<p><span>Those enterprises that are <strong>not </strong>arranged to make a profit do not qualify as partnerships. These organizations are termed nonprofit corporations if the business is incorporated. If the business is not incorporated, it is termed an <strong>unincorporated association</strong>. and is not a partnership. Examples of such organizations are religious, charitable, educational, scientific, civic, social, athletic and patriotic groups or clubs, and trade unions and associations.</span></p>

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<span>3.</span><span>3 - </span><span>Purpose of the Partnership</span>

<p><span>A partnership business must have an identity that it presents to the public and to the Internal Revenue Service. Some professional partnerships, such as CPA or law firms, use the last names of the partners as their partnership name. A partnership can also have two separate names. For example, the partners can use their own last names for the agreement and use a separate name to reinforce the presentation of the business. All partnerships must comply with applicable state laws with respect to the use of names.</span></p>

<p><span>In addition, the partnership agreement normally contains a short statement of the purpose of the business. Examples of such a statement are “the purpose of the Langley Partnership is to engage in the manufacture and sale of cigar boxes;” or “the purpose of the Geraci Brothers Partnership is to purchase, refurbish, and sell used furniture.” Within some limitations, a broadly stated purpose permits expanding the scope of the partnership.</span></p>

<p><span>When entering into a partnership agreement, partners should discuss their personal goals, as well as each partner’s objectives for the business. Each partner should know the other’s fears, weaknesses, and aspirations. A well-planned partnership addresses these issues in advance, hopefully eliminating future problems.</span></p>

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<span>3.</span><span>4 - </span><span>Understanding the Partnership Concept</span>

<p><span>In a partnership, the partners must make a commitment that the success of the partnership depends upon a relationship of trust and confidence. Naturally, the partners’ ability to agree on the most appropriate course of action for the business is essential.</span></p>

<p><span>Formally referring to one’s business relationship or to a business enterprise with the words “partners” or “partnership” are not legal prerequisites to forming a partnership. Simply joining with other persons and running a shared business can create a partnership. However, when these words are used, this ensures that a partnership is intended. For example, if some question exists about whether a person is an employee of a sole proprietorship or whether the person is a partner, calling him or her a partner makes this person a partner in intent.</span></p>

<p><span>Another defining characteristic of a partnership is that partners do not receive salaries; rather, they receive a percentage of the profits, often taking an agreed upon amount from the business at regular intervals, which is commonly called a draw. A draw can be taken monthly or biweekly against the yearly partnership shares. In addition to receiving a share in the profits, partners assume the same percentage of the debts and other obligations.</span></p>

<p><span>Further, partners do not necessarily have to share ownership equally. They can agree on any percentage of ownership or distribution of the profits. For example, one partner could own 40 percent of the partnership, and two others could own 30 percent each. However, in the absence of an agreement otherwise, partners do share ownership equally, regardless of the initial contributions to the partnership.</span></p>

<p><span>To avoid great difficulty in the event of a disability or death of one of the partners, a business continuation plan is essential. This is true not only for the surviving partnership, but also for the deceased partner’s family. In the absence of such a plan, the partnership is automatically dissolved. The deceased partner’s estate in entitled to receive its share of the partnership assets, and the surviving partners must finalize the partnership business. In many cases, the partnership assets must be sold to settle with the estate of the deceased partner.</span></p>

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<div style="margin-left:auto;"><span>3.</span><span>5 - </span><span>When is a Partnership Created?</span>

<p><span>The following components indicate that a partnership has been created:</span></p>

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<ul>

<li><span>the receipt, or right to receive, a share of the profits;</span></li>

<li><span>the expression of the intent to be partners;</span></li>

<li><span>the participation, or right to participate, in the control of the business;</span></li>

<li><span>the sharing, or agreeing to share, losses or liabilities; and</span></li>

<li><span>the contributing, or agreeing to contribute, money or property to the business.</span></li>

</ul>

<p><span>Sometimes confusion arises over whether a legal partner exists. These questions are answered by the intentions of the people doing business together. A partnership is a voluntary relationship, either expressed or implied, so a partner cannot be recruited against his or her will. However, the intention to be a partner <em>can </em>be implied from the circumstances. For example, if two brothers and a sister, who have no other business relationship, each inherit one-third of their father’s business, they do not automatically become partners because they never agreed to do business together. On the other hand, if the three move forward to operate the business, then they have become partners. This is so, even if no written partnership agreement exists between them.</span></p>

<p><span>Note that joining interests does not automatically create a partnership for tax purposes or otherwise. For instance, mere co-owners of a small apartment building are not necessarily partners. Even if they lease the units and share the rents, this activity does not create a partnership if they do not actively conduct a business on or with the property.</span></p>

<p><span>Further, the sharing of the expenses of a project does not automatically create a partnership or even a joint venture. If adjoining landowners dig a common ditch in order to facilitate drainage from both properties, this does not create a partnership for legal or tax purposes.</span></p>

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<div style="margin:0px auto;"><span>3.</span><span>6 - </span><span>How is a Partnership Formed?</span>

<p><span style="font-size:12pt;">A partnership is created by means of an oral or written contract between those desiring to be partners. This instrument is known as <b>Articles of Partnership</b>. A partnership should operate under written articles, although many do not.</span></p>

<p><span style="font-size:12pt;">The Articles of Partnership establish the agreement of the partners. Areas covered in this agreement typically include</span></p>

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<li><span style="font-size:12pt;">the names of the partners;</span></li>

<li><span style="font-size:12pt;">the partnership name;</span></li>

<li><span style="font-size:12pt;">the business to be conducted;</span></li>

<li><span style="font-size:12pt;">the place of business;</span></li>

<li><span style="font-size:12pt;">the contributions of each partner;</span></li>

<li><span style="font-size:12pt;">each partner’s share of the profits and losses;</span></li>

<li><span style="font-size:12pt;">each partner’s special duties;</span></li>

<li><span style="font-size:12pt;">drawing account arrangements;</span></li>

<li><span style="font-size:12pt;">bookkeeping provisions;</span></li>

<li><span style="font-size:12pt;">restrictions of authority on the partners;</span></li>

<li><span style="font-size:12pt;">provisions of settling differences;</span></li>

<li><span style="font-size:12pt;">the duration of the partnership; and</span></li>

<li><span style="font-size:12pt;">provisions for dissolving the partnership.</span></li>

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</ul>

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<div style="margin:0px;color:rgb(0,0,0);font-family:Arial, 'MS Sans Serif', sans-serif, Helvetica;font-size:medium;"><span>3.</span><span>7 - </span><span>Types of Partnerships</span>

<p><span>Naturally, partnerships can be organized for many different purposes. They can sell products or provide services, manufacture, distribute, or even operate as agents. However, professional partnerships such as those of accountants, doctors, or lawyers are subject to special partnership rules, which are set by members of their professions.</span></p>

<p><span>In addition, partnerships can take several forms. Each form of partnership affords the members various powers and subjects them to various liabilities.</span></p>

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<li><span><strong>general partnership</strong>—The general partnership is a major form of partnership principally governed by the UPA (see the next section titled “The Uniform Partnership Act (UPA)), and is one of the more simple forms of partnership. In a general partnership, all of the partners are actively involved in conducting the partnership business. Two or more partners act as co-owners of the business, regardless of whether this association is officially call a “partnership.” The partners generally determine the term (length of time) of a general partnership. If the partnership does not prepare its own partnership agreement, the rules of the UPA are applied.</span></li>

<li><span><strong>joint venture</strong>—A joint venture is an express or implied contractual arrangement in the nature of a general partnership. A joint venture is undertaken for a specific transaction and for a specific limited purpose, which is intended to be accomplished within a specific time-frame. In this respect, a joint venture is considered a “limited purpose partnership.” Examples of joint ventures are erecting a single structure, renovating one old building, or offering one series of beginning yoga lessons. Those involved in joint ventures should have a partnership agreement covering the basics of the partnership, as well as the extent of the venture, management issues, staffing issues, conflicts of interest, and tax issues.</span></li>

<li><span><strong>limited partnership</strong>—A limited partnership is a statutorily authorized entity that must be attached to an ongoing business. It is an association between two or more persons, and it has one or more general partners and one or more limited partners. In a limited partnership, the limited partner is sometimes called a “passive partner” who is not actively involved in the conduct of the partnership business.</span></li>

</ul>

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<li><span>Like the sole proprietor, the general partner in a limited partnership has personal and unlimited liability for the debts and the obligations of the business. However, the limited partner only contributes capital, and he or she has no right to participate in the management and the operation of the business. Likewise, the limited partner assumes no liability beyond his or her capital contribution. The existence of a limited partnership is not terminated by the death of a limited partner.</span></li>

</ul>

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<li><span><strong>registered limited liability partnership</strong>—A registered limited liability partnership (LLP) is a separate form of a general or a limited partnership. An LLP can be formed by filing an application with the office in the state in which it is registered. A partner in an LLP is not individually liable for debts and obligations of the partnership arising from errors, omissions, negligence, incompetence, or malfeasance committed in the course of the partnership business by another partner, unless at the time, the first partner was directly involved in that activity or knew of it. In most states, LLP registrations must be renewed annually.</span></li>

</ul>

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<span>3.</span><span>8 - </span><span>The Uniform Partnership Act (UPA)</span>

<p><span>The principles of partnership are set forth in the Uniform Partnership Act (UPA), which is a body of law that establishes basic legal rules for partnerships. In most states, the UPA standardizes the partnership law, but most states’ UPA rules can be varied to suit local conditions. Those states that have not adopted the UPA have similar statutes. However, some rules cannot be varied. For example, the UPA rule that “each partner is responsible for all debts of the partnership” cannot be altered.</span></p>

<p><span>The UPA partnership rules are not a requirement for forming a partnership, but all partnerships should have a formal written partnership agreement. In the absence of a written agreement, an oral contract is satisfactory. However, most legal professionals strongly recommend that a written partnership agreement be in place.</span></p>

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<span>3.</span><span>9 - </span><span>The Partnership Agreement</span>

<p><span>The purpose of a partnership agreement is to tailor the agreement between the partners to suit their particular needs and objectives. The rules of an agreement can be varied by an express statement in the partnership agreement. Even if the partners know their state’s UPA rules and decide they want to use them, it is not wise to rely solely on the UPA to define key clauses in any partnership agreement. These clauses should be created by the partners, and this decision should be explicitly expressed in the partnership agreement.</span></p>

<p><span>This agreement stipulates the rights, management, and ownership interests of the partners. A partnership agreement can be as simple or as complex as the business situation dictates. Although Articles of Partnership are not specifically required by the UPA, written partnership agreements are suggested. As identified in a previous section of this chapter, Articles of Partnership state the financial, material, and managerial contributions by the partners into the business and the roles of the partners in the business relationship.</span></p>

<p><span>A well-drafted partnership agreement should be written clearly and should be free of any confusing legal jargon. Further, the agreement should clearly express decisions that the partners have made to meet their needs.</span></p>

<p><span>Legally, the partnership begins whenever the partners agree that it does. In some circumstances, partnerships can be based on an oral agreement. It can even be implied from the circumstances. However, the best approach to a partnership agreement is a written one.</span></p>

<p><span>Eventually, one or more of the partners may want or be forced to discontinue his or her interest in the partnership. This can occur upon the death of one of the partners. Ideally, this event should be planned for in advance in the partnership agreement.</span></p>

<p><span>In addition to establishing the rules of governing the partnership during its existence, the partnership agreement should establish the basics of what will happen if the partnership ends. This issue must be addressed at the time the partnership is formed, not after the death or disability of one of the partners.</span></p>

<p><span>Although creating the perfect partnership agreement does not have a prescribed legal formula, a partnership lawyer can assist the partners and suggest possible solutions to any concerns. The lawyer cannot, however, make basic decisions for the partners, such as what happens when the partnership ends—a partnership agreement must address the real needs and concerns of the partners and the partnership.</span></p>

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<span>3.</span><span>10 - </span><span>The Partnership and Property Rights</span>

<p><span>The partnership method of conducting business is accompanied by specific property rights. (“Property rights” here refer to the ownership interest in the partnership as a business, which is not the same as property owned by the partnership.)</span></p>

<p><span>In a partnership, no partner can assign his or her individual share of ownership—only a creditor of the firm can attach individual ownership rights. While a partner cannot assign “ownership” to another party, he or she can assign an “interest” to another party, which allows that party to receive distributions, etc. (but no ownership rights). Hence, partners can assign their interest to subordinate a loan, for example. The ownership portion of a partnership as an asset has restrictions that are unique to the partnership structure and cannot be viewed as any other asset.</span></p>

<p><span>A working knowledge of these partnership rights is essential for partners to clearly understand the partnership concept and the need for creating a business continuation plan.</span></p>

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<span>3.</span><span>11 - </span><span>The Partnership and Liabilities</span>

<p><span>A partnership implies the unlimited personal liability of each partner. This is a fundamental principle of a partnership. Each partner is personally liable for all partnership debts and obligations that cannot be paid by the partnership itself.</span></p>

<p><span>This rule is provided by the UPA, and this rule cannot be changed. So, partners, as well as the partnership itself, are personally and individually liable for all of the legal obligations of the partnership.</span></p>

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<span>3.</span><span>12 - </span><span>Interests in the Partnership</span>

<p><span>In addition to property rights in partnership assets, each partner owns partnership interest. Partnership interest consists of a partner’s share of the profits and surplus. It is considered intangible personal property.</span></p>

<p><span>Under the UPA, a partnership interest is assignable (see next section for definition), but the assignment itself does not dissolve the firm. Further, the assignee does not actually become a partner. The assignee does not have the right to interfere in the management of the business. Likewise, the assignee does not have the right to information about the partnership’s affairs. However, the assignee is entitled to receive the profits that the assignor would have received. Further, if the assignment makes such provisions, the assignee can receive the assignor’s share of the profits and surplus upon the dissolution, accounting, and ”winding up” of the partnership.</span></p>

<p><span>In the event of a partner’s death, the partnership interest goes to an executor or administrator who is entitled to receive its value in cash as the deceased’s share, which is distributed to the heirs.</span></p>

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<span>3.</span><span>13 - </span><span>Express, Implied, and Apparent Authority</span>

<p><span>Two types of authority are conveyed to partners: (1) express authority actually bestowed upon a partner, and (2) implied actual authority. Express authority can be stated in the partnership agreement, or it can simply originate from the decisions made by a majority of the partners.</span></p>

<p><span>Implied actual authority includes authority that is neither expressly granted nor expressly denied; rather, it is reasonably deduced from the nature of the partnership.</span></p>

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<span>3.</span><span>14 - </span><span>The Duties of the Partners</span>

<p><span>Partners are considered fiduciaries to each other. The fiduciary relationship between partners means that each partner owes complete loyalty to the partnership. He or she may not engage in any activity that conflicts with the interest of the partnership. Further, each partner owes the duty of good faith and utmost loyalty to the other partners. This rule of uncompromising fidelity is supreme. The fiduciary relationship exists based upon the high standard of trust and reliance that the partners must expect from one another. Honesty and integrity are the most important requirements of a partnership.</span></p>

<p><span>The fiduciary ties between the partners are the ties that bind the partnership. This, of course, is essential to the long-term success of a partnership. If the partnership is unsuccessful, the surviving partners will have little or nothing for their families in the event a partner dies.</span></p>

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<span>3.</span><span>15 - </span><span>Prohibited Actions of a Partner</span>

<p><span>Just as a partner is obligated to perform certain duties for the partnership, partners also are legally prohibited from doing certain things. For example,</span></p>

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<li><span>a partner cannot refuse to disclose material facts affecting the partnership business to the other partners;</span></li>

<li><span>a partner cannot secretly obtain for himself or herself an opportunity that is available to the partnership;</span></li>

<li><span>partners cannot fail to distribute partnership profits to other members of the partnership; and</span></li>

<li><span>partnership assets cannot be diverted for one partner’s personal use.</span></li>

</ul>

<p><span>According to recent rulings of the courts, even those who have seriously discussed a partnership must adhere to the same standards of good faith that bind partners. This is true even if those involved do not actually participate in a partnership agreement.</span></p>

<p><span>For example, suppose two people seriously plan to open a shoe repair business, and they locate the perfect storefront. For one person to lease the store first as a sole proprietor and engage in the business alone, cutting the other out of the arrangement, is a breach of fiduciary duty.</span></p>

<p><span>Precisely when the partner-like responsibility begins is not completely clear. However, some fiduciary duties of trust exist when negotiations are involved.</span></p>

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<span>3.</span><span>16 - </span><span>The Continuity of the Life of a Partnership</span>

<p><span>Naturally, a plan that ensures the continuation of the partnership business is essential if the partnership business can no longer continue to operate. Certain withdrawal events prompt the need for dissolving, “winding up,” or terminating the partnership.</span></p>

<p><span>Withdrawal events are</span></p>

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<li><span>when the partnership receives notice of a partner’s election to withdraw;</span></li>

<li><span>when a partner is ejected from the partnership by partner vote or by judicial decree;</span></li>

<li><span>a partner declares bankruptcy; and</span></li>

<li><span>a partner dies.</span></li>

</ul>

<p><span>When one of these events triggers the decision to end a partnership, any existing partnership business should be completed as quickly as possible. From a legal perspective, ending a partnership business involves three stages: (1) dissolving, (2) “winding up,” and (3) terminating. These stages are discussed in detail in the section “What Happens to a Partnership After the Death of a Partner?” later in this chapter.</span></p>

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<span>3.</span><span>17 - </span><span>The Legal Relationship among Partners</span>

<p><span>The most important decision in organizing a partnership is in selecting the partners. The relationship of the partners to each other is a consideration separate from the relationship of the partners to third parties. When entering a partnership, the partners are legally bound to certain obligations and certain rights. As long as the rights of third parties are not affected, the partners can vary their rights and obligations by agreement.</span></p>

<p><span>Although many partnership agreements specifically detail the responsibilities, duties, and restrictions on partners, this type of detail is usually not helpful, because trust is the central ingredient in any partnership. Mistrust between partners does not provide a sound basis for the partnership.</span></p>

<p><span>Furthermore, no agreements, clauses, or provisions can make up for the absence of faith and trust. If mistrust is apparent, perhaps the partners should seriously questions whether the partnership is a good idea.</span></p>

<p><span>A partner has the authority to bind the partnership (hold it accountable) by making decisions in the ordinary course of partnership business. The rights and duties of the partners between themselves are basically controlled by the terms of the partnership agreement. However, this is not true for those outside the partnership agreement. So, all the partners must explicitly trust each other.</span></p>

<p><span>A partner cannot, however, bind all the other partners, regardless of what he or she does. Many actions are prohibited by the UPA. For example, the UPA prohibits</span></p>

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<li><span>conveying a partner’s interest in any partnership property;</span></li>

<li><span>mortgaging a partnership property to a lien to cover personal debts;</span></li>

<li><span>attempting to dispose of partnership property, rather than a partner’s own interest in the partnership, through a will;</span></li>

<li><span>assigning a partnership property in trust for creditors or on the assignee’s promise to pay the debts of the partnership;</span></li>

<li><span>disposing of the “good will” of the partnership business;</span></li>

<li><span>committing any act that would make it impossible to conduct the ordinary business of the partnership; and</span></li>

<li><span>agreeing to a judgment for the other side in a lawsuit against the partnership.</span></li>

</ul>

<p><span>Even though the UPA prohibits these acts, the partnership agreement can supersede these acts with express provisions. However, regardless of what the partnership agreement states, partners in trading partnerships (those directly involved in trade, such as merchants selling a product) do have the apparent authority to borrow money or to execute loans on behalf of the partnership.</span></p>

<p><span>Non-trading partnerships include service businesses, such as dry cleaners, accounting firms, restaurants, banks, real estate enterprises, law firms, and others. Partners in non-trading partnerships do not have the apparent authority to borrow money on behalf of the partnership. In trading partnerships, if one partner is unreliable, this exposes the other partner to his or her irresponsible acts. For example, even without actual authorization, an untrustworthy partner can borrow money, leaving the other partners responsible for the loan.</span></p>

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<span>3.</span><span>18 - </span><span>Contributions to the Partnership</span>

<p><span>Naturally, a healthy respect for money is critical for a partnership business to work. Conflicts over money can consume a partnership. All prospective partners must reach an understanding of exactly how they will handle money matters. This arrangement should be specified in the partnership agreement.</span></p>

<p><span>The sum total of the money and the property the partners contribute is directed to the exclusive and permanent use in the enterprise; this sum is called partnership capital. No partner can withdraw any part of his or her capital contribution without the consent of the other partners.</span></p>

<p><span>Where profits are concerned, profits are always distinguished from capital. If the partnership agreement defines how profits are to be distributed but does not mention losses, then the UPA provides that each partner must contribute toward the losses to his or her share of profits.</span></p>

<p><span>Alternately, a partnership may decide to divide profits and losses equally based on such issues as a disproportionate monetary contribution or some special skills contributed by one partner—no formula exists for distributing profits or losses. Rather, the partners decide on who to distribute them. Moreover, the partnership can divide the profits and losses in any way that all partners agree is fair. However, these transactions must be considered when contemplating the possibility that one partner may die during the course of the partnership agreement.</span></p>

<span>Contributing Assets, Cash, or Skills/Services</span>

<p><span>The partnership requires assets to commence business, which are initially contributed by the partners. Partnership property is the sum of all of the partnership assets, including initial capital contributions.</span></p>

<p><span>In simple situations, each partner contributes cash only. Sometimes partners contribute equal amounts; sometimes they contribute unequal amounts. Regardless, if all the contributions are cash contributions, the partnership agreement should specifically state how much money each partner has contributed toward the partnership.</span></p>

<p><span>In other cases, partners may contribute no capital, instead contributing only their specific skill or some personal services. For example, two partners may decide that a third partner will receive a partner’s interest in a partnership business because of a promise to contribute needed legal expertise.</span></p>

<span>Property Contributions</span>

<p><span>Another type of contribution partners can make is property. Property contributions can be office furnishings or equipment or even the building that will house the partnership. In some instances, a partner may not want to contribute the building itself, so he or she may contribute the use of the building and lease it to the partnership.</span></p>

<p><span>Any value of property contributed to a partnership must be ascertained as well as the condition of the property contributed. The partners must agree on how to value property that a partner contributes to the partnership.</span></p>

<p><span>So what is considered a property contribution? A partner can sell, loan, lease, or rent property to the partnership, all of which are considered property contributions and are thus distinguished from capital contributions. Property contribution transactions are appropriate when, for example, one partner possesses an item that the partnership wants to use, such as an item that is too expensive for the partnership to buy.</span></p>

<span>Tracking Contributions</span>

<p><span>Tracking contributions of any type can be a complex matter. Tracking usually becomes even more complicated as the partnership progresses and acquires more assets. In the event of the death of a partner, accurate distributions must be made to surviving partners, so the accurate tracking of partners’ contributions is essential.</span></p>

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<span>3.</span><span>19 - </span><span>The Rights of the Partners</span>

<p><span>Although partners can choose for themselves certain activities within the business for which they are individually responsible or in which they can specialize, each partner has an equal voice in the managing the business.</span></p>

<p><span>Upon termination of the partnership, such as in the event of the death of a partner, each partner is entitled to be repaid his or her capital contribution to the partnership. Unless otherwise agreed, partners are not entitled to interest on this sum. However, if the return of their capital contribution is delayed, then they are entitled to interest at the legal rate from the date when their capital contribution should have been paid.</span></p>

<p><span>Additionally, each partner has the right and the full power to represent and to bind the partnership within the normal cause of business. As established earlier in this chapter, trust is the foundation of the partnership. Partners are always at risk that one partner can obligate the other partners, even if they never authorized this partner to do so. In fact, a partner can bind a partnership even when the other partners instruct him or her not to, so trust becomes a very important element in the partnership relationship.</span></p>

<p><span>For example, suppose three people are partners in a retail jewelry store, and they discuss buying an expensive assortment of watches for the upcoming Christmas season. They vote two-to-one against buying such a particularly expensive collection. Even so, the losing partner can purchase the costly collection anyway with a manufacturer who has no knowledge of the other partners’ opposition to the purchase. Because this activity is considered to be within the normal cause of business, this act binds the partnership.</span></p>

<p><span>Although the powers of any partner can be limited by means of the partnership agreement, any limits are unlikely to be binding on people outside the partnership and who have no actual knowledge of the limitations. In fact, outsiders are entitled to rely on the apparent authority of a partner. The outsiders’ relationship with the partner is determined by the customs of the particular trade or the business involved.</span></p>

<p> </p>

<p> </p>

<span>3.</span><span>20 - </span><span>Ownership of Partnership Property</span>

<p><span>The title to real estate that is purchased with partnership funds is in the name of the partnership, a partner, or in the name of a third party. However, any other property that a partnership owns is typically held in the partnership’s name. The partners are free to decide whether property used by the partnership for the partnership business is to be considered partnership property or if it is to be owned by an individual partner.</span></p>

<p><span>In some cases, such property is used only by the partnership. The property can be loaned, leased, rented, or even used free. Unless an express agreement is made to the contrary, property that is acquired with partnership funds is considered partnership property. It is important to remember this with respect to a deceased partner’s estate, wherein the choice of arrangement could unfavorably affect the estate.</span></p>

<p><span>Questions that the courts seek to answer when determining partnership property are the following:</span></p>

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<ul>

<li><span>In what name was the property purchased?</span></li>

<li><span>What was the source of funds used to buy the property?</span></li>

<li><span>Were insurance, taxes, or liens used to pay for by the property?</span></li>

<li><span>Were income or proceeds from the property treated as partnership funds?</span></li>

<li><span>Was the property used in the partnership business?</span></li>

<li><span>Was the property improved with partnership funds?</span></li>

<li><span>Was the property carried on the books of the partnership as an asset?</span></li>

<li><span>Did the partners make any admissions concerning the ownership of the property?</span></li>

</ul>

<p> </p>

<span>3.</span><span>21 - </span><span>Partners’ Liability of Partnership Debts</span>

<p><span>Even though partners are personally and individually liable for all of the legal obligations of the partnership, they are not, however, liable for the personal, non-partnership debts and obligations of the other partners.</span></p>

<p><span>In addition to debts and obligations incurred in the normal operation of the partnership business, each partner is liable for any damages that result from the negligence of another partner in the course of partnership business. Additionally, each partner is liable for damages resulting from fraud or other intentional acts committed by other partners in the ordinary course of partnership business.</span></p>

<p><span>For example, suppose three people are partners in a catering service. Two partners are wealthy, and the other one is not. The partnership has just opened and the partners have not yet procured their insurance. Driving on his way to a catering event, the poor partner hits another car and injures all of the family members in the car. The family’s lawyer sues the partnership and is awarded a considerable judgment against the business.</span></p>

<p><span>Under the circumstances, the wealthier partners are just as personally liable as the poor partner for any amount of the judgment that is unpaid by the business. That is, they are personally liable for what is left unpaid after all partnership assets have been used, so their personal property can be seized to satisfy the judgment. This can include their homes, cars, etc., depending upon what property is protected by their state’s debtors’ exemption laws.</span></p>

<p><span>Further, a <strong>silent partner</strong>, one whose membership in the partnership is not revealed to the public, is as liable for partnership debts as any other partner. However, a <strong>sub-partner </strong>is not, because a sub-partner is not legally involved with the partnership. A sub-partner is a person who makes a separate agreement with one partner to share in that partner’s profits.</span></p>

<p> </p>

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<span>3.</span><span>22 - </span><span>Public Liability of the Partnership</span>

<p><span>All traditional legal rules of responsibility apply to partnerships. For example, all partnerships must competently perform any services they provide to the public. Otherwise, the partnership can be liable for negligence on the part of the partnership in general or on the part of its employees. Competence means that a partner must use the level of professional skill, care, and diligence that generally applies to a profession or trade.</span></p>

<p><span>In committing a negligent act, the partnership is liable for “any wrongful act or omission of any partner acting in the ordinary course of business of the partnership where loss or injury is caused to any person.” So, using the example of the catering service partner, if a partner negligently causes an accident while driving a car on partnership business, the entire partnership is liable for any damages. Generally, the partnership is also liable for an intentionally wrongful act, deceit, or assault a partner commits during the course of partnership business.</span></p>

<p><span>Of course, liability insurance can be purchased to insure against such occurrences. Premiums are paid for protection against occurrences that are relatively unlikely. Notwithstanding, one convincing negligent action can ruin a partnership, leaving the partners and their families without support.</span></p>

<p> </p>

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<div style="margin:0px 40px;">

<div style="margin:0px auto;"><span>3.</span><span>23 - </span><span>Rights of a Partner Against the Partnership</span>

<p><span style="font-size:12pt;">Even in a well-intentioned and well-planned partnership, serious disagreements sometimes occur. In these circumstances, partners have formal legal rights by way of the provisions of the UPA. These include the following:</span></p>

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<ul type="disc">

<li><span style="font-size:12pt;">Each partner is entitled to all partnership information at any time, and each partner has the duty to supply this information.</span></li>

<li><span style="font-size:12pt;">Each partner has an equal right with the other partners to possess partnership property for partnership purposes, and a partner cannot assign his or her right of partnership property.</span></li>

<li><span style="font-size:12pt;">Each partner is entitled to an accounting of the partnership assets when circumstances warrant it.</span></li>

<li><span style="font-size:12pt;">Each partner has the right to legal action for an injunction to restrain illegal partnership acts and to appoint a receiver to handle the partnership assets.</span></li>

<li><span style="font-size:12pt;">Each partner has the right to “breach of contract” actions concerning the partnership agreement.</span></li>

<li><span style="font-size:12pt;">Each partner has the right to legal action to dissolve the partnership under certain circumstances.</span></li>

<li> </li>

</ul>

</div>

</div>

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<div style="margin:0px;"><span>3.</span><span>24 - </span><span>Tax Issues</span>

<p><span>In the event of the death of a partner, the partnership distributes cash in payment of his or her share of the partnership. In such a case, the gain is not recognized to the partner’s estate, except to the extent that the distributed money exceeds the value/cost basis of the deceased portion of ownership (interest) in the business (partnership).</span></p>

<span>Distributive Share</span>

<p><span>The partnership itself is not subject to taxation. Rather, the partnership is simply a “pass through” to the individual partners. The partners pay their shares of income tax through their own individual tax returns. Each partner is taxed on his or her <strong>distributive share</strong>of partnership income. The distributive share is the amount of money a partner is considered to have received as income according to the Internal Revenue Service Code. A partner’s distributive share can be more than the profits or payments he or she actually receives from the partnership. This often occurs when profits are retained in the business.</span></p>

<p><span>Partnerships cannot retain significant earnings for such things as future expansion or anticipated expenses without the partners having to pay retained earnings tax on that money.</span></p>

<span>Tax Consequences of Contributions</span>

<p><span>No taxable gain or loss occurs simply because money is transferred from a partner to the partnership. Likewise, no taxable gain or loss occurs if a partner withdraws some or all of the money he or she has already contributed to the partnership. However, if a partner contributes property, especially property like real estate that may have increased or decreased in value since buying it, the tax consequences of these transactions can become quite complex. Such a situation can affect the partnership only after the death of a partner.</span></p>

<p><span>When establishing and tracking partners’ capital accounts for future consideration in the event the death of a partner or the termination of the partnership, the following issues must be considered:</span></p>

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<ul>

<li><span>How much capital is required to operate the partnership?</span></li>

<li><span>What are the ratios of capital to be contributed by each partner?</span></li>

<li><span>Are additional contributions mandatory or voluntary?</span></li>

<li><span>If the contributions are other than cash, what are the complete descriptions of the property?</span></li>

<li><span>If the contributions are other than cash, what is the valuation of the property?</span></li>

<li><span>What is the status of loans made to the partnership by various partners?</span></li>

<li><span>What has been the withdrawal of cash or property from the partnership?</span></li>

</ul>

<p><span>Other tax issues involving contributed property also need to be considered. For example, the contribution of real estate with an outstanding mortgage or any encumbered property or an automobile with a loan balance can present difficulties. If mortgaged or encumbered property is contributed to a partnership, the partnership liabilities are increased by the amount of the debt.</span></p>

<p><span>The IRSC permits a 1031 tax-free exchange of real estate. For example, a partner or a partnership can sell one piece of real estate and buy another for what the first piece sold. No tax results. Any profits from the sale are rolled over into the second sale.</span></p>

<p><span>However, the seller and buyer of the property must be the same type of legal entity. So, if a partner sells the first property to the partnership, this does not qualify as a tax-free exchange. This issue must be kept in mind when allowing for the distribution of property after the death of a partner.</span></p>

<p><span>Tax consequences are also forthcoming if a person receives an interest in a partnership in return for his or her contribution of services. Services are not regarded as property. Therefore, if a contributing partner receives a capital interest in a partnership in exchange for his or her services, taxable income results.</span></p>

<span>Tax Issues with Family Limited Partnerships</span>

<p><span>A family limited partnership permits business owners and their children to address tax, business succession and estate planning issues simultaneously. Parents can present assets as gifts to their children at highly discounted rates and still maintain control of the assets. Also in a family limited partnership, eventual estate taxes are reduced because of the discounted assets.</span></p>

<p><span>Moreover, the parents are general partners in a family limited partnership, and they hold minor shares of the partnership while maintaining the power and the control. The children are the limited partners, and they own a percentage of the shares. However, the children have no authority, rights, or control over the operation and management of the partnership.</span></p>

<p><span>Compared to many trust vehicles, family limited partnerships have considerable flexibility when parents anticipate leaving a substantial amount of money to their children. Family limited partnerships offer the potential to keep the assets within the family. However, care must be exercised in coordinating the gift of shares of the family limited partnership to the children with regard to the annual gift tax exclusions or the lifetime exclusion.</span></p>

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<span>3.</span><span>25 - </span><span>What Happens to a Partnership After the Death of a Partner?</span>

<p><span>The UPA provides that every partnership dissolves when one of the partners dies. Dissolving the partnership does not automatically result, however, when the partners have consented in their partnership agreement to continue the business.</span></p>

<p><span>For example, if the deceased partner instructs through his or her will that the partnership should be continued after his or her death, the partnership can be continued with the consent of the other partners. However, surviving partners cannot continue the business in the absence of such an agreement. Continuing the business can create liability for the surviving partners if the value of the deceased partners share is diminished.</span></p>

<p><span>On the other hand, if the deceased partner instructs the executor to continue the partnership business, the surviving partners cannot be forced to participate in this arrangement. However, if the surviving partners desire this arrangement, the partnership can be reconstituted with the executor as a new member of the partnership. Technically, this process is that of creating and forming a new partnership.</span></p>

<p><span>The partnership agreement must also address the issue of what happens if a partner becomes mentally ill, disabled, or dies. Otherwise, a serious risk of conflict exists. Any rules on this subject set forth in the partnership agreement are legally enforceable.</span></p>

<p><span>Obviously all of these concerns are significant when surviving partners must effectively handle the remaining affairs of the partnership. The following sections address more fully the series of events that must occur after the death of a partner, which are the dissolution, winding up, termination, and liquidation of the partnership. But first, the<strong>right of first refusal </strong>must first be addressed, which is the right of the remaining partners to have the first opportunity of buying a deceased partner’s share.</span></p>

<span>The Right of First Refusal</span>

<p><span>Most partnership agreements contain provisions prohibiting a partner from transferring his or her interest in the partnership to a third party without giving the remaining partners the opportunity to buy him or her out first. Using the right of first refusal, if one partner dies, the surviving partners have the option to buy the deceased partner’s share and to continue the partnership business.</span></p>

<p><span>If no provisions are made for the right of first refusal, the following situations may arise:</span></p>

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<ul>

<li><span>Ultimately, the business may have to be liquidated, and it is not likely that used assets sold piecemeal would be worth much.</span></li>

<li><span>If the deceased partner attempted to transfer his or her interest in the partnership without the surviving partners’ consent, this is not only prohibited by the UPA but also could create new or additional conflicts among the surviving partners for the estate.</span></li>

<li><span>The surviving partners may be left with heirs who will try to sell the deceased partner’s interest or who may want to actively participate in the business. The right of first refusal protects the remaining partners.</span></li>

</ul>

<p><span>Within the rules of the UPA, the partnership agreement can be anything the partners want it to be. For example, an heir can inherit a partner’s share of the partnership business and prefer not to be bought out by the remaining partners. The heir may prefer to retain this share.</span></p>

<p><span>With a properly drafted partnership agreement in place, the heir could not force himself or herself into the partnership; the heir would have to sell his or her partnership share. The surviving partners could then decide to make the heir a new partner, or they could decide to buy the heir out.</span></p>

<p><span>With a right of first refusal provision in place, if one partner dies and the surviving partners cannot or will not buy out the interest of the heir, the partnership must be liquidated. The entire business must be sold and the proceeds divided. But, the surviving partners still have a choice. They can either buy the deceased partner’s share of the business or let the partnership be liquidated.</span></p>

<p><span>If a partner suddenly becomes seriously injured, mentally incompetent, or dies, making quick arrangements is nearly impossible. Such circumstances require preplanning. As part of the preplanning effort, a buy-out arrangement should be a part of the partnership agreement. The buy-out arrangement should define the terms by which the surviving partners can buy out the interest of the deceased partner. The following are two key areas that should be covered when formulating a buy-out clause:</span></p>

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<ol>

<li><span>the method in which to value the partnership must be decided.</span></li>

<li><span>the method in which payments will be made by the surviving partners must be decided.</span></li>

</ol>

<p><span>In the event of the death of a partner, a buy-sell agreement can provide for the continuity of the partnership business.</span></p>

<span>Dissolving a Partnership</span>

<p><span>The UPA defines dissolution as “the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on of the business, as distinguished from the winding up of the business.” Dissolution is discussed first; “winding up” a business is discussed in the next section.</span></p>

<p><span>Dissolving a partnership is the actual decision to end it. It is the point when the partners cease to carry on the business together. Dissolution simply describes a change in the partnership relationship and is a preliminary step to winding up and termination.</span></p>

<p><span>Remember that the partnership is an intimate and voluntary contractual business relationship between the partners. When one partner, for whatever reason, ceases to be a member of the partnership, the partnership, as it is known, no longer exists.</span></p>

<p><span>Further, dissolving a partnership changes the legal relationship of the partners. From the legal perspective, no new partnership business can be undertaken after the partnership is dissolved. To limit their liabilities, sometimes a partnership sends formal written notices to creditors and to other business contacts advising them that the partnership has been dissolved and cannot undertake new business. However, no official or government office or requirement currently requires that this notice be recorded.</span></p>

<p><span>Essentially, dissolving a partnership terminates the authority of the remaining partners to act for the partnership, except to the limited extent necessary to wind up the firm’s business. Dissolution does not refer to the other steps in the process of completing and finishing a partnership. Dissolution is distinguished from winding up and terminating the business. It has nothing to do with whether the partnership business continues with different partners as a new and separate identity or whether the partners are going their separate ways. It is simply the act of <strong>deciding not to continue </strong>the partnership in its current form.</span></p>

<p><span>Of course, the partnership business can be continued after the dissolution process by forming another partnership. This is known as <strong>reconstituting the partnership</strong>. The partnership can be reconstituted under another form, perhaps with only the remaining partners or with the substitution of a new partner for the deceased partner.</span></p>

<p><span>If the deceased partner had no buy-out agreement with the other members of the partnership, his or her share of the partnership must be handled through probate. If the partnership agreement provides for the remaining partners to buy out the deceased partners share, the probate process can be eliminated.</span></p>

<p><span>Forming a new entity does not necessarily have to be another partnership. If a new entity is created and has only one survivor, a sole proprietorship can also be formed. If, upon the death of a partner, the surviving partners decide to incorporate, then the new entity created can be a corporation.</span></p>

<span>The Winding Up of a Partnership</span>

<p><span>People decide to dissolve a partnership for many reasons, but the principal cause is the death of a partner. After dissolving a partnership, the surviving partners have the duty to wind up the partnership affairs without delay. Upon the death of a partner, the surviving partner succeeds to the ownership of the firm’s assets as a <strong>liquidating trustee</strong>. In fact, winding up is sometimes referred to as <strong>liquidation</strong>. (See the next section in this chapter for more information on the liquidation process.)</span></p>

<p><span>The winding up of a partnership is the responsibility of the surviving partners, not that of the personal representative. Partners in a dissolved partnership retain the authority to carry on only to the extent necessary to bring an end to existing partnership business. Under the UPA, each partner is liable for his or her share of any liability created by the partners in the course of closing down partnership business, just as if the partnership had not been dissolved.</span></p>

<p><span>The surviving partners do have some discretion on how to wind up the partnership after the dissolution. They may do the things necessary to close down the existing partnership business. However, if the surviving partners do not act diligently and in good faith in winding up the partnership business, the courts can appoint a <strong>receiver</strong>. Because of the receiver’s fiduciary status, each partner is held responsible to the estate of the deceased partner as a trustee of the partnership assets.</span></p>

<p><span>During the winding up process, the surviving partners must make a fair and complete disclosure of all facts affecting the partnership assets. They must account for all property values, tangible or intangible. Further, the partners may have the burden of proving that this trusteeship is carried out in exact compliance with the high standards of responsibility required of trustees. Given the great amount at stake, the partnership needs a plan that relieves the individual partners of this burdensome status.</span></p>

<p><span>In some states, the surviving partners are required to give a bond as a condition of their rights to manage and to settle the partnership affairs. If the surviving partners do not give the required bond within the time specified, the personal representative of the deceased must give the bond and become the administrator of the partnership.</span></p>

<p><span>Although the UPA specifically provides that no partners are entitled to compensation for acting in the partnership business, they are entitled to reasonable compensation for their services in winding up the partnership affairs. If the surviving partners commit any breach of fiduciary duty, they can be disqualified from receiving compensation for winding up the partnership business.</span></p>

<p><span>As liquidators, one of the first duties of the surviving partners is to collect the partnership’s accounts receivable. Undoubtedly, some of the accounts receivable will not be able to be collected. Perhaps inventory or equipment will have to be disposed of for cash. Selling the inventory is usually accomplished through secondhand dealers, who sell the goods for only a fraction of their original value. This could cause ruinous consequences not only to the partnership, but to the estate of the deceased as well. Further, intangible assets such as “going concern” value and good will typically disappear. Their loss is total.</span></p>

<p><span>So what about the deceased’s steady income? If the partnership was successful, he or she probably made consistent withdrawals, and his or her family’s comforts were geared toward this income. However, the surviving partners cannot make any payments of any type to the deceased partner’s family until the business is closed out. During this time, the family must rely on life insurance proceeds or on advances the personal representative may make from the deceased’s personal estate.</span></p>

<p><span>Under the UPA, the personal representative cannot interfere with the winding up of the partnership unless the surviving partners have acted illegally or unless the process has been unreasonably delayed. Otherwise, the personal representative must wait until the winding up process has been completed. In the meantime, the personal representative cannot fully appraise the estate or complete the estate tax scheduled until the deceased partner has been liquidated and his or her share has been ascertained. During this time, the family may experience a shortage of assets, or the business of the surviving partners could possibly be jeopardized.</span></p>

<span>Terminating a Partnership</span>

<p><span>The final step in the process after a partner dies is the actual termination of the partnership business. Termination effectively ends the surviving partners’ authority—it is the ultimate result of the winding up of the partnership affairs.</span></p>

<p><span>Once the partnership ends, no further partnership business of any kind is legally authorized. If a creditor, however, acting in good faith and without the knowledge of the dissolution of the partnership, extends credit to a surviving partner for matters that are deemed part of the partnership business but which in reality are not because of the dissolution and termination of the partnership, all of the partners can be held liable for this debt.</span></p>

<span>Liquidating a Partnership after the Death of a Partner</span>

<p><span>In the event of the death of a partner, there are many sacrifices and losses suffered by everyone. The surviving partners and the heirs suffer heavy losses if the business is improperly continued. The following is a discussion of alternatives, if no plans are made for the community of a partnership prior to the death of a partner.</span></p>

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<span>3.</span><span>26 - </span><span>What Happens to the Business After Concluding the Partnership?</span>

<p><span>After a partnership has been concluded after the death of a partner, the surviving partners have many decisions to make and factors to consider. Among these are whether they want to</span></p>

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<ul>

<li><span>incorporate the personal representative as a partner;</span></li>

<li><span>form a new partnership with heirs;</span></li>

<li><span>purchase the deceased partner’s interest in the business.</span></li>

</ul>

<p><span>These scenarios are described in the following sections.</span></p>

<span>The Personal Representative as a Partner</span>

<p><span>Some states have enacted special statutes that permit the partnership business to be continued under certain conditions with the deceased partner’s personal representative as a partner.</span></p>

<p><span>This plan, however, cannot function unless the surviving partners agree to it. They may refuse if the personal representative is unfamiliar with the business or if the court has limited his or her liability. Further, such a plan is contingent upon the personal representative’s willingness to be a partner.</span></p>

<span>Forming a New Partnership with Heirs</span>

<p><span>Sometimes, rather than face liquidation, the surviving partners form a new partnership with the heirs. However, this presents legal and economic obstacles.</span></p>

<p><span>The first obstacle encountered with forming a new partnership with heirs is that the heirs usually cannot enter the partnership until the administration proceedings are completed. Such a plan is only possible when the only heir and the personal representative are the same person. Even then, the deceased’s creditors and the tax authorities must be satisfied first.</span></p>

<p><span>Another legal obstacle is the rule that no one can force another to be his or her partner. If the surviving partners want to continue the business with the heir, they can do so only if the heir is willing.</span></p>

<p><span>Surviving partners sometimes continue the business by forming a new partnership with the spouse of the deceased partner. It is nearly impossible to arrange a partnership after death because the burdens are unequally shared: the spouse is often inexperienced and usually has another agenda.</span></p>

<p><span>Moreover, the surviving partners and the heir may have different objectives for the business. The surviving partners probably want to continue to develop and expand the business, often at the expense of immediate profits. The heir, on the other hand, probably wants a current income.</span></p>

<p><span>From an economic perspective, unless the new partner has been active in the management of the partnership business, the surviving partners have the bulk of responsibility for ensuring the business survives.</span></p>

<span>When Heirs Purchase a Partner’s Interest</span>

<p><span>Sometimes the heirs want to purchase the interest of the surviving partners. This plan has many disadvantages. First, the surviving partners have a legal duty to liquidate the business, and all creditors must be satisfied first. Surviving partners can be relieved of liquidating the business only if the personal administrator and all heirs consent. Minor heirs are unable to give consent; other heirs may be unwilling.</span></p>

<p><span>Another issue with heirs purchasing the surviving partner’s interest is that the surviving partners would be selling themselves out of the jobs and would have to start over. The heirs would have the burden of managing the business without the skill and advice of the deceased or of the surviving partners.</span></p>

<p><span>Finally, the heirs may have to compete with the surviving partners. However, such a plan is an alternative solution to liquidating the partnership.</span></p>

<span>Purchasing a Partner’s Interest</span>

<p><span>Sometimes the surviving partners may want to avoid the sacrifices and losses of liquidating the partnership and decide to purchase the deceased partner’s interest. The first obstacle to overcome is to obtain the necessary cash to pay for the deceased’s interest. If the surviving partners do not have sufficient personal wealth, they would have to borrow the money and pay the debt over a period of time.</span></p>

<p><span>When purchasing the deceased partners interest, surviving partners also have legal obstacles to contend with. First, the deceased’s personal representative can demand that the business be liquidated. Second, the surviving partners must have a sound purchase contract that withstands any legal attacks by dissatisfied heirs.</span></p>

<p><span>In many states, if a surviving partner is also the personal representative of the estate, this partner is precluded from making a binding sale to himself or herself, because a fiduciary cannot purchase from himself or herself.</span></p>

<p> </p>

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<span>3.</span><span>27 - </span><span>The Buy-Sell Agreement Alternative to Liquidation</span>

<p><span>All of the previous scenarios have addressed situations where no agreement to purchase had been entered into before the death of a partner. Ideally, a plan is created before the death of a partner and thereby eliminates all possibilities of liquidation losses. The buy-sell agreement is an excellent way to achieve this objective.</span></p>

<p><span>As with the buy-sell agreement discussed for use in the sole proprietorship, although the buy-sell agreement itself seems to accomplish the objective of business continuation, it must also be properly financed. The plan cannot be implemented if the funds to conduct the transaction are unavailable.</span></p>

<span>Financing the Buy-Sell Agreement without Insurance</span>

<p><span>If the partnership is successful and cash rich, the partners may be able to produce the cash necessary to finalize the buy-sell agreement in the event of the death of one of the partners. Without using insurance to finance the buy-sell agreement, the partners could</span></p>

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<ul>

<li><span>build up the purchase price in advance through savings. This plan is impractical because no one knows exactly when the funds will be required. It may be days, months, or even years.</span></li>

<li><span>pay the purchase price in installments. This plan is impractical because it essentially mortgages the partnership business and the futures of the surviving partners.</span></li>

<li><span>borrow the purchase prices at the time of death. This plan is impractical because the ability to borrow cannot be assured beforehand, and issues are associated with mortgaging the futures of the partnership business and the surviving partners.</span></li>

</ul>

<span>Benefits of the Insured Buy-Sell Agreement</span>

<p><span>Just because a partnership agreement has a provision that, in the event of the death of a partner, the surviving partner’s interest will be paid in a lump sum or on a set schedule does not necessarily mean that the partnership will actually have sufficient money to make that payment.</span></p>

<p><span>A good way to ensure sufficient funds is for the partnership business to buy life insurance on each partner. For many partnerships, this is a practical way of obtaining the money needed to pay off a deceased partner’s interest. A life insurance policy serves as a legal exchange for a deceased partner’s interest in the partnership. If a partner dies, the partnership-financed insurance policy pays off the deceased’s share. The policy proceeds become partnership property, and partnership-operating income does not have to be used for buying the interest of the deceased.</span></p>

<p><span>In addition, the benefits of an insured buy-sell agreement are many. The surviving partners, the heirs, the estate, and the partners all reap benefits during their lifetimes. The benefits to the surviving partners are</span></p>

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<ul>

<li><span><strong>the future of the partnership is better assured</strong>—The insured buy-sell agreement ensures the continuation of the partnership business without interruption. The plan expedites the purchase of the deceased partner’s interest. Because the agreement is already set up, the price is already agreed upon, and the money for the purchase is available. Further, the business remains in tact.</span></li>

<li><span><strong>the surviving partners avoid liquidation losses</strong>—The liquidation of a going business invariably results in substantial losses. This is avoided with the insured buy-sell agreement.</span></li>

<li><span><strong>the surviving partners avoid becoming liquidating trustees</strong>—Using a buy-sell agreement, the surviving partners have the status of “purchases” rather than that of liquidating trustees, which is certainly a burdensome position.</span></li>

</ul>

<p><span>The benefits to the heirs and the estate are</span></p>

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<ul>

<li><span><strong>the estate receives payment in full and in cash immediately</strong>—The insured buy-sell agreement immediately places the full amount of the sale price of the deceased partner’s interest in the firm in the hands of the executor, which avoids any bickering, bargaining, or delay.</span></li>

<li><span><strong>the estate can be settled promptly and efficiently</strong>—Using a buy-sell agreement, the immediate cash allows the executor to promptly, efficiently, and economically administer the estate.</span></li>

<li><span><strong>the surviving spouse is relieved of business worries</strong>—The surviving spouse is free from any future responsibilities of the partnership.</span></li>

</ul>

<p><span>The benefits to the partners during their lifetimes are</span></p>

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<ul>

<li><span><strong>the partnership is stabilized</strong>—With the stabilization of the business assured, the partners and their customers are free to enter into permanent dealings. Employees are assured of a more secure organization, and the funds of the partnership are not drained.</span></li>

<li><span><strong>a savings medium is provided</strong>—The insured buy-sell agreement is essentially an advance installment method of purchasing a deceased partner’s interest. This is a savings program automatically completed. After a few years, the policy contains a guaranteed cash value, making it a convenient and effective savings program that is directly focused on a single objective.</span></li>

<li><span><strong>the future of the partnership is bright</strong>—With a buy-sell agreement in place, each partner can predict what will happen in the event of the death of one of the partners. The business will be strong and stable.</span></li>

</ul>

<span>Types of Partnership Buy-Sell Agreements</span>

<p><span>Partnership buy-sell agreements have two basic types: (1) the partners can buy policies on each other, which is referred to as a <strong>cross-purchase plan</strong>; or (2) the partnership itself can buy the policies. This type of buy-sell arrangement is referred to as an <strong>entity agreement</strong>.</span></p>

<span>Cross-Purchase Plan</span>

<p><span>For small partnerships, a cross-purchase plan is the most common and is usually most practical. Using this plan, the partners agree to purchase a deceased partner’s interest in the partnership. The partners pay for and own the life insurance policies on the other partners, but the partnership itself is not a party to the agreement.</span></p>

<p><span>In addition, cross-purchase plans reduce the possibility of unfairly increasing the worth of the deceased partner’s share. The insurance on each partner is in an amount that is approximately the same as his or her share of the purchase price if another partner dies before him or her.</span></p>

<p><span>In a larger partnership, however, a cross-purchase plan is usually not manageable. For example, in a five-person partnership, each partner must purchase four life insurance policies, one for each of the other partners. This means the partners would be purchasing a total of 20 policies, the total cost of which would be extremely high.</span></p>

<span>Entity Agreement</span>

<p><span>Under these circumstances, it makes more sense to set up an entity agreement and have the <em>partnership </em>rather than the individual partners pay for a single policy on each partner’s life. In this way, the partnership itself is a party to the agreement, along with the partners.</span></p>

<span>Factors for Determining the Choice of Agreement</span>

<p><span>Some factors for determining which type of buy-sell agreement is suitable for a particular partnership are the</span></p>

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<li><span><strong>number of partners</strong>—A large partnership can make the cross-purchase plan impractical.</span></li>

<li><span><strong>ages of the partners</strong>—Where the partners’ ages vary greatly, the younger partners, who typically hold smaller interests in the partnership, may be unable or unwilling to maintain insurance on the older partners, who probably own the larger interests.</span></li>

<li><span><strong>ratio of interest among surviving partners</strong>—Using an entity agreement, surviving partners share ownership in the same ratio as they had before the death of a partner. Using a cross-purchase plan, the surviving partners can specify the proportion of the deceased’s interest that each surviving partner buys, regardless of their current proportionate interests.</span></li>

<li><span><strong>tax factors</strong>—Using a cross-purchase agreement, the cash value of the policies that the deceased partner owned on the lives of the other partners is subject to federal estate tax. When the partnership owns the insurance to finance an entity agreement, the value of the insurance on the life of a deceased partner is not included as insurance in his or her gross estate. Other more complicated tax factors must be considered but should be discussed with a competent tax attorney.</span></li>

</ul>

<span>Valuing the Partnership</span>

<p><span>Probably the most important consideration in the buy-sell agreement is the provision for valuing the business—a fair method must be used to determine its worth. Many different methods exist for valuing a business, and no method of valuation is superior to all others. The method of valuation depends on the nature of the business and on the surviving partners’ relationships and their expectations; a method must be employed that fits the situation.</span></p>

<p><span>A primary consideration is that the partnership is given the greatest chance to survive; therefore, the partnership agreement should be drawn to ensure this happens. If the buy-out price is too high, the surviving partners may decide to simply liquidate the business. In addition, how are necessary payments to be made? The heirs may require a lump sum, which could pose a hardship for the partners.</span></p>

<p><span>Naturally, a partnership business is probably not worth more than the value of its hard, tangible assets in the beginning of the business. When the business has become large enough, a more complex and effective valuation method may be necessary.</span></p>

<p><span>Although no method can be precise, some common methods of valuing a partnership after the death of a partner include the</span></p>

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<ul>

<li><span>book value method;</span></li>

<li><span>set dollar method;</span></li>

<li><span>appraisal method; and</span></li>

<li><span>capitalization of earnings method;</span></li>

</ul>

<p><span>Each of these methods is described in the following sections.</span></p>

<span>The Book Value Method</span>

<p><span>The book value method for valuing a partnership business is probably the simplest. Simply put, the book value is calculated by taking the total value of the partnership assets and deducting the total partnership liabilities. The result represents the net worth of the business and is the method the UPA requires if the partnership agreement fails to adopt a valuation method.</span></p>

<p><span>Unfortunately, using the book value method to determine the value of a deceased partner’s interest in a partnership does not consider such issues as reputation, a well-known name, good will, etc. Furthermore, the amount of life insurance on a deceased partner is included in the book value of the partnership, where the partnership is the beneficiary of the policy. Because book value often refers to acquisition cost, it probably does not accurately reflect the partnership’s true and current worth, or fair market value.</span></p>

<p><span>The net worth of the partnership is calculated as of the date of the death of a partner. This is the amount the deceased’s estate receives, or is the amount for which the surviving partners acquire the deceased partner’s share. The assets that are normally included in calculating net worth include</span></p>

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<ul>

<li><span>all cash, after subtracting all partnership debts owed;</span></li>

<li><span>the current market value of all tangible assets of the partnership. This includes the net value of current inventory plus the present value of other items known as fixed assets, such as office furnishings, manufacturing equipment, the building housing the partnership, etc.</span></li>

<li><span>all accounts receivables that are determined to be reasonably collectable. This is money still owed for work already completed and billed.</span></li>

<li><span>all earned but unbilled fees and all money presently earned for work in progress. These fees are notably important in professional partnerships, such as law or consulting firms. Scenarios included in this category include those where construction work is being done or where an invoice, for whatever reason, has not yet been sent but the revenue has been earned. This is not really the same as an account receivable.</span></li>

</ul>

<p><span>In settling partnership accounts, the UPA ranks the liabilities of the partnership for payment as follows. These liabilities are presented in the order in which they should be paid:</span></p>

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<ol>

<li><span>those owing to creditors, other than partners;</span></li>

<li><span>those owing to partners, other than for capital and for profits;</span></li>

<li><span>those owing to partners with respect to Capital Planning Strategies;</span></li>

<li><span>those owing to partners with respect to profits.</span></li>

</ol>

<p><span>The book-value method is most effective for new businesses that do not have much except for their fixed assets. These businesses have not yet acquired a good reputation, a well-known name, good will, or an impressive client list. This method is also employed for businesses whose worth is determined by the value of tangible assets, such as a gift store.</span></p>

<span>The Set Dollar Method</span>

<p><span>Using the set dollar method for valuing a partnership is a great tool for preplanning. With the set dollar method, the partners agree in advance that if one partner dies, the others will buy out that partner’s share for a predetermined price. The price is typically re-evaluated every year or so because of business fluctuations and the changing economy.</span></p>

<p><span>The set dollar method is most effective when the primary worth of the business is the activity of the partners. It works best when the business has no substantial hard assets or much value in inventory. This method is particularly good for most partnership service businesses, especially those in their first few years of business.</span></p>

<p><span>In addition, the set dollar method is often used when the partners’ primary concern is the continuation of the business and their relationship with each other. By valuing the partnership in advance, the deceased partner’s estate does not have the burden of getting involved in valuing the partnership interest.</span></p>

<p><span>One of the perks of the set dollar method of valuation is that it combines simplicity with fairness. The buy-out price is fair because it is known and all agreed to it. Also, because the price is predetermined, appraisals and accountants are not necessary when a partner dies.</span></p>

<span>The Appraisal Method</span>

<p><span>Using the appraisal method of partnership valuation, the partners agree to have an independent appraiser determine the worth of the partnership at the time of a partner’s death. The buy-sell agreement could even specify a particular appraiser.</span></p>

<p><span>This method can be a good choice, because at the time the agreement is drafted, the partners cannot possibly know the valuation of the partnership in the future. However, a distinct disadvantage of using the appraisal method is that it often takes some time to get the appraiser’s report. Also, the appraisal method of valuation makes it difficult to determine in advance what a partnership interest is worth if the partners need this information.</span></p>

<p><span>Nonetheless, the appraisal method is highly effective in certain situations. Some businesses are inherently more suitable to this method than others. Such businesses include antique stores, real estate partnerships, and businesses that sell collectibles, such as coins or stamps. This method is also effective for any business where the market can be used to determine the price of inventory.</span></p>

<span>The Capitalization of Earnings Method</span>

<p><span>The capitalization of earnings method is used to demonstrate that the ongoing nature of a successful partnership business has solid value. The capitalization of earnings method values a partnership based on what the business earns annually. Gross earnings or net profits are multiplied by some multiple, which is an arbitrary preset number used to determine the worth of the business. For example, it may be decided that the fair value of a business is three times the average net profits for the past two years. So, three times the average net profits of the partnership for the past two years equals the buy-out price.</span></p>

<p><span>If using a multiplier based on gross earnings rather than on profits, the multiplier should be expressed in terms of a fraction. For example, in a profitable business, one-third of gross earnings might be used.</span></p>

<p><span>Naturally, if the partnership is new, using the capitalization of earnings method to value the partnership is not fair or effective. This method requires several years’ history and profits before it can be practically utilized.</span></p>

<span>Contents of the Insured Buy-Sell Agreement</span>

<p><span>The content of the partnership insured buy-sell agreement is similar to the agreement used when arranging for the sale and purchase of a sole proprietorship. The partnership insured buy-sell agreement should include</span></p>

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<ul>

<li><span>a commitment that the surviving partners or the partnership, in the case of an entity agreement, will buy and the deceased’s partner’s estate will sell the deceased’s interest in the partnership to the surviving partners.</span></li>

<li><span>a commitment for the purchase price of each partner’s interest or the valuation method for determining the purchase price of each partner’s interest in the partnership;</span></li>

<li><span>the commitment to purchase and maintain life insurance on the lives of the partners for financing the purchase;</span></li>

<li><span>a description of the life insurance policies;</span></li>

<li><span>provisions for adding, substituting or withdrawing policies as changes occur in the partnership itself;</span></li>

<li><span>a provision for the ownership and control of the life insurance policy;</span></li>

<li><span>a commitment for the time and method of paying any balance of the purchase price that exceeds the insurance proceeds;</span></li>

<li><span>a commitment to disposing of any insurance proceeds the exceed the purchase price;</span></li>

<li><span>beneficiary arrangements;</span></li>

<li><span>provisions that the deceased’s estate be held harmless from claims of creditors of the business;</span></li>

<li><span>a provision for disposing of the policies if the agreement is terminated during the lifetime of the partners;</span></li>

<li><span>provisions for altering, amending, or terminating the agreement.</span></li>

</ul>

<span>Arrangements for Paying Premiums</span>

<p><span>Surviving partners have several different ways to pay life insurance premiums subject to partnership buy-sell agreements: Some of these ways are listed below:</span></p>

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<ul>

<li><span><strong>premiums paid by partners other than the insured partner</strong>—Using this arrangement, partners other than the insured partner should pay the premiums for each policy, and these payments should be contributed in the same ratio in which the interests of the insured will be purchased and shared between the partners. This arrangement is beneficial when the partnership interests are not equally divided, or if the partners desire unequal interests in the event of the death of a partner.</span></li>

<li><span><strong>the pooling of premiums</strong>—Another method of allocating premiums is to pool the entire premiums required and to require each partner to pay a part. This pooling arrangement results in an equal sharing of the premium payments.</span></li>

<li><span><strong>premiums paid by respective insured’s</strong>—Under this arrangement, each partner pays premiums in the amount of insurance on his or her own life.</span></li>

<li><span><strong>premiums paid by the partnership itself</strong>—Using an entity agreement, the partnership pays the premiums.</span></li>

</ul>

<span>Arrangements for Designating Beneficiaries</span>

<p><span>As with paying premiums, many choices are also available to designate how beneficiaries receive the life insurance proceeds payable in a partnership-insured buy-sell agreement. These choices are as follows:</span></p>

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<ul>

<li><span><strong>The surviving partners can be designated as beneficiaries</strong>. Paying the death proceeds to those who have created and owned the premium fund is logical, and doing so puts the purchase money in the hands of those who own the life insurance proceeds. Simply, the surviving partners are obligated to buy the deceased’s interest in the partnership, and now they have the funds to do so. However, the surviving partners should not be the beneficiaries of the insurance proceeds when an entity plan is used.</span></li>

<li><span><strong>The deceased partner’s estate can be designated as beneficiary</strong>. If this beneficiary arrangement is made, the buy-sell agreement must clearly state that the insurance proceeds the estate receives are to be used to pay the purchase price of the deceased partner’s interest.</span></li>

<li><span><strong>Personal beneficiaries of the insured can be designated as beneficiaries</strong>. The objective of this arrangement is twofold. First, it is designed as business insurance to supply the purchase money for the deceased partner’s interest. Secondly, it is intended as personal insurance so that the purchase money remains in the form of insurance proceeds payable to the deceased’s family in installments under policy options.</span></li>

<li><span><strong>The partnership can be designated as beneficiary</strong>. The only occasion for this type of arrangement is the entity plan.</span></li>

</ul>

<span>Possible Problems of the Partnership Buy-Sell Agreement</span>

<p><span>The partnership business continuation plans discussed up to this point have been suitable in most cases. However, not all circumstances are typical, and sometimes the buy-sell agreement must be modified. A discussion of some of these problems follows.</span></p>

<span>Partners with Disproportionate Interests</span>

<p><span>In some partnerships, the interests are not equal or even close to being equal. For example, suppose one partner holds a 75 percent interest in the partnership, and the other partner owns 25 percent. The standard procedure for premium payment requires the partner with the smaller interest to purchase insurance on the life of the partner with the greater interest and pay these premiums. If this arrangement can be made, it is the best possible situation. These are the actuarially correct amounts that the partner with the smaller share should pay for.</span></p>

<p><span>However, often the partner with the greater interest is older, and sometimes the partner with the smaller interest cannot afford such premiums. In other cases, this arrangement simply seems unfair. Although many formulas can be used to devise a satisfactory solution to this situation, the partnership entity plan is probably the simplest.</span></p>

<span>The Uninsurable Partner</span>

<p><span>If an uninsurable partner has sufficient personal insurance that he or she is willing to sell and to assign to the partnership, then being uninsurable does not pose a problem. Or, the other partners could finance the purchase price of the insurable partner’s interest.</span></p>

<p><span>Alternatively, the partners other than the uninsurable member could deposit annually into a reserve fund an amount equal to what the life insurance premiums would have been. Then this fund could be soundly invested.</span></p>

<span>Liabilities of Large Partnerships</span>

<p><span>Some partnerships have relatively large liabilities. One remedy is a special joint policy of life insurance covering the partners in the amount of the obligations, with the face amount payable at the death of the first partner to die.</span></p>

<p><span>If a trustee is used, the policy could be made payable to the trustee with instructions to apply the proceeds to the debts.</span></p>

<span>Tax Issues with the Buy-Sell Agreement</span>

<p><span>Insurance premiums are not a tax-deductible expense. If the buy-sell agreement is cross-purchase with the partners insuring each other, then the partnership can pay the premiums and charge an equal, or prorated amount to each partner as income. If the buy-sell agreement is entity-style where the partnership owns the policies, then the premiums still have to “pass through” to the partners. An agreement between the partners on the best approach that is acceptable to all is necessary before the buy-sell agreement is structured.</span></p>

<p> </p>

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<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">1 - </span><span id="ctl00_Layout_lblChapterName">The Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">To protect the continuity of the corporation, thoroughly understanding the fundamental nature of the corporation and how it operates is essential. Just as in a sole proprietorship and a partnership, the death of a corporation stockholder can pose many problems, which must be considered when arranging the continuation of the corporate business. This preplanning is in the best interest of everyone, including the deceased’s family and his or her estate, the employees of the business, and the surviving stockholders.</span></p>

<p><span id="ctl00_Layout_lblContent">This chapter describes these issues as well as other fundamental characteristics of corporations, including the ways in which a corporation is formed and approved, the types of corporations, property rights, liabilities, and the reasons for liquidating a corporation.</span></p>

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<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">2 - </span><span id="ctl00_Layout_lblChapterName">Defining a Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">Whenever a new business is established, involved parties must legally decide whether the enterprise should be operated in an unincorporated form, or whether it should be formed as a corporation. The corporation is the most complex of the business structures in our discussion.</span></p>

<p><span id="ctl00_Layout_lblContent">The corporation was first defined by Chief Justice Marshall of the United States Supreme Court. In his famous decision in 1819 in the case of Dartmouth College vs. Woodward, he stated that a corporation is “an artificial being, invisible, intangible, and existing only in contemplation of the law.” So, a corporation is a distinct legal entity that is separate from the individuals who own it.</span></p>

<p><span id="ctl00_Layout_lblContent">Over the years, however, this definition and similar ones have been severely criticized as overemphasizing the nature of a corporation as an artificial legal entity. Those who denounce this definition claim that it fails to properly emphasize the association of the natural persons who comprise the corporation. Although Chief Justice Marshall’s definition is the legal one, in everyday terms, the corporation can be thought of as a group of one or more people acting as a unit and vested with personality by the policy of law.</span></p>

<p> </p>

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<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">3 - </span><span id="ctl00_Layout_lblChapterName">Considerations for Incorporating</span></h2>

<p><span id="ctl00_Layout_lblContent">In determining whether a corporation is a practical form of business operation, the following issues should be considered:</span></p>

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<li><span id="ctl00_Layout_lblContent">What is the size of the risk, that is, what is the amount of the investor’s liability for debts and taxes?</span></li>

<li><span id="ctl00_Layout_lblContent">What is the continuity of the life of the business if something happens to the principal or principals?</span></li>

<li><span id="ctl00_Layout_lblContent">Which legal structure ensures the greatest adaptability for administering the business?</span></li>

<li><span id="ctl00_Layout_lblContent">What is the influence of the applicable law?</span></li>

<li><span id="ctl00_Layout_lblContent">What are the possibilities of attracting additional capital?</span></li>

<li><span id="ctl00_Layout_lblContent">What are the needs for and the possibilities of attracting additional expertise?</span></li>

<li><span id="ctl00_Layout_lblContent">What are the costs and procedures in starting up the business?</span></li>

<li><span id="ctl00_Layout_lblContent">What are the tax advantages and disadvantages of the corporate structure?</span></li>

<li><span id="ctl00_Layout_lblContent">What is the ultimate goal and purpose of the enterprise?</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">In determining whether a corporation is a suitable form of operating a business, all factors must be considered in the context of the specific business operation. Many issues are tax-related; others are not. Only the owners can decide which entity form offers the greatest advantages and the fewest disadvantages to them.</span></p>

<p> </p>

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<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">4 - </span><span id="ctl00_Layout_lblChapterName">How a Corporation is Formed</span></h2>

<p><span id="ctl00_Layout_lblContent">A corporation can be created only by sovereign authority. This authority rests on the state and federal government. Those businesses that are set up in the District of Columbia are chartered by the federal government. Otherwise, corporations are chartered by the state in which they are formed. Corporations that do business in more than one state must comply with the laws of that state, which may vary considerably, as well as with federal laws regarding interstate commerce.</span></p>

<p><span id="ctl00_Layout_lblContent">In contrast, a sole proprietorship is formed by simply joining the components necessary to operate a particular business. The owner obtains the required licenses and permits and opens up shop. Equally simplistic is how partnerships are created—by the voluntary oral or written agreement of all of the partners.</span></p>

<p><span id="ctl00_Layout_lblContent">Although establishing a corporation can be complex and is certainly more complex than that of a sole proprietorship or a partnership, at least the procedures for creating a corporation are well-defined. The organizers of the corporation must prepare a<strong>Certificate of Incorporation </strong>or <strong>Articles of Incorporation</strong>. These articles are also referred to as the <strong>charter</strong>, or the <strong>bylaws</strong>. These articles state the powers and the limitations of the particular enterprise, and they must be signed by at least one incorporator.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">5 - </span><span id="ctl00_Layout_lblChapterName">The Model Business Corporation Act</span></h2>

<p><span id="ctl00_Layout_lblContent">A corporation is created by its Articles of Incorporation. They define the corporation’s essential characteristics and basic structure. This “character,” as it is called, must be submitted and approved by the state before the corporation’s legal existence can begin.</span></p>

<p><span id="ctl00_Layout_lblContent">The Model Business Corporation Act was prepared by the American Bar Association, and it sets forth the required contents of a character. The act is intended to serve as a guide for revising state business corporation laws. When adopted by a state, the provisions of the Model Business Corporation Act apply to all existing corporations.</span></p>

<p><span id="ctl00_Layout_lblContent">The required articles of incorporation are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent"><strong>a description of the corporation’s stock</strong>, that is, the number of shares, how many classes of shares exist, and the par value of the shares (“par” means equal; par value equals the established value).</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>classes of share</strong>, that is, the name of each class, its preferences, voting powers, limitations, restrictions, qualifications, and special or relative rights.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>series of classes</strong>, that is, the portion of a class of shares issued with a certain dividend rate, redemption privileges, liquidation preferences, conversion privileges, etc.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>pre-emptive rights</strong>, that is, the stock holder’s right to buy a portion of any new stock of the same class authorized and issued by the corporation.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>any special provisions</strong>.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the address of the initial registered office of the corporation </strong>and the name of its initial registered agent.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the names and addresses </strong>of the members of the corporation’s initial Board of Directors.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>one or more incorporators</strong>, either “natural persons” or another corporation, domestic or foreign. (All incorporators do not need to be residents of the state of incorporation). Usually the state statutes specify the number of incorporators or directors a corporation must have. Typically, a minimum number of these must be citizens of the United States and residents of the state of incorporation.</span></li>

</ol>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">6 - </span><span id="ctl00_Layout_lblChapterName">Corporation Approval</span></h2>

<p><span id="ctl00_Layout_lblContent">The approval for the corporation is in the form of a completed certificate that is sent to the proper state official, or division, for approval. Incorporation taxes and fees must be paid at this time. Upon approval, a new corporation is created.</span></p>

<p><span id="ctl00_Layout_lblContent">Often, the incorporator does not have to be a stockholder. When this is the case, the corporation needs at least one stockholder to proceed with the election of the Board of Directors. The corporation becomes fully developed after the first meeting of the incorporators and directors. At this meeting, the bylaws that govern the corporation are adopted, and officers are elected. Now the corporation is ready to begin its business.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">7 - </span><span id="ctl00_Layout_lblChapterName">The Corporate Name</span></h2>

<p><span id="ctl00_Layout_lblContent">When forming a corporation, the organizers must decide on a corporate name. Federal law requires that the name of the corporation must include the words “corporation,” “company,” “incorporated,” “limited,” or an abbreviation of one of these.</span></p>

<p><span id="ctl00_Layout_lblContent">The purpose of this requirement is so that people who are not familiar with the corporation are made aware that they are dealing with an entity to which no individual can be held personally liable. For example, if the corporate business is unable to pay its debts or obligations, no individual can be personally liable to pay these debts, as can be the case in a sole proprietorship or a partnership. The exception to this liability protection is if an officer or director personally guarantees a loan or debt, or if criminal activity is present.</span></p>

<p><span id="ctl00_Layout_lblContent">Further, the corporate name must accurately describe what the business does. Its name cannot mislead the public with respect to what the corporation does or does not do. Also, the name of a new corporation cannot resemble or approximate any other corporation that does business within the same jurisdiction.</span></p>

<p><span id="ctl00_Layout_lblContent">When forming a corporation, the organizers must subscribe for capital stock. Shares in a corporation are generally considered securities within the meanings of state and federal securities laws.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">8 - </span><span id="ctl00_Layout_lblChapterName">Selecting the Tax Status of a Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">Once the corporation receives registration approval in the state of domicile, it must file with the Internal Revenue Service for a tax identification number. This tax I.D. number is specific to that corporation and identifies the corporation as an entity for tax purposes. Application for the tax I.D. number is required before the corporation can establish a banking account, vendor arrangements, or can initiate any form of business activity.</span></p>

<p><span id="ctl00_Layout_lblContent">The incorporators or Board of Directors decide the tax status of the corporation. The corporation can select from two definitions of tax status:</span></p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent">Any corporation is considered a C corporation that has a graduated tax schedule, similar to that which would apply to an individual income tax schedule. The C corporation also has a defined set of tax guidelines.</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">An election to be taxed other than a C corporation is available through an election when applying for the corporate tax I.D. number. This election allows the corporation to be taxed as an S corporation.</span></p>

<p> </p>

<p> </p>

<ol>

<li value="2"><span id="ctl00_Layout_lblContent">Under the S corporation election, a corporation is referred to as a Sub-S corporation and is not subject to an individual tax schedule, as is the C corporation. Profits and losses of an S corporation pass through to a certain class of stockholders as defined by the corporate charter. This “pass through” characteristic is similar to that of how a partnership is taxed. However, the S corporation acquires certain tax benefits in how income can be designated, as well as how other issues of income and expenses are treated.</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">The primary difference between the C corporation and the S corporation with respect to life insurance planning issues is that the C corporation has its own tax obligation, which is referred to as a <strong>“closed gate” </strong>in keeping certain expenses within the corporate tax venue. Conversely, the S corporation, having no individual tax obligation, has an <strong>“open gate” </strong>through which profits and losses pass through to the stockholders.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">9 - </span><span id="ctl00_Layout_lblChapterName">Types of Corporations</span></h2>

<p><span id="ctl00_Layout_lblContent">Corporations fall into many broad classifications. The attributes of any corporation can vary according to its character, which is generally determined by the nature of the business of the corporation as stated in its articles of incorporation. The nature and the character of a corporation, as disclosed by its character, cannot be changed or enlarged in excess of its powers.</span></p>

<p><span id="ctl00_Layout_lblContent">Generally, corporations are classified as <strong>public </strong>or <strong>private</strong>. This distinction refers to the powers of a particular corporation and to the purpose of its creation. A public corporation is a government body, for example, a state or political subdivision of a state. A private corporation is a non-governmental body and is further divided between a <strong>non-stock corporation </strong>and a <strong>stock corporation</strong>.</span></p>

<p><span id="ctl00_Layout_lblContent">Non-stock corporations are usually divided into various types of membership, including religious and charitable organizations. Stock operations are those that have capital stock. Capital stock is divided into <strong>shares</strong>. The corporation is empowered by law to distribute dividends, or shares of surplus profits, to its stockholders. Stock corporations can be further classified as <strong>financial corporations</strong>, such as bank and insurance companies; <strong>public service corporations</strong>; <strong>business corporations</strong>; or <strong>professional corporations</strong>.</span></p>

<p><span id="ctl00_Layout_lblContent">Further classification comes from defining the business corporation as a <strong>publicly held corporation </strong>or a <strong>close corporation</strong>. A publicly held corporation is one in which its stock is traded on one of the open exchanges. This type of corporation is characterized by being owned by a substantial number of stockholders, most of whom take no part in the active management of the corporate business.</span></p>

<p><span id="ctl00_Layout_lblContent">On the other hand, a close corporation is a private corporation, or privately held, and its stock is not openly traded. A close corporation is also referred to as a closely held corporation. The close corporation is our central topic of discussion with respect to<strong>business continuation plans</strong>.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">The Close Corporation</span></h3>

<p><span id="ctl00_Layout_lblContent">A close corporation is a corporation whose franchise is owned by a small group of stockholders. Generally, these stockholders are actively engaged in the management of the corporation. Often, the entire corporation consists of only the Board of Directors, officers, and shareholders. Typically the management of this type organization is in the hands of a small group of people.</span></p>

<p><span id="ctl00_Layout_lblContent">In many jurisdictions, special statutes have been enacted to permit single individuals to form a close corporation. Whether a small group or a single individual, in forming a close corporation, the members limit their personal liability, but they conduct business without the formality often required by other types of corporations.</span></p>

<p><span id="ctl00_Layout_lblContent">A single stockholder or a very small number of stockholders generally hold the outstanding shares of stock in close corporations. Frequently, these stockholders are family and relatives, so the relationship between the management and the principal stockholders is very close. Because of the nature of the closely held corporation, the stockholders have a good knowledge of the corporation and of each other. In addition, these stockholders often have voting rights with respect to the activities of the corporation. They can choose to prohibit the transfer of shares to persons who are not family members or who are not employees of the corporation.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Characteristics Of A Close Corporation</span></h4>

<p><span id="ctl00_Layout_lblContent">The following factors generally characterize a close corporation:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">a small number of stockholders</span></li>

<li><span id="ctl00_Layout_lblContent">the recognition of partnership-like relationships</span></li>

<li><span id="ctl00_Layout_lblContent">the provision of minimum corporate formality</span></li>

<li><span id="ctl00_Layout_lblContent">no ready market for the shares of the corporation</span></li>

<li><span id="ctl00_Layout_lblContent">shareholder knowledge of the corporation</span></li>

<li><span id="ctl00_Layout_lblContent">the recognition of the autonomy of the participants in a close corporation to achieve contractually desirable arrangements</span></li>

<li><span id="ctl00_Layout_lblContent">a tight relationship between management and the principle stockholders and the stockholders’ desires for involvement in the voting process</span></li>

<li><span id="ctl00_Layout_lblContent">the provisions for certain dispute resolution techniques, such as provisional directors and optional dissolution by a stock holder</span></li>

<li><span id="ctl00_Layout_lblContent">the ease of enforcement of arrangements to preserve the close corporation status under a stockholders agreement</span></li>

<li><span id="ctl00_Layout_lblContent">generally subject to broad transfer restrictions.</span></li>

<li><span id="ctl00_Layout_lblContent">the operation and relationship of the stockholders to each other typically resemble partnerships rather than traditional corporations.</span></li>

</ul>

<h4>

<span id="ctl00_Layout_lblContent">Close Corporation Statutes</span></h4>

<p><span id="ctl00_Layout_lblContent">The statutes addressing close corporations are generally of two distinctions:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">They are statutes that are simply a part of general corporation laws, although they authorize provisions in corporation charters to modify the traditional corporate structure to fit the needs of the closely held business.</span></li>

<li><span id="ctl00_Layout_lblContent">They are statutes that are entirely devoted to the issues of close corporations.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">To take advantage of close corporation status, most states require that a close corporation must state its intent in its articles of incorporation to be considered a closely held corporation. Many modern statutes actually bar close corporations’ securities from the exchanges or from the over-the-counter market. The close corporations are required to make their restrictions explicit on the transfer of shares by agreements, and they must limit their number of stockholders.</span></p>

<p><span id="ctl00_Layout_lblContent">Many statutes define the various ways in which participants in close corporations can shape their arrangement to suit their needs. For example, close corporation founders can arrange matters so that persons contributing skill and efforts rather than cash have a larger say.</span></p>

<p><span id="ctl00_Layout_lblContent">Also, the members of a close corporation operate under the assumption that the membership is limited. Therefore, any changes in ownership can be traumatic, and special provisions for the transfer of stock may be necessary.</span></p>

<p><span id="ctl00_Layout_lblContent">Further, in some states, those forming a close corporation can reject one or all of the assumptions that the law typically makes about allocating control in an ordinary corporation.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">The Close Corporations vs. the Partnership</span></h4>

<p><span id="ctl00_Layout_lblContent">As in a partnership, a few individuals have a very close relationship in a close corporation. These individuals combine their talents and skills in conducting a business enterprise.</span></p>

<p><span id="ctl00_Layout_lblContent">Because a close corporation is generally small, each of the stockholders is usually a director and/or an officer, making the corporation a going concern in his or her life. The close corporation is a great investment for stockholders. As with the death of a partner, if a stockholder dies, his or her survivors would be eager for the corporation to continue. In fact, it is likely vital to them that the corporation continue.</span></p>

<p><span id="ctl00_Layout_lblContent">Also similar to partnerships, stockholders in a close corporation often conduct themselves and their business affairs like partners. In fact, it is not uncommon for them to refer to themselves as partners. Some courts have even applied partnership law to resolving disputes in closely held corporations. In recent years, the courts have relaxed their attitudes with respect to the statutory compliance of close corporations. They permit some deviations in their behavior from traditional corporate norms.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Limited Liability Considerations for Closed Corporations</span></h4>

<p><span id="ctl00_Layout_lblContent">Corporations have the benefit of limited liability. Although this limited liability is an advantage for larger organizations, the benefits for a closely held corporation are not so great. For example, with respect to bank loans, lease obligations, and major suppliers, owners and stockholders in a close corporation are often asked to personally guarantee any credit extended. Their limited liability is often waived.</span></p>

<p><span id="ctl00_Layout_lblContent">Further, the corporation does not limit the liability of a stockholder for his or her own wrongful acts or omissions. Therefore, the stockholder can be held personally liable for the full amount of losses or damages resulting from these wrongful acts or omissions.</span></p>

<p><span id="ctl00_Layout_lblContent">Sometimes whether a close corporation should be incorporated at all is questioned. While questions of liability and continuity may suggest that partners in a partnership should incorporate and form a close corporation, tax factors could suggest that a close corporation should become a partnership. Some businesses try to use both forms of organizations, attempting to gain all of the advantages of both forms of organizations, while at the same time rejecting the disadvantages of either.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Fiduciary Duty of Closed Corporations</span></h4>

<p><span id="ctl00_Layout_lblContent">The rules about fiduciary obligations are slightly different in the context of the close corporation. Remember that in a partnership, the fiduciary relationship between partners means that each partner owes complete loyalty to the partnership. He or she may not engage in any activity that conflicts with the interest of the partnership.</span></p>

<p><span id="ctl00_Layout_lblContent">This meaning often becomes blurred in a close corporation. Naturally, the distinctions between officers or directors and stockholders tend to lose their significance in small corporations. Frequently, these people are one of the same. Further, effective operations and rational decision-making are often hard to maintain in small corporations. But in a close corporation, some managers or stockholders could have their own interests at stake.</span></p>

<p><span id="ctl00_Layout_lblContent">This factor should be considered when planning the estates of stockholders in a close corporation and constructing the buy-sell agreement. While personal factors can occur in larger corporations, they are more prevalent in a typical close corporation. Personal motivations and feelings can often interfere with the objective performance of any duties, including fiduciary ones.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">10 - </span><span id="ctl00_Layout_lblChapterName">Rights and Powers of the Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">The powers of a corporation are those granted by the state, as found in the formal corporate charter and in applicable statutes; attributes of these rights and powers are listed below. The corporation’s only power is to conduct the type of business authorized by its charter.</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">The expressed powers on the corporation’s charter are often stated as broadly as possible. This avoids any question of engaging in acts beyond the scope of the charter.</span></li>

<li><span id="ctl00_Layout_lblContent">Generally, a corporation can be formed for any lawful purpose. Naturally, special statutes and requirements govern a corporation’s conduct with respect to banking, insurance, transportation, and other activities that are closely related to the public interest.</span></li>

<li><span id="ctl00_Layout_lblContent">A corporation has the power of continued existence during the period designated in its charter. It has the right to use its corporate name, and the power to change its name, subject to applicable laws. A corporation also has the right to use a corporate seal, although in most states, a corporate seal is not required.</span></li>

<li><span id="ctl00_Layout_lblContent">A corporation has the power to enter into all contracts necessary to conduct its business. It has the power to employ officers, employees, and agents to conduct its affairs.</span></li>

<li><span id="ctl00_Layout_lblContent">A corporation has the power to acquire and hold property for purposes that are consistent with the powers granted to it. It may borrow money, contract indebtedness, and furnish security for any debt.</span></li>

<li><span id="ctl00_Layout_lblContent">A corporation can sue and be sued in its corporate name.</span></li>

<li><span id="ctl00_Layout_lblContent">A corporation can make bylaws for governing its affairs, consistent with its formal charter and with applicable laws. It can enter into joint ventures, but a corporation cannot become a partner unless specifically authorized by its charter.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">Common law holds that, unless expressly authorized, a corporation has no right to purchase its own share of stock. However, the courts have held that a corporation does have the implied power to acquire its own shares, as long as it does so in good faith and without injury to its creditors or stockholders. To prevent such an injury, this purchase must be made from surplus.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">11 - </span><span id="ctl00_Layout_lblChapterName">Managing the Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">Centralizing management is an advantage of the corporation. Of course, the centralization of management can be accomplished in a partnership, too. However, in a corporation, the corporation statutes encourage the centralized approach.</span></p>

<p><span id="ctl00_Layout_lblContent">Stockholders elect directors who are responsible for managing the corporation. This Board of Directors elects officers who carry out the management policies. A president and a secretary are typically required, and other officers may be necessary, as well. The corporation’s articles of incorporation and the state statutes further define the rights and responsibilities of the directors, officers, and stockholders.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">The Stockholders</span></h3>

<p><span id="ctl00_Layout_lblContent">The stockholders in a large corporation have no authority to participate in the corporation’s ordinary business. In this way, they are often referred to as <strong>inactive stockholders</strong>. The operation of the corporation’s business is managed by the Board of Directors; the stockholders elect the directors. However, in a smaller close corporation, the stockholders are active participants in the corporation’s business. These types of stockholders are referred to as <strong>active stockholders</strong>.</span></p>

<p><span id="ctl00_Layout_lblContent">In addition to electing the Board of Directors, the stockholders participate in various decisions that relate to the existence, powers, and capital structure of the corporation. These decisions include approving the disposal of the aggregate corporate assets, approving a mortgage on the corporate property, amending the corporate charter or effecting any changes in the capital stock, approving the dissolution of the corporation, and approving any consolidation or merger.</span></p>

<p><span id="ctl00_Layout_lblContent">Sometimes stockholders render their decisions by majority vote. In some situations, for example, in the mortgaging of the corporation’s realty, a vote of two-thirds or greater is usually required by statute. Some states require that stockholders must vote before a corporation can purchase its own stock, and the percentage necessary to secure this approval is specified.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">The Board of Directors</span></h3>

<p><span id="ctl00_Layout_lblContent">After the election by the stockholders, the Board of Directors meets and proceeds with the management of the ordinary affairs of the corporation. However, a board member has no individual authority to act for the corporation; he or she only acts as a Board with the other members when they are assembled at an official meeting of the board.</span></p>

<p><span id="ctl00_Layout_lblContent">The Board of Directors elects corporate officers, and their salaries are fixed by the Board. Then the officers proceed by hiring agents and employees to execute the daily business of the corporation. Although the Board of Directors can delegate to officers and agents, they can delegate only ministerial power to administer the affairs of the corporation. For example, the Board cannot delegate discretionary powers.</span></p>

<p><span id="ctl00_Layout_lblContent">While the Board members are not exactly considered trustees, they do hold a fiduciary relationship to the corporation and to its stockholders. They are obligated to exercise the same degree of care and prudence in conducting its affairs as would be exercised by an ordinary prudent person in conducting his or her affairs. Further, a director cannot exercise his or her official position for his/her own benefit; the director must act only for the benefit of the corporation. The corporate assets must not be wasted or misapplied.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">The Officers</span></h3>

<p><span id="ctl00_Layout_lblContent">The Board of Directors acts only in official meetings. Because these meetings obviously cannot be held continually, the Board delegates duties on behalf of the corporation to officers. Corporate officers are elected by the Board of Directors.</span></p>

<p><span id="ctl00_Layout_lblContent">The duties of each officer are typically specified in the bylaws of the corporation. The offices usually consist of a president, at least one vice president, a secretary, and a treasurer. It is the duty of these officers to carry on the business of the corporation. This includes hiring and supervising the agents and employees of the corporation.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">12 - </span><span id="ctl00_Layout_lblChapterName">Property Rights in a Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">As described earlier, a corporation is an entity separate and distinct from those who participate in it. So exactly who holds the title to the assets of a corporation? This title is vested in the corporation as a legal entity. For example, suppose a small gift store is formed as a close corporation, and there are only two stockholders. Which of the two actually owns the inventory? Do they share ownership? When a crystal clock is sold to a customer, who is the seller?</span></p>

<p><span id="ctl00_Layout_lblContent">The answer to these questions is that the inventory is held in the corporate name. When the crystal clock is sold, it is sold by the corporation acting through its authorized representatives. Neither of the two stockholders actually has any legal ownership in the inventory. If someone should unlawfully possess any of the inventory, it can be recovered only in the name of the corporation.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">13 - </span><span id="ctl00_Layout_lblChapterName">The Assets of the Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">The assets of a corporation are owned by the corporation and not by the stockholders, officers, or Board of Directors. So, if one of the participants in the gift store corporation described earlier wanted to own the crystal clock, he or she would purchase it from the corporation. Alternatively, he or she could receive it as a dividend, but this person would still have to receive title to the clock from the corporation.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">14 - </span><span id="ctl00_Layout_lblChapterName">The Interest of Each Stockholder</span></h2>

<p><span id="ctl00_Layout_lblContent">Although no person can own property in connection with a corporation, persons do own other rights, namely intangible rights. Stockholders collectively own the “franchise of the corporation to be a corporation.” The primary franchise of being a corporation is a special privilege conferred by the state. This special privilege vests in the group of individuals who comprise the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">A stockholder has the following rights:</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the right to receive dividends</strong>—Stockholders also own the rights accruing to one who holds a share in a stock corporation. A share of the capital stock is the right to partake, according to the amount put into the fund, in the surplus profits of the corporation. This is the right to share in dividends when they are declared by the Board of Directors. Dividends are corporation funds that are obtained from the earnings and profits of the corporation and that are appropriated by a corporate act. These dividends are divided among the stockholders. Dividends are declared by the Board of Directors.</span></li>

</ul>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">Two rights comprise a share of stock:</span>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent">The right to receive a fractional share of surplus profits in the form of dividends when they are declared</span></li>

<li><span id="ctl00_Layout_lblContent">The right to receive a like share of the residuals upon the dissolution of the corporation</span></li>

</ol>

</li>

</ul>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the right to transfer stock interest and to have the transfer made on the corporate books </strong>A stockholder has the property right to transfer his or her shares at will. However, the right can be circumvented by the corporate charter or by means of some contract between the stockholders. This right can be circumvented only within reason. An absolute prohibition against transferring stock, however, is invalid, because it goes against public policy. The courts look more favorably upon restricting the transfer of close corporation stock than upon restricting the stock of publicly held corporations.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the right to inspect the books and records of the corporation</strong>—This right is conferred by common law and in most states, by statute. A stockholder has a right to inspect the books and records of the corporation at reasonable times and places and for proper purposes. Most states grant this right, regardless of the motive or the purpose behind the inspection. This right can be exercised in person or by the stockholder’s authorized agent or attorney. Copies can be made of the books and records.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the right to attend stockholders’ meetings and to vote for directors</strong>—All stockholders have the right to attend stockholder meetings and to vote on corporate matters. In some situations, the right to vote by proxy is conferred by state statute or by the corporation’s bylaws. In a stockholders meeting, shareholders represent themselves and their own interests, and they may vote as they desire. One vote is generally allowed for each share of voting stock.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the right to adopt bylaws</strong></span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the right to receive a certificate as evidence </strong>of his or her share of the stock</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the right to require that the property of the corporation be employed for proper corporate purposes</strong></span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the right to subscribe for any new shares of stock</strong></span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the right to vote on such matters as the change of corporate name</strong>, the change in the capital structure of the corporation, or any other material change</span></li>

</ul>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">15 - </span><span id="ctl00_Layout_lblChapterName">Liabilities in a Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">The most commonly cited non-tax-related advantage of operating a business as a corporation is the ability to enjoy the protection of limited liability. Usually, this is the primary consideration. Because a corporation is regarded as a distinct legal entity separate and apart from its stockholders, a corporation enjoys a limited liability that is not afforded by the formation of a sole proprietorship or a partnership. Sole proprietors are liable to the full extent of their personal assets to the creditors of their unincorporated business, as are partners in a partnership.</span></p>

<p><span id="ctl00_Layout_lblContent">Sole proprietors are personally liable to the full extent of their assets by creditors for business-related acts or omissions committed by themselves, by their employees, and by their agents. Likewise, a partner is personally liable for these as well as for those acts or omissions of another partner.</span></p>

<p><span id="ctl00_Layout_lblContent">A stockholder, on the other hand, is not personally liable for the debts and obligations of the corporation or for the acts of fellow stockholders, corporate directors, officers, employees, or agents. The stockholder of a corporation is liable for contractual obligations only to the extent of his or her investment in the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">Although a corporation can be sued, the corporation is the proper defendant to a lawsuit, not the stockholders. This rule does have a few exceptions: under some circumstances, the corporate entity is disregarded, but this usually happens only in case of fraud.</span></p>

<p><span id="ctl00_Layout_lblContent">In some cases limited liability is overstressed as a benefit of incorporation. To remedy the liability issue, sole proprietors and partners can take out liability insurance to cover most risks, thereby limiting their liability with an insurance policy. Any risk of loss that owners of non-corporate organizations may experience from wrongful acts or omissions can be substantially reduced by this insurance in the ordinary course of business. Liability can be circumvented.</span></p>

<p><span id="ctl00_Layout_lblContent">In some organizations, the nature of the business is such that risk of loss cannot be adequately insured. This could include hazardous enterprises where liability insurance is either unavailable or prohibitively expensive. Naturally, in these cases, limited liability is a crucial factor.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Express, Implied, and Apparent Authority</span></h3>

<p><span id="ctl00_Layout_lblContent">A corporation can be held liable for all acts of its officers, agents, and employees performed within the general powers of the corporation and with the express or implied authority of the corporation. A corporation has two types of authority: (1) <strong>express actual authority </strong>and (2) <strong>implied actual authority</strong>. Express actual authority is authority actually bestowed. Typically, express authority originates from the decisions made by a majority of the stockholders.</span></p>

<p><span id="ctl00_Layout_lblContent">Implied actual authority includes authority that is neither expressly granted nor expressly denied. Implied authority is reasonably deduced from the nature of the business.</span></p>

<p><span id="ctl00_Layout_lblContent">If an authorized corporation representative enters into a contract that is beyond the express actual or implied actual authority of a corporation, an <strong>ultra vires contract</strong>exists. An ultra vires contract is one that is beyond the scope or powers of the corporation. Such a contract cannot be enforced against the corporation, unless the other party has already performed and the corporation has received some benefit from the contract.</span></p>

<p><span id="ctl00_Layout_lblContent">Further, just because an act is committed in the course of an ultra vires transaction does not relieve the corporation of liability.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Liability of Officers, Agents, and Employees</span></h3>

<p><span id="ctl00_Layout_lblContent">When representatives act for a corporation, they assume no personal liability if their act is within their authority or if their act is validated by the corporation. However, without validation or express or implied authority, the representative can be liable to the corporation for any damages. The representative can also be held liable to the other party for breach of implied warranty or authority.</span></p>

<p><span id="ctl00_Layout_lblContent">If a representative of a corporation commits an act such as negligent or willful injury to another while he or she is acting within the scope of his or her authority, the representative and the corporation can be held liable for any resulting damages.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Liability of the Directors</span></h3>

<p><span id="ctl00_Layout_lblContent">As described earlier in this chapter, a corporation’s directors are obliged to exercise the same degree of care and prudence in managing the corporation as they would use in handling their own affairs. Directors must be honest and diligent in performing their duties. As such, when any mistakes, omissions, or errors in judgment are made, directors can be held liable. They can also be held liable for damage or injury to the corporation that results from their failure to act, their failure to act with reasonable prudence, or their negligent or willful acts that are adverse to the corporation’s welfare.</span></p>

<p><span id="ctl00_Layout_lblContent">In some states, laws impose statutory liability upon directors and officers for breach or neglect of certain duties; for example, the failure to make a required report. Statutory liability is created by the legislative or executive branches of government. Laws, statutes, or other rulings are enacted, and these create the liability exposure. On the other hand, common law liability stems from the body of law that is created in the courts. Common law is not written, legislated, or upheld by statutes. Rather, it is based on written judicial decisions known as <strong>precedent</strong>.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Liability of the Stockholders</span></h3>

<p><span id="ctl00_Layout_lblContent">Stockholders as a classification are not actively involved in managing a corporation. Therefore, they have no liability for acts of the corporation. Generally speaking, stockholders are not liable for the debts of their corporation. So, if a corporation should become insolvent, in the absence of any special statutory liability, a stockholder stands to lose only his or her capital investment.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Defining Active Stockholders</span></h4>

<p><span id="ctl00_Layout_lblContent">An active stockholder is one who is engaged in some form or another in the daily business operations of the corporation. They can serve on the Board of Directors, in the role of officer or agent of the corporation, in a full- or part-time capacity, or in any capacity of engagement.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Defining Inactive Stockholders</span></h4>

<p><span id="ctl00_Layout_lblContent">An inactive stockholder is one who has provided invested capital by purchasing corporate stock but takes no active role in the daily business operations of the corporation. The only participation of the inactive stockholder is in electing the Board of Directors, attending stockholder meetings as they are scheduled, and voting on issues that may be presented to the stockholders.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">The Death of a Stockholder</span></h4>

<p><span id="ctl00_Layout_lblContent">Within the true meaning of the corporation, the corporation’s Articles of Incorporation typically provide for its perpetual existence. Its succession is continued for the period specified by its charter or by statute. Because a corporation is treated as a separate entity with continuity of life, events such as the death of an owner really have no effect on the legal structure of the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">However, this is not to say that the death of a stockholder has no effect at all on the corporation. Even though the death of a stockholder has no legal effect on the existence of the corporation, as in a sole proprietorship or a partnership, the death of a stockholder has other consequences, which can be specified in a shareholder agreement. Of course, these consequences depend on whether the deceased stockholder was a sole stockholder, a majority stockholder, minority stockholder, equal stockholder, inactive stockholder, or active stockholder.</span></p>

<p><span id="ctl00_Layout_lblContent">Still, the corporation’s legal existence is not displaced by any changes in the ownership of its shares of stock. Shares in a corporation can be passed to heirs, because they are personal property.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">Retaining the Corporate Interest</span></h5>

<p><span id="ctl00_Layout_lblContent">After the death of a stockholder in a larger corporation or in a publicly held corporation, the deceased can bequeath his or her shares in the corporation to his or her heirs. This has no real effect on the continuity of the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">Unfortunately, in a closely held or smaller corporation, the business can suddenly be without the skills, knowledge, abilities or talents of an important individual who is not easily replaceable. The result is that the corporate entity can be unnerved. It may be in jeopardy, and the confidence of the clientele can be seriously weakened. Some immediate options upon the death of a stockholder are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">the surviving stockholders can decide to continue the corporate enterprise with the heirs of the deceased stockholder as a part of management;</span></li>

<li><span id="ctl00_Layout_lblContent">the surviving stockholders may want to purchase the stock of the deceased;</span></li>

<li><span id="ctl00_Layout_lblContent">the surviving stockholders may consider selling their own interests.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">From the standpoint of the heirs, if they want to sell their newly acquired stock, they may learn that neither the corporation nor the remaining shareholders are financially capable of buying them, and the stock has no established market. In these circumstances, the heirs have no choice other than to retain the stock and to play an active role in the business.</span></p>

<p><span id="ctl00_Layout_lblContent">To ensure the financial security of the corporate owners and their families, preplanning and a buy-sell agreement can play important roles. The provisions of the agreement must be tailored to satisfy the requirements and the objectives of the stockholders, as well as those of the corporation. The purpose of such an agreement is to provide the funds necessary so that the deceased’s interest can be purchased and to provide a way that the business can continue in a smooth and uninterrupted manner.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">The Death of a Sole Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">The death of a close corporation stockholder can have a severe impact, even though his or her death does not affect the legal existence of the corporation. Even more debilitating is the death of a sole stockholder, which makes administering an active business even more challenging than it already is. When a sole stockholder dies, he or she essentially leaves his or her estate and heirs in a predicament similar to that found in a sole proprietorship or partnership. For example, the personal representative immediately takes possession of all of the deceased’s assets to conserve them and to apply them to the payment of all debts, business and personal. The personal representative must ensure that the remaining property of the estate is then distributed to those who are entitled to it.</span></p>

<p><span id="ctl00_Layout_lblContent">The personal representative has no authority to continue the business of the corporation and must promptly dispose of it or dissolve it. If a personal representative, especially one who is unfamiliar with operations, continues the business without authorization, then the estate values are often significantly reduced.</span></p>

<p><span id="ctl00_Layout_lblContent">In the context of the corporation’s business, the personal representative has the right to receive dividends that may be declared on the shares of the company. Further, personal representatives have the right to vote upon the shares, but their possession of these rights is purely fiduciary. Therefore, they are answerable to the beneficiaries for their conduct in relation to these assets, as well as in all other assets held in their trust.</span></p>

<p><span id="ctl00_Layout_lblContent">Without the benefits of preplanning, any attempts to maintain the continuity of the close corporation business are only accomplished through a post-mortem plan.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">Issues for the Heirs and the Estate of a Sole Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">If the sole stockholder does not, prior to his or her death, make arrangements for the future of his or her corporation, then the personal representative is required to sell or to liquidate the business. If the corporation is a successful one, sometimes the personal representative or the heirs attempt to keep the business operating, despite the lack of authority to do so.</span></p>

<p><span id="ctl00_Layout_lblContent">Sometimes it is difficult to determine whether a continuation of the corporation is authorized. In one respect, the personal representative has the duty to conserve the estate’s assets. But in another respect, the personal representative is penalized if he or she continues the business without authority. Moreover, sometimes the heirs request that the personal representative continue the corporation business, giving their consent to this. However, such continuation is considered to be unauthorized.</span></p>

<p><span id="ctl00_Layout_lblContent">Even if all heirs are competent adults, the personal representative must obtain unanimous consent to keep the business operating. If all of the heirs are of age, competent, and willing to consent, and if profits result, the personal representative must turn the profits over to the estate. However, if losses are sustained as a result of continuing the business, then the consenting heirs have surrendered their right to hold the personal representative liable. Not having an effective business continuation plan can cause the heirs to forfeit their legal right to hold the personal representative to account.</span></p>

<p><span id="ctl00_Layout_lblContent">In most states, authority can be granted to the personal representative to carry on the business temporarily. If the business is to be continued under the authority of a state statute, it is likely to be permitted to continue only as long as is necessary to wind up the work in progress and to wind up the affairs of the business. Even a court order does not allow the business to run indefinitely.</span></p>

<p><span id="ctl00_Layout_lblContent">Some statutes permit the continuation of a business for the purpose of its sale as a going concern during the normal period of estate administration. A few states permit the personal representative to continue the deceased’s business until a sale can be made, even though it cannot be made during the normal period of estate administration. However, favored business conditions must exist for such a statute to apply. Favored business conditions mean that the business is profitable as an ongoing concern; a good business climate and/or market exists.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">The Absence of Wills and Trusts of a Sole Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">If the deceased sole stockholder does not have a will or living trust, the personal representative must dispose of the personal property of the estate for cash. If cash or other property exists that is sufficient to pay the debts, taxes, and administration expenses, then the personal representative can conserve the deceased sole stockholder’s stock for the beneficiaries of the estate. Difficulty can arise, however, if any of the heirs are minors.</span></p>

<p><span id="ctl00_Layout_lblContent">Although it may be the intent of the personal representative to get the best price upon liquidation of an asset, a forced sale of the stock or the assets of the corporation under these distressing conditions can result in considerable loss of value to the estate and to the heirs. The personal representative is responsible for promptly administering the estate.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">The Presence of Wills and Trusts of a Sole Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">If the deceased sole stockholder does have a valid will or living trust, the language in the will or trust must specifically address the issue of his or her shares of stock. Authority can be given to the personal representative to operate the business until a suitable buyer is obtained, or assets of the corporation are sold at the best market price. Or, the stock can be placed in trust for the heirs and the beneficiaries of the estate, or can be bequeathed to one or more of the heirs of the estate.</span></p>

<p><span id="ctl00_Layout_lblContent">However, if these shares represent a majority of the value of the deceased’s assets in the estate, some portion of the shares will probably have to be sold to raise the funds for paying debts and other expenses.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">The Death of a Majority Stockholder</span></h4>

<p><span id="ctl00_Layout_lblContent">A close corporation is similar to a partnership in that it involves a close and intimate association of a few individuals who combine their talents and skills in the conduct of a business enterprise. In the event of the death of a partner, the legal entity that was formed as a result of the partnership ceases to exist. While the death of a majority stockholder does not affect the legal existence of the corporation as it would in a partnership, it can have dire consequences to the corporation.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">Issues for the Heirs and the Estate of the Majority Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">Initially, the shares of the deceased majority stockholder go to the personal representative who holds them during the time of administration of the estate. This is done for the benefit of the creditors and the heirs or beneficiaries. The majority stockholder is usually the person who contributes a particular vital skill to the close corporation or who was the primary source of capital and credit. He or she was a valuable member of the corporate crew, and the corporation will likely suffer as a result of his or her death.</span></p>

<p><span id="ctl00_Layout_lblContent">Unlike a partnership, where the surviving partners can wind up the partnership, seek a new partner, or reconstitute the partnership with only the surviving partners, the corporation has perpetual life, binding the minority stockholders to an uncertain future. This can create a hostile or unfriendly environment that affects the ongoing operations of the business. The personal representative is responsible for managing all of the assets of the deceased majority stockholder’s estate. The uncertainty of the minority stockholders, officers, and employees may make the prospect of maintaining a going concern difficult.</span></p>

<p><span id="ctl00_Layout_lblContent">Questions must be addressed, such as, if the surviving minority stockholders decide not to resign, will the new owner of the shares be content to allow the surviving minority stockholders to run the business? Conflicts of interest are sure to result. The surviving minority stockholders will undoubtedly be required to continue operating the business alone. They are likely to feel that more of the profits should go to them in the form of salary increases for their additional efforts. Will the new majority stockholder be willing to do this?</span></p>

<h5>

<span id="ctl00_Layout_lblContent">The Absence of Wills and Trusts</span></h5>

<p><span id="ctl00_Layout_lblContent">If the deceased majority stockholder does not have a will or living trust, the personal representative must dispose of the personal property of the estate for cash. This cash is used to pay the creditors of the deceased and to pay the taxes and administration expenses. What is left is forwarded to the heirs or beneficiaries who are entitled to it under the intestate laws of the state.</span></p>

<p><span id="ctl00_Layout_lblContent">If cash or other property exists that is sufficient to pay the debts, taxes, and administration expenses, then with the consent of all the heirs, provided they are all adult, the personal representative can conserve the deceased majority stockholder’s stock. He or she can then deliver the stock to those who are to receive it according to the directives of any preplanning or a buy-sell agreement. Otherwise, the personal representative must liquidate the shares of stock.</span></p>

<p><span id="ctl00_Layout_lblContent">If the stock must be liquidated, the estate may or may not be able to get a fair price for it. A factor that hinders obtaining a fair price for the stock is that the personal representative is required to carry out the administration of the estate with promptness. Naturally, prospective buyers are aware of this. A forced sale does not leave the estate in a very good bargaining position.</span></p>

<p><span id="ctl00_Layout_lblContent">Also, suppose administration of the estate takes place during a seasonal slump of the business or during a general business depression. A forced sale under these distressing conditions could result in a considerable loss to the estate and to the heirs.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">The Presence of Wills and Trusts</span></h5>

<p><span id="ctl00_Layout_lblContent">If the deceased majority stockholder leaves a valid will or living trust, he or she must specifically address the issue of his or her shares of stock. If the stock has not been bequeathed or placed in a trust, the stock is not automatically liquidated to pay creditors and other claims, except as a last resort. However, if these shares represent a majority of the deceased’s assets, some portion will probably have to be sold to raise money for paying the debts.</span></p>

<p><span id="ctl00_Layout_lblContent">If such a sale is necessary, the sale may involve disposing of a number of shares, which can change the balance of control in the close corporation. In this case, the shares could bring a fair price from the surviving minority stockholders, but only if the stockholders have the funds available for the purchase. Otherwise, the remaining shares in the estate are of little value.</span></p>

<p><span id="ctl00_Layout_lblContent">Of course, it is possible to pass on these majority shares in-tact. However, the recipients of the shares inherit control of the corporation. Unless they can take an operative role in managing the corporation’s business, the corporation and the surviving minority stockholders will likely see difficulty, frustration, and even disaster in their futures.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">Issues for the Surviving Minority Stockholders</span></h5>

<p><span id="ctl00_Layout_lblContent">A majority stockholder is one who holds the majority of a stock in a corporation. In a close corporation, the controlling interest of the deceased majority stockholder passes into the hands of a new majority stockholder. This is facilitated by the personal representative of the estate, who conveys the stock of the deceased majority stockholder to the heirs or to someone who purchases it from the estate. Typically, if no advanced plans are made, the stock generally passes to an heir, who becomes the new majority stockholder. This can be the spouse of the deceased, who is often inexperienced and usually has another agenda. The heir can also be an adult child who is unable or unwilling to contribute to the work of the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">Regardless of the personal characteristics of the heir, he or she is now the majority stockholder in this situation and has a voice in future meetings. Even in light of inexperience, this new interest can dominate the board. We know that the Board of Directors directs the management and dividend policy of the corporation, but the entire future of the close corporation can be changed upon the arrival of a new majority stockholder.</span></p>

<p><span id="ctl00_Layout_lblContent">Typically, in the event of the death of a majority stockholder, the surviving minority stockholders, those who own the lesser number of shares, are left to carry the burden of the work of the corporation. One option is for the minority stockholders to form a new organization. However, in doing so, they would have to sell their stock to raise capital. Unfortunately, little or no market exists for minority holdings in a close corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">At the same time, minority stockholders can be outvoted at meetings, so their jobs are in jeopardy. They could choose to resign, but if they decide to leave and begin business on their own, they would have the corporation to deal with as a competitor, and they would not have an established client base. Such a situation is a perfect example of how important preplanning is, which gives minority stockholders control of the business in the event of the death of a majority stockholder.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">The Death of a Minority Stockholder</span></h4>

<p><span id="ctl00_Layout_lblContent">From the perspective of the corporate business as a whole, the consequences of the death of a minority stockholder can be just as grim as the loss of a majority stockholder. Often, it is the minority stockholders who contribute a major part of the effort, while the majority stockholder makes the most of the capital contribution.</span></p>

<p><span id="ctl00_Layout_lblContent">Regardless, the death of the majority stockholder or the minority stockholder interrupts the close and personal relationship of the principals.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">Issues for the Heir and the Estate of a Minority Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">The shares of the deceased minority stockholder pass to the hands of the personal representative, who is required to sell the deceased’s shares of the stock in the process of administering the estate. From that point, the shares’ final disposition depends on the status of the estate and on the provisions of the deceased’s will, if any. (Typically in a close corporation, the greater number of participants own minority stock interest.)</span></p>

<p><span id="ctl00_Layout_lblContent">If no provisions have been made in the will for the disposition of the stock, the personal representative is in a tenuous position. While he or she must collect the assets of the estate, including the stock, the personal representative can also be surcharged for any losses that result to the estate; he or she can also be surcharged for not selling the stock at an “adequate” price, even though a very limited market exists for minority interest in a close corporation. These scenarios all emphasize the fact that delay in the administration of the estate can be costly for their heirs. Preplanning by way of an agreement to sell these holdings to the surviving stockholders for a satisfactory price can avoid delay and unnecessary expenses to the estate. The close corporation can continue with a minimum of interruption.</span></p>

<p><span id="ctl00_Layout_lblContent">Regardless of whether a will exists, the position of the personal representative differs greatly from his or her position in the situation of the majority stockholder. In the case of the majority stockholder, because a controlling interest exists in the close corporation, the personal representative typically possesses a marketable estate asset. This is not to say that the stock is easily marketable—remember, these shares are not publicly traded in over-the-counter exchanges. In the case of a deceased minority stockholder, the only real available market for the stock is in the surviving majority stockholders. Because they already control the corporation, the bargaining position of the estate of the deceased minority stockholder is not a good one.</span></p>

<p><span id="ctl00_Layout_lblContent">Under optimum circumstances, the personal representative can dispose of the minority interest at a reasonable price, which is acceptable to the probate court. This price must also be acceptable to the estate. Further, the stock must be disposed of at this acceptable price within the limited probate period.</span></p>

<p><span id="ctl00_Layout_lblContent">If the will or trust specifically bequeaths the shares of the minority stockholder to one or more beneficiaries, or if an agreement exists where the heirs accept the shares, and if funds are available to pay estate obligations, then the minority stock ownership will ultimately pass into the hands of the deceased’s family.</span></p>

<p><span id="ctl00_Layout_lblContent">The optimum situation produces an heir who is ready, capable, enthusiastic, and willing to accept the surviving majority stockholders as his or her business associates. However, if the new owner of the stock is an inactive stockholder, conflicts and trouble will ensue. As we know, optimum situations do not commonly occur.</span></p>

<p><span id="ctl00_Layout_lblContent">Again, the issues of new ownership arise. The surviving spouse, adult child, or other relative as the new minority stockholder often has an agenda of his or her own, or perhaps this person is simply not experienced in business. Perhaps he or she is not at all familiar with this particular business.</span></p>

<p><span id="ctl00_Layout_lblContent">Although the deceased minority stockholder probably earned a good living as a result of his or her position and efforts in the corporation, it will prove very difficult to convince the new stockholder that this was more a result of the effort than merely the perks of the position.</span></p>

<p><span id="ctl00_Layout_lblContent">Coming into a business under these circumstances, new stockholders often expect favorable and consistent income in the form of dividends on the stock. In reality, this is not always possible. In fact, any surplus of corporate earnings usually goes toward the further development of the corporate business.</span></p>

<p><span id="ctl00_Layout_lblContent">Conflicts invariably arise, many of which cannot be resolved. Ultimately, either the new minority stockholder will concede and sell the stock at less than an acceptable price, or the conflict will escalate. Unfortunately, lawsuits over mismanagement often result. These lawsuits only worsen the problems, causing significant expense and even further strife.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">The Absence of Wills and Trusts—Minority Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">First, if no will or living trust exists, the personal representative is required to dispose of the stock for cash unless all of the heirs, provided they are all adult and capable of consent, agree to accept the shares in lieu of liquidation. Also, the estate must have sufficient other property to pay all the debts and obligations of the deceased and his or her estate.</span></p>

<h5>

<span id="ctl00_Layout_lblContent">The Presence Of Wills And Trusts—Minority Stockholder</span></h5>

<p><span id="ctl00_Layout_lblContent">If the deceased stockholder leaves a will or living trust without specific provisions for disposing of his or her stock, then the situation is the same: in the absence of any other agreement by the beneficiaries to accept the stock certificates rather than cash, the personal representative must sell the stock. Of course, such an agreement cannot be transacted unless the estate has sufficient other property available for discharging all estate obligations.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">The Death of an Equal Stockholder</span></h4>

<p><span id="ctl00_Layout_lblContent">Many close corporations are small, often comprised of one, two, or a few individuals. In close corporations that have only two stockholders, each stockholder owns one-half of the shares of stock. Many of these corporations began as partnerships and were incorporated later as the business and the need for limited liability grew.</span></p>

<p><span id="ctl00_Layout_lblContent">These types of informal close corporations are often referred to as <strong>incorporated partnerships</strong>. In an incorporated partnership, the decisions, the work, and the profits are shared equally. Often, these stockholders consider themselves partners, even referring to one another as partners.</span></p>

<p><span id="ctl00_Layout_lblContent">When such a close corporation suffers the death of one of the equal stockholders, the surviving stockholder must carry on alone. For a time, the surviving stockholder has no one with whom to share the decision making process and other burdens. In such a situation, the personal representative holds the position of the deceased at stockholders’ and directors’ meetings.</span></p>

<p><span id="ctl00_Layout_lblContent">Remember that the personal representative represents principally the creditors and the heirs of the deceased stockholder. Therefore, his or her perspective of the objectives of the surviving equal stockholder is limited. In the end, the deceased stockholder’s position is held either by some purchaser of the deceased’s stock, if the personal representative is required to liquidate, or by a member of the deceased stockholder’s family.</span></p>

<p><span id="ctl00_Layout_lblContent">Regardless of who the new stockholder is, he or she is unlikely to be an acceptable “equal” to the surviving stockholder. An equal stockholder cannot possibly be replaced in terms of objectives and the harmony that united the partners and created a successful business. Unfortunately, in these situations, the conflicts that arise often lead to the ultimate liquidation of the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">Just like the majority stockholder and the minority stockholder, equal stockholders must preplan, because issues for the heirs and for the estate of the majority stockholder, problems with an absence of wills or trusts, and benefits from the presence of wills and trusts are similar to those of the deceased minority stockholder.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Issues for the Inactive Stockholder</span></h4>

<p><span id="ctl00_Layout_lblContent">Inactive stockholders receive benefits from their investment in the business from dividends on their stock and from the potential appreciation in value of this stock. Desiring the greatest possible return on their investments, inactive stockholders are in a position to demand that dividends are distributed instead of increasing the salaries of the active minority stockholders.</span></p>

<p><span id="ctl00_Layout_lblContent">Unfortunately, unless the majority stock passes into the hands of an experienced recipient such as one who is already active in the affairs of the corporation, or one who is a favorable associate, or one who is willing to assume this burden, then the heirs and the estate are likely to be better off with the cash value of promptly liquidated stock.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">16 - </span><span id="ctl00_Layout_lblChapterName">Liquidating the Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">In the worst case scenario, a suitable arrangement may not be found for disposing of a deceased stockholder’s interest in a close corporation without an insured buy-sell agreement. In this case, the only alternative is to liquidate the close corporation. The terms <strong>liquidation </strong>and <strong>dissolution </strong>are often confused when referring to the termination of a corporation. Liquidation is sometimes called “winding up,” which is the process of settling or winding up the corporation’s affairs; it is the orderly disposition of the corporation’s assets. Winding up includes discharging the corporation’s outstanding obligations and liabilities and distributing the remaining assets, if any, to the individual stockholders.</span></p>

<p><span id="ctl00_Layout_lblContent">Conversely, dissolution refers to the formal termination of the corporation’s existence. It is the official termination of the corporation’s existence and its extinction as an entity.</span></p>

<p><span id="ctl00_Layout_lblContent">When the winding up process is concluded, Articles of Dissolution must be filed. Because the corporation was initiated by an act of power by the state, the existence of the corporation cannot be terminated except by that same act of the power. Therefore, a certificate of dissolution is issued by the state in which it was chartered. At this point, the legal existence of the corporation ceases for all purposes.</span></p>

<p><span id="ctl00_Layout_lblContent">When a corporation finally dissolves, taxation occurs at the corporate level or at the stockholder level. For taxation purposes, the corporation or individual stockholders must recognize any gain or loss on any distributed property or funds. In terms of capital gain, the stockholder is treated as if the liquidation distributions were the proceeds from the actual sale of his or her stock. Further, the corporation is generally required to recognize a gain or a loss on a liquidating sale of its assets to third parties, even when those proceeds are made to the corporation’s stockholders.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">17 - </span><span id="ctl00_Layout_lblChapterName">Planning for the Continuance of the Corporation</span></h2>

<p><span id="ctl00_Layout_lblContent">Obviously, a close corporation needs some type of viable agreement to handle the disposition of a stockholder’s interest in the corporation in the event of the stockholder’s death. Having such a plan in effect reaps two great benefits:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">The business of the corporation can be continued without interruption.</span></li>

<li><span id="ctl00_Layout_lblContent">The heirs can be promptly and fairly provided for.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">In a close corporation, such an efficient and reliable plan can be accomplished only when the surviving stockholders acquire the deceased stockholder’s shares. While this objective can be accomplished in the most efficient possible way with an insured buy-sell agreement, the alternative of succession planning and its disadvantages is first discussed, followed by a thorough discussion of the close corporation buy-sell agreement.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Succession Planning</span></h3>

<p><span id="ctl00_Layout_lblContent">Many close corporations arrange to transfer stock only by a first-offer arrangement. Typically, this provision is part of the incorporation certificate, although sometimes it is a separate agreement. Such a provision provides that no stock of the corporation will be transferred to a person who is not already a stockholder unless the stock is first offered for sale to the other stockholders or to the corporation at some predetermined price.</span></p>

<p><span id="ctl00_Layout_lblContent">The right of the other stockholders to have this first opportunity of buying a deceased stockholder’s shares is known as the <strong>right of first refusal</strong>, which was discussed in Chapter 3. During the stockholders’ lifetime, this provision is essential to govern the transfers of stock. It serves to prevent any shares of stock from passing into the hands of outsiders.</span></p>

<p><span id="ctl00_Layout_lblContent">In a close corporation, the first-offer arrangement merely provides that if the estate or the heirs decide to sell the stock, they must give the surviving stockholders or the corporation the first opportunity to purchase it. Of course, the heirs/surviving stockholders are free to retain the stock if they wish. Naturally, if the heirs inherit a majority interest in the corporation, they will probably decide to retain their interest. However, this arrangement does not provide for the surviving stockholders to actually purchase the stock.</span></p>

<p><span id="ctl00_Layout_lblContent">The stockholders in a close corporation typically take their profits of the corporation in the form of salaries. This seems only fair, because in most cases, the share of these profits is directly attributable to the personal services and skills performed by the stockholders themselves against the earnings on their invested capital. In the event of the death of a stockholder, the importance of this method of payment becomes clearer when salary payments are discontinued.</span></p>

<p><span id="ctl00_Layout_lblContent">Another alternative that some close corporations use for providing for the transfer of stock is that, in the event of the death of a stockholder, the surviving stockholders have the option to purchase the deceased’s shares at a predetermined price and within some specified time.</span></p>

<p><span id="ctl00_Layout_lblContent">Under optimum circumstances, the surviving stockholders decide to purchase the deceased’s stock at an agreed price. In the best of all situations, they would have the money available to pay for the stock. The result is that the surviving stockholders are able to gain the full and complete ownership and control of the close corporation. At the same time, the heirs and the estate receive payment in full and in cash immediately.</span></p>

<p><span id="ctl00_Layout_lblContent">However, if the surviving stockholders are unable to exercise their option because of lack of funds, then this provision obviously does not go far enough to provide for the lack of funding. In the most complex of situations, a majority stockholder’s estate, now holding the power to vote, could vote against the corporation’s resolution to buy the deceased’s interest. In this case, the corporation is effectively declining to exercise its option. As a result, the majority interest could be offered to outsiders.</span></p>

<p><span id="ctl00_Layout_lblContent">For this reason, a close corporation is a prime candidate for the preplanning benefits of the buy-sell agreement. Often, the board members, officers, and shareholders enter into a buy-sell agreement with each other at the time of incorporation to prevent the stock from getting into the hands of those outside the original group of shareholders.</span></p>

<p><span id="ctl00_Layout_lblContent">Additionally, every minority stockholder in a close corporation has the duty to see that his or her stock interest does not pass into the hands of an inactive member of his or her family. Preplanning and a buy-sell agreement can avoid these issues and can guarantee the amicable continuity of the close corporation. Such an agreement permits the majority stockholders to purchase the shares at a fair price at the minority shareholder’s death. Such an agreement could also permit the shares to be redeemed by the corporation.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Buy-Sell Arrangements for the Close Corporation</span></h3>

<p><span id="ctl00_Layout_lblContent">The close corporation can arrange for the sale of the business interest of a deceased stockholder with a buy-sell agreement. A buy-sell agreement for a close corporation is a binding contract between a seller and a buyer. It is an agreement for the sale of the stock to a designated buyer at a predetermined price. Moreover, the buy-sell agreement is the most secure plan for circumventing the many disturbing problems that the death of a stockholder brings. The agreement is set up in advance, and it is an enforceable contract.</span></p>

<p><span id="ctl00_Layout_lblContent">A valid buy-sell agreement between stockholders is really the only viable plan to ensure the successful continuation of the business of a close corporation. It ensures that the surviving stockholders will receive the full and complete ownership and control of the business. At the same time, it ensures that the deceased stockholder’s family receives the full value of the stock. To take these benefits one step further, an insured buy-sell agreement ensures that the money required to fund the purchase is available when it is needed.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Types of Buy-Sell Agreements</span></h4>

<p><span id="ctl00_Layout_lblContent">In a close corporation, the stockholders have a choice of buy-sell arrangements. These are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the Stock Redemption Agreement</strong>—The stock redemption agreement is also sometimes called an <strong>entity purchase agreement</strong>. This type of agreement binds both the stockholders and the corporation. In the event of the death of a stockholder, the corporation is bound to purchase the stock to the extent of its available surplus. The redemption agreement allows for corporate funds to be used to purchase the stock. These funds are not tax-deductible. Naturally, the remaining stockholders own a larger portion of the corporation. However, the cost basis of their stock does not increase.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the Cross-Purchase Agreement</strong>—In the event of the death of a stockholder, the cross-purchase agreement binds the surviving stockholders to purchase one another’s shares of stock.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">When using a cross-purchase arrangement, the individual stockholders enter into an agreement without involving the corporation. The surviving stockholders must purchase the stock from the deceased stockholder’s estate. Only a surviving stockholder’s own funds can be used for this purchase.</span></p>

<p><span id="ctl00_Layout_lblContent">The agreement can be structured so that the deceased’s estate must sell the interest in the business, leaving the surviving stockholders with the option of purchasing the interest of the deceased’s estate directly. The main advantage of a cross-purchase agreement is that the surviving stockholders receive an accelerated cost basis in that portion of the stock that is purchased.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the Trusteed Cross-Purchase Agreement</strong>—The trusteed cross-purchase agreement is another means of providing for the complete disposition of a deceased stockholder’s shares. Where the cross-purchase style of a buy-sell agreement is preferred but the number of stockholders makes issuing policies between the stockholders cumbersome, a third-party arrangement can be used to facilitate the arrangement.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">A trust must be established, or a non-stockholder individual can act as an “escrow agent” for the group of stockholders. All of the stockholders execute the cross-purchase agreement; the stockholders, in turn, transfer their shares of stock into the trust, or to the escrow agent, who serves as the third party.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the “Wait and See” Style of Buy-Sell Agreements</strong>—Often, the choice between an entity purchase and a cross-purchase style of agreement is difficult because of the changing circumstances for the individual or the corporation. The climate of tax reforms and revisions can also create doubt as to the best approach to use.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">An arrangement that solves this dilemma is the “wait and see” buy-sell agreement. In this type of agreement, the owners agree among themselves to sell their shares to each other or to the corporation. The buy-sell agreement contains all of the required provisions, with two exceptions:</span></p>

<ul>

<li>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent">The purchaser is not determined until after the death of a stockholder.</span></li>

<li><span id="ctl00_Layout_lblContent">The amount of purchase is not determined until after the death of a stockholder.</span></li>

</ol>

</li>

</ul>

<h4>

<span id="ctl00_Layout_lblContent">Factors in Determining the Choice of Buy-Sell Agreement</span></h4>

<p><span id="ctl00_Layout_lblContent">Many factors must be considered before deciding which of the four styles of buy-sell agreements is most suitable for a close corporation. Some of these factors are</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>convenience</strong>—The cross-purchase plan requires that the stockholders buy policies on each other. For the close corporation that has only a few stockholders, the cross-purchase agreement is usually more advantageous and practical. For the close corporation that has more than three stockholders, the cross-purchase plan may not be manageable. For example, in a five-person close corporation, each stockholder must purchase four policies, one on each of the other stockholder’s lives. This requires the purchase of 20 policies, which would be impractical.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">If the cross-purchase arrangement is beneficial for other reasons, the trusteed plan should then be considered. The trusteed plan provides many of the advantages of the cross-purchase plan while simplifying the process of policy procurement. Using the same five-person example, the trustee or third-party escrow agent requires only the purchase of five policies. Should the trusteed plan not be agreeable, then it then makes sense to go with the entity stock redemption style of agreement.</span></p>

<p><span id="ctl00_Layout_lblContent">If the stockholders are uncertain or disagree about the type of agreement they should choose, then the “wait and see” style of buy-sell agreement may be appropriate.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>adjustment to equity</strong>—Using the cross-purchase agreement, the cash value in the policy that each stockholder owns on the lives of the other stockholders is an equity that must be addressed when a stockholder dies. Unless other provisions are made, the estate of the deceased stockholder owns the life insurance policies on the surviving stockholders.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">These policies’ cash values are includable in the deceased stockholder’s estate, and the surviving stockholders, or the close corporation, must make provisions to purchase these policies for the amount of the cash value. With such an arrangement, a transfer-for-value exposure is not really a risk. (Transfer-for-value means if a person sells or transfers a policy to another, a “transfer-for-value” regulation (IRS Code) takes affect and changes the cost and/or tax free components of that policy. Exceptions are made for family members, partnerships and corporations in which the individual is an owner.)</span></p>

<p><span id="ctl00_Layout_lblContent">If the buy-sell price is more than the death proceeds that the surviving stockholders receive, and a large balance was to be paid over time, then a transfer-for-value exposure does become a risk. The estate can then elect to hold the policies until the balance is paid in full to protect the note obligation.</span></p>

<p><span id="ctl00_Layout_lblContent">Using an equity-stock redemption style of buy-sell agreement establishes the cash values of the policies as an asset of the close corporation. As an asset, each stockholder’s valuation increases to reflect the growing asset. Therefore, the purchase price of the deceased stockholder’s shares is higher than that in the cross-purchase style of buy-sell agreement.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>use of policy cash values</strong>—Using an entity stock redemption style of buy-sell agreement creates a corporate asset that is equal to the cash value of the policies that the corporation owns. As such, these funds are available for business purposes if they are needed. However, at the same time, these funds are at risk to corporate creditors.</span></li>

</ul>

<h4>

<span id="ctl00_Layout_lblContent">Tax Consequences of the Buy-Sell Agreement</span></h4>

<p><span id="ctl00_Layout_lblContent">Buy-sell agreements can have significant tax consequences to the corporation as well as to the individual stockholders. Therefore, careful consideration must be given to the tax effects of these arrangements during their planning and implementation. This is especially true in situations where the primary objective of the buy-sell agreement is to provide for the valuation of the shares at the death of the stockholder. If executed correctly, a binding determination as to the value of this asset can be made for estate tax purposes.</span></p>

<p><span id="ctl00_Layout_lblContent">For transfer tax purposes (when property is transferred), the Internal Revenue Service provides that the basis of property acquired from the deceased stockholder is the property’s fair market value. The purchase price set forth in a buy-sell agreement is generally recognized as the fair market value, provided that</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">the buy-sell agreement is a bona fide business arrangement;</span></li>

<li><span id="ctl00_Layout_lblContent">the buy-sell agreement is not just a method of transferring a stockholder’s interest for less than fair market value;</span></li>

<li><span id="ctl00_Layout_lblContent">the terms of the agreement are comparable to similar agreements.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">In addition, the following provisions are required for the agreement to be binding for federal estate tax purposes:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">The deceased’s estate must sell its stock, and a surviving stockholder or the corporation must buy or have an option to buy the stock.</span></li>

<li><span id="ctl00_Layout_lblContent">The agreement must restrict the stockholders from transferring their shares during their lifetimes.</span></li>

<li><span id="ctl00_Layout_lblContent">The purchase price agreed upon must be reasonable at the time the agreement is executed.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">If the corporation sets aside funds each year to fund the buy-sell agreement, the accumulated earnings tax can be imposed. In some cases, a penalty tax can be imposed on unreasonably accumulated earnings against the close corporation. Further, when the appreciated assets of the corporation are used to redeem the deceased’s shares, the corporation may have to recognize a gain for the difference between the basis of the amounts distributed and their fair market value.</span></p>

<p><span id="ctl00_Layout_lblContent">Unlike the payments made under partnership buy-sell agreements, payments made under a close corporation buy-sell agreement generally do not result in income to the deceased, unless the sale occurs before death, and the estate receives the proceeds after death.</span></p>

<p><span id="ctl00_Layout_lblContent">Other tax considerations are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">whether the close corporation’s premium payments can be taxed to the stockholders as dividends;</span></li>

<li><span id="ctl00_Layout_lblContent">whether the close corporation’s payments in redeeming a deceased stockholder’s shares can be considered a dividend to the surviving stockholders or to the estate;</span></li>

<li><span id="ctl00_Layout_lblContent">whether the death benefit proceeds will affect the calculation of the corporate alternative minimum tax; or</span></li>

<li><span id="ctl00_Layout_lblContent">whether the surviving stockholders have a greater need to realize a “stepped-up” cost basis for purchasing the deceased stockholder’s shares through the cross-purchase style of buy-sell agreement.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">When deciding on the appropriate design of a buy-sell agreement, complex tax issues are involved. As a result, competent tax and legal counsel should be consulted.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Enforcing the Buy-Sell Agreement</span></h4>

<p><span id="ctl00_Layout_lblContent">Using a buy-sell agreement compels the performance of buying and selling. The contracted parties are required to proceed with the purchase and sale of the business interest when a buy-sell contract is signed, because these agreements are matters of contract law.</span></p>

<p><span id="ctl00_Layout_lblContent">Generally, the failure of one party to carry out his or her contractual obligations results in an award of monetary damages to the injured party. However, in the case of a buy-sell contract for the sale of close corporation stock, the courts take the position that monetary damages really do not remedy the situation satisfactorily. This is mainly because no open market exists for shares of stock. Therefore, the courts enforce the agreements.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Restrictions on Transfers of Stock</span></h4>

<p><span id="ctl00_Layout_lblContent">One of the main characteristics of property is its transferability. The owners of property have the right and the power to dispose of their property. Generally, within the limitations of the Articles of Incorporation, a feature of the close corporation is that ownership interest in the company can be freely transferred. For example, shares of stock are considered negotiable instruments, and these can be transferred in the same manner as other personal property.</span></p>

<p><span id="ctl00_Layout_lblContent">In closely held corporations, transferring shares of a corporation is frequently restricted, because the existing stockholders often want to maintain or limit ownership. An insured buy-sell agreement permits retaining the ownership of the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">Because stock in a close corporation is considered securities, or negotiable instruments, some restrictions do limit the transfer of the stock. Typically, the transfer of the securities of a corporation can be conducted under the following circumstances:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">The transfer must be for the mutual convenience and protection of the parties.</span></li>

<li><span id="ctl00_Layout_lblContent">The transfer must not be unreasonable.</span></li>

<li><span id="ctl00_Layout_lblContent">The stock must be acquired within the terms of any restrictions.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">After the transfer has been established, the new stockowner acquires all of the rights and security of the stock.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Financing the Buy-Sell Agreement</span></h4>

<p><span id="ctl00_Layout_lblContent">Although a buy-sell agreement established before the death of a stockholder is necessary to ensure the successful continuation of the close corporation, the agreement must also be properly financed. Such a plan could not be implemented if the funds to conduct the transaction are unavailable.</span></p>

<p><span id="ctl00_Layout_lblContent">Of course, if the close corporation and the surviving stockholders are very liquid, they may be able to produce the cash necessary to finalize the buy-sell agreement without using insurance to finance the buy-sell agreement. Their alternatives to an insured buy-sell agreement, none of which are very practical, are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent"><strong>building up the purchase price in advance through savings</strong>—The plan is impractical because no one knows exactly when the funds will be required. It may be days, or months, or years. In addition, the accumulated earnings tax can become an issue.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>paying the purchase price in installments</strong>—This plan is impractical because it essentially mortgages the business and the futures of the corporation and the surviving stockholders.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>borrowing the purchase price at the time of death</strong>—This plan is impractical because the ability to borrow cannot be ensured beforehand. The issues of mortgaging the futures of the corporation and the surviving stockholders apply here.</span></li>

</ol>

<h4>

<span id="ctl00_Layout_lblContent">Benefits of the Insured Buy-Sell Agreement</span></h4>

<p><span id="ctl00_Layout_lblContent">Life insurance can be used to fund buy-sell agreements. The premiums are relatively inexpensive, considering that the intended continuity of the corporation may be at stake. Using a buy-sell agreement funded by life insurance allows the heirs of the deceased stockholder to receive cash in exchange for their stock. By funding the buy-sell agreement with life insurance, the buy-out and its method of funding are predetermined; the viability of the corporation is guaranteed.</span></p>

<p><span id="ctl00_Layout_lblContent">The immediate benefits of the insured buy-sell agreement are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">it removes any doubt about whether the surviving stockholders will be in a position to purchase the deceased stockholder’s interest;</span></li>

<li><span id="ctl00_Layout_lblContent">it provides the surviving stockholders with the most convenient and practical methods of obtaining the purchase money when it is required; and</span></li>

<li><span id="ctl00_Layout_lblContent">it guarantees a market for the sale of the stock and fixes the value of the stock for estate tax purposes.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">In addition, the insured buy-sell agreement serves three functions:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">In the event of death of one of the stockholders, it places the entire ownership and control of the close corporation in the hands of the surviving stockholders.</span></li>

<li><span id="ctl00_Layout_lblContent">It provides the deceased stockholder’s estate with the full value of his or her stock in full and immediately.</span></li>

<li><span id="ctl00_Layout_lblContent">It provides a source of capital for the “living” buy-sell provisions (ownership/interest) through use of policy cash values.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">The insured buy-sell agreement has many other benefits as well. Benefits exist for the surviving stockholders, the heirs, the estate, and for the stockholders during their lifetimes.</span></p>

<p><span id="ctl00_Layout_lblContent"><strong>The benefits to the surviving stockholders are</strong></span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the close corporation’s future is better assured</strong>—The insured buy-sell agreement ensures the continuation of the corporation business without interruption. The plan affects the purchase of the deceased stockholder’s interest in the company immediately. Because the agreement has been set up previously, the price has been agreed upon, and the money for the purchase is available. The business remains sound.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the surviving stockholders avoid liquidation losses</strong>—The liquidation of a going business invariably results in substantial losses, which are avoided with the insured buy-sell agreement.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the surviving stockholders avoid business disruption </strong>in the form of a new stockholder.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent"><strong>The benefits to the heirs and to the estate are</strong></span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the estate receives payment in full and in cash immediately</strong>—The insured buy-sell agreement immediately places the full amount of the sale price of the deceased stockholder’s interest in the hands of the personal representative. There is no bickering, bargaining, or delay.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the estate can be settled promptly and efficiently</strong>—Using a buy-sell agreement, the immediate cash allows the personal representative to promptly, efficiently, and economically administer the estate.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the surviving spouse is relieved of business worries </strong>in terms of future responsibilities for the corporation.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent"><strong>The benefits to the stockholders during their lifetimes are</strong></span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the corporation is stabilized</strong>—With the stabilization of the business assured, the partners are at liberty to pursue the business of the corporation. Employees are assured of a more secure organization. The funds of the corporation are not drained.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>a savings medium is provided</strong>—The insured buy-sell agreement is essentially an advance installment method of purchasing a deceased stockholder’s interest. This is a savings program automatically completed. The policy contains a cash value, making it a convenient and effective savings program that is directly focused on a single objective.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the future of the corporation is bright</strong>—With a buy-sell agreement in place, each stockholder can predict what will happen in the event of the death of one of the other stockholders. The business will survive.</span></li>

</ul>

<h4>

<span id="ctl00_Layout_lblContent">Provisions of the Insured Buy-Sell Agreement</span></h4>

<p><span id="ctl00_Layout_lblContent">Although it is a relatively simple instrument, the buy-sell agreement should be drawn by a competent attorney, because the insured buy-sell agreement is the legal basis for ensuring that, upon the death of a participant in a close corporation, the surviving stockholders will succeed to the agreement’s full control and ownership. Moreover, the agreement provides that the estate of the deceased stockholder will receive the full value of his or her stock interest at once.</span></p>

<p><span id="ctl00_Layout_lblContent">The three main elements of the close corporation’s insured buy-sell agreement are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">the surviving stockholders bind themselves to purchase the deceased stockholders stock;</span></li>

<li><span id="ctl00_Layout_lblContent">life insurance policies are carried on the life of each stockholder to supply the purchase money for the deceased stockholder’s interest; and</span></li>

<li><span id="ctl00_Layout_lblContent">the personal representative of the deceased will transfer the deceased’s shares of stock to the surviving stockholders with the payment of the purchase price.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">Naturally, no two agreements for the purchase of a deceased stockholder’s shares of stock are exactly alike. However, the close corporation insured buy-sell agreement should include the following provisions:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">a commitment that the stockholders will not sell or otherwise dispose of their stock during their lifetimes without first offering it to the other stockholders or to the corporation in the case of a stock redemption agreement;</span></li>

<li><span id="ctl00_Layout_lblContent">a commitment that the surviving stockholders will buy and the deceased’s stockholder’s estate will sell and transfer the deceased’s stock interest to the surviving stockholders or to the corporation in the case of a stock redemption agreement;</span></li>

<li><span id="ctl00_Layout_lblContent">a commitment for the purchase price for the stock and the valuation method for determining the purchase price;</span></li>

<li><span id="ctl00_Layout_lblContent">a commitment to purchase and maintain life insurance policies in the agreed amount on the lives of the stockholders for financing the purchase. In the case of a stock redemption agreement, the corporation purchases and maintains the policies;</span></li>

<li><span id="ctl00_Layout_lblContent">a description of the life insurance policies;</span></li>

<li><span id="ctl00_Layout_lblContent">a provision for the ownership and control of the life insurance policies and the disposal of the policies, as well as the conditions of policy ownership transfers;</span></li>

<li><span id="ctl00_Layout_lblContent">a commitment for the time and manner of paying any balance of the purchase price exceeding the insurance proceeds and for the disposition of any insurance proceeds in excess of the purchase price.</span></li>

</ul>

<h4>

<span id="ctl00_Layout_lblContent">Contents of the Buy-Sell Agreement for a Close Corporation</span></h4>

<p><span id="ctl00_Layout_lblContent">The following illustrates the general structure of a buy-sell agreement. Naturally, no two agreements are exactly alike. However, all insured buy-sell agreements used for the purchase of a deceased’s stockholder’s interest in a close corporation should include</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the parties to the agreement</strong>—The necessary parties are the stockholders. Often, a trustee whom the stockholders select is a party to the agreement as well. The trustee serves as an impartial third party. He or she holds the shares of stock and the insurance policies during the lifetimes of the stockholders. When a stockholder dies, the trustee supervises the buy-sell agreement transaction. However, the participation of a trustee is not required.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">If the buy-sell agreement is a stock redemption agreement, the corporation must also be a party to the agreement, because the corporation itself will acquire the shares of the deceased stockholder.</span></p>

<p><span id="ctl00_Layout_lblContent">In community property states, it is generally advised that the spouses of the stockholders be parties to the agreement.</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>the purpose of the agreement</strong>—The insured buy-sell agreement should contain a statement of its purpose and intent. It should</span>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent">identify the parties as active stockholders;</span></li>

<li><span id="ctl00_Layout_lblContent">state that the transfer of stock to anyone other than the surviving stockholders disturbs the success, management, and control of the corporation;</span></li>

<li><span id="ctl00_Layout_lblContent">state that the parties want to avoid such an occurrence.</span></li>

</ol>

</li>

<li><span id="ctl00_Layout_lblContent"><strong>the “first-offer” commitment</strong>—The agreement should contain a provision stating that if any of the stockholders desire to dispose of their interest in the corporation, they must first offer the shares to the other stockholders.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the commitment to sell and buy</strong>—The agreement should clearly state that upon the death of a stockholder, his or her estate will sell and the surviving stockholders will buy all of the stock that the deceased owns at the time of his or her death. In the case of the stock redemption agreement, the stockholders commit their estates to sell the stock to the corporation, and the corporation agrees to purchase them from the estate.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the price to be paid and the valuation formula</strong>—Designating the purchase price to be paid for the business can be done in several ways, but it is always paid per share. The stockholders can select any valuation formula that is suitable to them, but the agreement must state the chosen method.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>financing the purchase with life insurance</strong>—The life insurance policies, which are part of the buy-sell agreement, should be recorded in the body of the agreement. Alternately, they can be appended to the agreement. The agreement should state that the insurance is intended to provide cash, which is to be applied toward the purchase price of the deceased stockholder’s shares of stock.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">The agreement should further state that the proceeds of the insurance when received by the deceased’s estate, whether directly as named beneficiary or indirectly from the surviving stockholders or the trustee, will be considered payment for the purchase price of the stock.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>provisions for adding, substituting, or withdrawing policies</strong>—Because a stock purchase agreement is likely to remain in effect for many years, changes in the value of the corporation can occur during the time the buy-sell agreement is in force. Consequently, the amount of life insurance should also be changed.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">For example, if the value of the stock increases, the stockholders will naturally want to buy additional life insurance. If, on the other hand, the value of the stock decreases, the stockholders may want to discharge some of the insurance. The agreement should specify how all parties can add, substitute, or withdraw policies. Naturally, the record of any changes should be made part of the original agreement.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>adjustments to the purchase price</strong>—The insured buy-sell agreement should contain provisions for any adjustments that may occur if the insurance proceeds and the purchase price differ. In some cases the amount of insurance proceeds can differ from the purchase price. Typically, the agreement should provide that if the purchase price is less than the insurance proceeds, the purchase price will be the amount of the insurance proceeds. So, the amount of insurance proceeds is essentially the purchase price.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">On the other hand, if the purchase price is more than the insurance proceeds, paying the balance can be handled in many ways. For example, if the balance is small, the stockholders should be required to pay it in cash when the stock is transferred. If the balance is larger, other arrangements must be made. For example, the surviving stockholders can pay the balance with interest-bearing notes, or the corporation can pay the balance using a stock redemption agreement made payable to the estate.</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>securing unpaid balances</strong>—Security for any unpaid balance of the purchase price must be provided for. For example, the personal representative of the deceased can retain some percentage of stock, perhaps up to 150 percent of the amount of each unpaid note. In this case, the personal representative transfers the stock held as collateral as each note is paid.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the payment of premiums</strong>—The buy-sell agreement should state who must pay the life insurance policy premiums. In most purchase arrangements, each stockholder obtains and owns the policies on the lives of the other stockholders, and each stockholder pays for the policies. The proceeds of each policy represent the portion of the insured’s shares, which the premium payer is obligated to purchase.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">In the case of the stock redemption agreement, the corporation pays the premiums; however, the corporation should not pay the policy premiums unless the stock redemption plan is used. When using a cross-purchase plan, the corporation can make the payments on behalf of the stockholders and charge them to the salary accounts of the individual stockholders. This ensures that the premiums are paid.</span></p>

<p><span id="ctl00_Layout_lblContent">If the stock holdings are equal, the premiums can be allocated by pooling and sharing them equally. If the ages of the stockholders are significantly different, then the pooling of premiums essentially requires the older stockholders to pay more than their fair portion.</span></p>

<p><span id="ctl00_Layout_lblContent">If each stockholder shares equally in the premium payments, he or she is entitled to equally share in the cash values of the policies. The problem for the older stockholders encountered in pooling is that the cash value credits do not correspond with the cash values in the policies on their own lives.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>ownership of the insurance policies</strong>—The buy-sell agreement should designate who owns the right to exercise the benefits and privileges of each policy during the insured’s lifetime. For example, if a trustee is made a party to the agreement, the ownership benefits may be vested in the trustee. Otherwise, it is reasonable that the owner of each policy should receive the benefits of the policy.</span></li>

</ul>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">In the case of a stock redemption agreement, the corporation is the logical receiver of the benefits. Also, if exercising ownership rights is restricted in any way, these restrictions should be clearly identified in the agreement.</span></li>

</ul>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>disposition of policies on the lives of survivors</strong>—The cross-purchase agreement should contain provisions for disposing of the insurance policies on the lives of the surviving stockholders after the death of one of the stockholders. Typically, each insured is granted an option to take over the insurance on his or her life after the differences in cash values are adjusted. The buy-sell agreement must be revised for the remaining stockholders.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>provisions for amending, revoking, or terminating the agreement</strong>—The buy-sell agreement should permit the stockholders to amend, revoke, or terminate the agreement at any time. Such actions should be defined in writing. Events that initiate amending, revoking, or terminating the agreement are the dissolution or bankruptcy of the corporation.</span></li>

</ul>

<h4>

<span id="ctl00_Layout_lblContent">Valuation of the Stockholders’ Interest</span></h4>

<p><span id="ctl00_Layout_lblContent">The value of each stockholder’s interest in the close corporation must be established, and the price to be paid for his or her interest must be determined. The purchase price used in the agreement can be established using one of the following methods:</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>by a qualified appraiser</strong>—This method is referred to as the <strong>appraisal method</strong>. This method of valuation is sometimes sound, because at the time of the drafting of the agreement, the stockholders cannot possibly know the valuation of the stock at some unknown time in the future. Using an independent appraiser to determine the worth of the stock at the time of a stockholder’s death is referred to as the <strong>post-departure method</strong>.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">A distinct disadvantage of using the post-departure method is that getting the appraiser’s report is often delayed. Also, this method of valuation makes it difficult to determine in advance what the interest would be worth, if the stockholders need this information. The buy-sell agreement can specify the particular appraiser.</span></p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>by setting a fixed dollar price for the stock</strong>—This method of valuing the stock sets a price for the stock and is known as the <strong>set dollar method</strong>. As discussed in the previous chapter, the set dollar method is the greatest feature of preplanning. Using the set dollar method, the stockholders agree in advance that if one stockholder dies, the others will buy out his or her share on the basis of a predetermined price.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">The set dollar method is most effective when the primary worth of the business is the activity of the stockholders. It works best when the business has no substantial hard assets or much value in the inventory. This method is particularly good for most close corporation businesses, especially those in their first few years of business.</span></p>

<p><span id="ctl00_Layout_lblContent">Another perk of the set dollar method of valuation is that it combines simplicity with fairness: the buy-out price is fair, because it is known in advance, and all have agreed to it. Because the price is predetermined, appraisals and accountants are not necessary when a partner dies.</span></p>

<p><span id="ctl00_Layout_lblContent">The disadvantage of this method is that any fluctuations in the market value of the corporation’s assets are not reflected.</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>by setting a fixed dollar price, which is subject to an annual review</strong>—Using this method, any fluctuations in the market value of the corporation’s worth are reviewed annually to consider the changes.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>by determining the book value of the corporation on a specific date</strong>—Most commonly, the date of the death of a stockholder is used to determine the book value. The book value method is defined as the monetary value of the stock interest. It is probably the simplest method of valuing a stockholder’s interest.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>by determining the price with some formula</strong>—Using the formula method of valuation, the price can reflect any type of formula upon which the stockholders agree. For example, it may be a multiplier predicated on gross or net earnings.</span></li>

</ul>

<h4>

<span id="ctl00_Layout_lblContent">Beneficiary Arrangements</span></h4>

<p><span id="ctl00_Layout_lblContent">Naturally, the insured buy-sell agreement must state to whom the life insurance policies will be made payable in the event of the death of one of the stockholders. Naming a beneficiary in these situations usually follows one of four arrangements. These are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent"><strong>the corporation as beneficiary</strong>—When using an entity stock redemption plan, the corporation itself is the purchaser of the deceased stockholder’s stock. Therefore, the corporation should be designated to receive the insurance proceeds.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>the trustee as beneficiary</strong>—If a cross-purchase plan is implemented, the stockholders can choose to have the plan administered by a trustee as an impartial third party. The best choice for the trustee is the corporation’s bank. In this case, the trustee should be the designated beneficiary of the life insurance policies.</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">Under these circumstances, the trustee is actually a party to the buy-sell agreement; this arrangement is referred to as a <strong>business insurance trust agreement</strong>. A business insurance trust agreement follows the cross-purchase agreement, tempered by the trust provisions. For example, the trust provisions should require</span></p>

<ul>

<li>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">the insurance policies to be made payable to the trustee.</span></li>

<li><span id="ctl00_Layout_lblContent">the insurance policies to be deposited with the trustee.</span></li>

<li><span id="ctl00_Layout_lblContent">the ownership rights of the policies to be granted to the trustee; however, the stockholders can retain these rights.</span></li>

<li><span id="ctl00_Layout_lblContent">the stockholders to endorse their stock certificates and deposit them with the trustee; however, the stockholders maintain their rights to receive all dividends payable on the stock and the right to vote their shares.</span></li>

<li><span id="ctl00_Layout_lblContent">the trustee’s job is to supervise and to administer the terms of the buy-sell agreement, in the event of the death of a stockholder. The trustee collects the life insurance proceeds and distributes them according to the agreement.</span></li>

<li><span id="ctl00_Layout_lblContent">If the insurance proceeds are not sufficient to cover the purchase price, as occurs in some situations, the trustee must obtain the notes, as required in the properly drafted buy-sell agreement. These notes obligate the surviving stockholders to make the payment of the purchase price directly to the deceased stockholder’s estate. The trustee delivers them the deceased’s personal representative with any required collateral. When the notes are paid, the personal representative returns the collateral to the surviving stockholders.</span></li>

<li><span id="ctl00_Layout_lblContent">Making a trustee part of the buy-sell agreement is recommended. It ensures that the purchase and sale of the deceased’s stock are handled efficiently.</span></li>

</ul>

</li>

</ul>

<p> </p>

<p> </p>

<ol>

<li value="3"><span id="ctl00_Layout_lblContent"><strong>the surviving stockholders as beneficiaries</strong>—If a business insurance trust agreement with a trustee is not implemented, the surviving stockholders should be made beneficiaries of the life insurance policies. This plan promptly places the funds for the purchase of the deceased’s stock with the surviving stockholders.</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">This arrangement renders some equity to the circumstances occurring at the death of a stockholder. For example, the surviving stockholders are bound to pay the agreed price for the deceased stockholder’s stock, and they hold the insurance proceeds until this transaction can be completed. On the other hand, the personal representative, holding the shares of stock, is bound to transfer the shares when the transaction is completed. Therefore, each side holds something the other wants, thereby balancing the power between the parties.</span></p>

<p><span id="ctl00_Layout_lblContent">The proceeds are included in figuring the cost basis of the shares of stock the survivors acquire. Further, the survivors have achieved a favorable income tax position in case they decide to sell these shares later.</span></p>

<p> </p>

<p> </p>

<ol>

<li value="4"><span id="ctl00_Layout_lblContent"><strong>the insured’s estate as beneficiary</strong>—Making the deceased’s estate beneficiary of the insurance proceeds does not permit a balance in the situation when a stockholder dies, because it favors the estate and not the surviving stockholders. In this situation, the personal administrator holds the stock and the funds to purchase the stock.</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">In the absences of such provisions in the buy-sell agreement, the insurance proceeds are not guaranteed to be used to credit the surviving stockholders with the funds needed to purchase the deceased’s shares of stock. In the worst of situations, the heirs could claim that they are entitled to receive these proceeds and the purchase price of the stock.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Tax Issues for the Buy-Sell Agreement for a Corporation</span></h4>

<p><span id="ctl00_Layout_lblContent">Using an insured buy-sell agreement, life insurance premiums are not a deductible business expense to the premium payer. However, when the corporation pays the insurance premiums and the premiums are charged to the stockholder’s salary accounts, the premiums can be deducted as <em>salary </em>for the corporation, although they are not deductible as <em>premiums</em>.</span></p>

<p><span id="ctl00_Layout_lblContent">For federal estate tax purposes, the basis of a deceased’s property is its fair market value at death or on the valuation date. The federal estate tax law specifically states the circumstances under which life insurance proceeds are considered taxable or non-taxable to the estate of the insured. If the insurance holds a non-taxable position, the estate is generally taxed on the value of the stock set forth in the buy-sell agreement, provided that the agreement meets the following criteria:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent">The agreement must be part of a bona fide business arrangement.</span></li>

<li><span id="ctl00_Layout_lblContent">The agreement must not be a device to transfer the stock for less than full and adequate consideration in money.</span></li>

<li><span id="ctl00_Layout_lblContent">The terms of the agreement must be comparable to similar arrangements entered into by persons in other transactions.</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">On the other hand, if the insurance is arranged in a taxable way, the insurance proceeds must be included in the taxable estate of the deceased stockholder. The value of the stock equal to the value represented by the taxable insurance is excluded from tax.</span></p>

<p><span id="ctl00_Layout_lblContent">Generally, the value of the stock as agreed upon in the buy-sell agreement is its value for estate tax purposes, provided that the previously stated qualifications are met. However, additional tax issues may require the advice of competent tax and legal counsel.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Tax Issues for the Subchapter S Corporation</span></h4>

<p><span id="ctl00_Layout_lblContent">Our discussion to this point has addressed issues surrounding the arranging for the continuation of a close corporation. The methods of funding the buy-sell agreement as well as the tax issues involved have been related to the close corporation doing business as a <strong>C corporation </strong>for tax purposes.</span></p>

<p><span id="ctl00_Layout_lblContent">The <strong>subchapter S election </strong>of a close corporation, which is to be treated like a partnership for tax purposes, has some unique characteristics that must be addressed when arranging the buy-sell agreement.</span></p>

<p><span id="ctl00_Layout_lblContent">Under the subchapter S selection for Internal Revenue Service purposes, all stockholders income or losses are either <strong>active </strong>or <strong>passive</strong>. Those stockholders who participate in operating and managing the business are considered to have received<strong>active income</strong>. This is usually reported as <strong>W-2 wages</strong>. Those stockholders who do not participate in operating and managing the business are considered to have received <strong>passive income</strong>. This is usually reported as <strong>K-1 income</strong>.</span></p>

<p><span id="ctl00_Layout_lblContent">Each stockholder of a subchapter S corporation must include his or her share of the corporation’s profits, regardless of whether the amount was actually distributed to this stockholder. If the amount was not distributed to the stockholder, he or she will still have an income tax liability on that amount. The funds that were not distributed are kept by the corporation for business purposes and are referred to as <strong>undistributed taxable income</strong>, or <strong>retained earnings</strong>. These monies can be distributed in the future but will not be taxable as income, as they have already been taxed in the past.</span></p>

<p><span id="ctl00_Layout_lblContent">This creates a problem with a self-funded buy-sell agreement, because the funds that are set aside each year represent taxable income to the stockholders. The insured buy-sell agreement provides an advantage to the stockholders of a subchapter S corporation. Other tax issues unique to the subchapter S corporation should be discussed with competent tax and legal counsel.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Buy-Sell Agreements for the Professional Corporation</span></h3>

<p><span id="ctl00_Layout_lblContent">In the past, a corporation could not practice a “profession,” because the canons of ethics by many professions such as law, medicine, and accounting prohibited it. However, when the Internal Revenue Service began to allow many tax-favored benefits for corporate employees, such as pension plans, profit sharing plans, group life and health plans, deferred compensation plans, and split dollar insurance plans, some professional groups formed non-corporate organizations. Through these organizations, professional groups could ethically practice their professions and be taxable as corporations, presuming they had a majority of corporate characteristics.</span></p>

<p><span id="ctl00_Layout_lblContent">Soon the states began to enact laws permitting only persons licensed to practice a particular profession to own interests in the corporation. For example, to maintain compliance with these statutes, if a stockholder lawyer dies, his or her estate must sell his or her stock interest only to a licensed lawyer or to the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">In 1969, the Internal Revenue Service conceded that the individual states should be permitted to determine the existence of a corporation. So, if a professional organization is recognized as a corporation by the state, it is a corporation for federal income tax purposes. Today, professional corporations are sanctioned in every state.</span></p>

<p><span id="ctl00_Layout_lblContent">So if a professional organization is formed as a corporation, a deceased stockholder’s stock must be sold to the surviving stockholders, to the corporation, or to members of the same profession. Naturally, most surviving stockholders would prefer to purchase the stock themselves or to have the corporation purchase it, rather than bring in a new stockholder.</span></p>

<p><span id="ctl00_Layout_lblContent">In the absence of a buy-sell agreement, many state statutes require that the price of a deceased stockholder’s shares in a corporation be determined by the book value method.</span></p>

<p><span id="ctl00_Layout_lblContent">Therefore, a satisfactory price for a deceased professional corporation stockholder must include satisfactory value for the tangible assets as well as the intangible assets like reputation, name, and good will.</span></p>

<p><span id="ctl00_Layout_lblContent">The value of these intangibles is best determined by the capitalization of earnings method, which demonstrates that the ongoing nature of a successful professional corporation does have real value. This method can be applied to the professional corporation’s average earnings, excluding professional salaries.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">1 - </span><span id="ctl00_Layout_lblChapterName">The Limited Liability Company</span></h2>

<p><span id="ctl00_Layout_lblContent">The popularity of the LLC has been steadily increasing since 1970, when Wyoming first established the limited liability company as a form of business entity. The LLC has now been adopted by statute in all 50 states and in the District of Columbia. Although all 50 states have adopted the LLC, the lack of uniformity between the various state statutes makes the LLC most attractive to those businesses that operate in one or two states.</span></p>

<p><span id="ctl00_Layout_lblContent">Before forming an LLC, as with sole proprietorships, partnerships, and corporations, certain factors should be considered. These factors include the tax implications, the benefits in establishing a family LLC as opposed to a family limited partnership, and the LLC’s effects on business planning. Full details on these issues are described in this chapter.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">2 - </span><span id="ctl00_Layout_lblChapterName">Integrating Corporate and Partnership Benefits</span></h2>

<p><span id="ctl00_Layout_lblContent">Forming an LLC is accomplished by drafting of articles of organization and filing them with the appropriate state agency. Most states require at least two members in the LLC, but some states will accept a one-member LLC. Owners of the business formed as an LLC are referred to as “members,” as opposed to stockholders of a corporation, or partners in a partnership.</span></p>

<p><span id="ctl00_Layout_lblContent">The limited liability company offers owners the limited liability of a corporation with the tax and management advantages of a partnership. The LLC is less restrictive than the S corporation and is not as complex. Instead of a corporate charter and bylaws of a corporation, the rules governing the LLC are established in an operating agreement.</span></p>

<p><span id="ctl00_Layout_lblContent">The limited liability company is a hybrid of the corporate and partnership business forms, providing the following advantages:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent">The owners have no liability for business debts, which is an advantage enjoyed by corporations but not by partnerships.</span></li>

<li><span id="ctl00_Layout_lblContent">Income and expenses (profits and losses) are channeled to the individual owners, which is an advantage enjoyed by partnerships and S corporations, but not by C corporations.</span></li>

<li><span id="ctl00_Layout_lblContent">The number and types of owners have no restrictions; various classes of ownership are generally permitted, which is an advantage enjoyed by the C corporation, but not by the S corporation or partnerships.</span></li>

<li><span id="ctl00_Layout_lblContent">Profits and losses are channeled to the owners at different levels of participation ratios and distribution amounts as selected by the members, an advantage enjoyed by a C corporation in the limited sense of stock classes but not by the S corporation or partnerships.</span></li>

</ol>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">3 - </span><span id="ctl00_Layout_lblChapterName">Tax Issues of Selection</span></h2>

<p><span id="ctl00_Layout_lblContent">Before January 1, 1997, selecting taxation for the limited liability company was complex and uncertain. To be taxed as a partnership was the general rule, because six corporate characteristics had to be satisfied for the LLC to be taxed as a corporation. A limited liability company formed after December 31, 1996, will generally be taxed as a partnership if the company has two or more owners, or as a sole proprietorship if it has only one owner, unless it was elected to be taxed as a corporation. This election can now simply be made under the “check the box” regulations by filing form 8832.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">4 - </span><span id="ctl00_Layout_lblChapterName">Replacing the Family Limited Partnership</span></h2>

<p><span id="ctl00_Layout_lblContent">The family limited liability company has also grown in popularity as an alternative to the family limited partnership. The family limited partnership has been used for business and estate planning and continues to be used for that purpose. However, the family limited liability company is used as often or more often because of the liability protection benefit and the simplification of the taxation issue.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">5 - </span><span id="ctl00_Layout_lblChapterName">Effects on Business Planning Issues</span></h2>

<p><span id="ctl00_Layout_lblContent">The limited liability company can have members that are individuals, partnerships, or corporations. The tax status can be that of a sole proprietorship, partnership, or corporation. Therefore, additional information is necessary, along with competent tax and legal counsel, so that the business needs for life insurance can be properly presented and developed. The existence of the LLC does not change the nature of the business planning issues as discussed in this course.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">1 - </span><span id="ctl00_Layout_lblChapterName">Other Uses of Life Insurance in Business</span></h2>

<p><span id="ctl00_Layout_lblContent">In addition to the many uses of life insurance for purchasing a business interest for succession planning, other types of life insurance plans can meet the financial needs and provide economic stability for the business entity. These plans include key person insurance, split-dollar plans, Section 162 Executive Bonus plans, deferred compensation arrangements, and corporate-owned life insurance. This chapter describes each of these types of plans in detail.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">2 - </span><span id="ctl00_Layout_lblChapterName">Key Person Insurance</span></h2>

<p><span id="ctl00_Layout_lblContent">One of the most often used applications is that of providing various benefits to the <strong>key person </strong>of the business. A key person insurance plan can be easily set up to provide a<strong>death-benefit-only plan</strong>, or a <strong>non-qualified deferred compensation plan</strong>. A key person insurance plan can also provide a benefit to the business by insuring the value of the key person, or persons, as a human asset. The business must protect against the negative economic impact that the loss of such a person can have on the continued operations, customer relationships, and credit worthiness of the business.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Who is a Key Person?</span></h3>

<p><span id="ctl00_Layout_lblContent">Generally, a key person is an employee whose death before retirement would have an adverse economic effect on the business. Such an adverse effect can be a loss of profits, the loss of credit standing, or the extra expense of hiring a capable replacement.</span></p>

<p><span id="ctl00_Layout_lblContent">The most objective test for determining exactly who a key employee is is the size of his or her salary. Naturally, a high salary is not the only criteria for determining a key employee, but it is typically an indication that this person is believed by management to be a valuable asset to the business.</span></p>

<p><span id="ctl00_Layout_lblContent">Another test for determining the key employee is his or her power over decision-making. If the person’s position permits him or her to make important managerial decisions or if this person exercises significant influence over the decision-making process, then this person may be considered invaluable to the success of the business. Such a person is a key employee.</span></p>

<p><span id="ctl00_Layout_lblContent">Other key employees are those who are directly accountable for performing management directives. Examples of such directives are in the areas of accounting, production, sales, or management. Sometimes a person who has customers or clients is considered a key person. This person’s position is invaluable because his or her death could result in the loss of a substantial portion of the business.</span></p>

<p><span id="ctl00_Layout_lblContent">An obvious key person is one whose presence represents a source of capital in the business. This may be direct or indirect, such as through the person’s standing in the community or his or her influence with lending institutions. Sometimes banks request a specific co-signer for business loans. Naturally, the death of this person would have detrimental effects on the sources of capital available to the business.</span></p>

<p><span id="ctl00_Layout_lblContent">Finally, a person can be considered a key person because of some unusual or unique talent he or she possesses. Regardless of this person’s job description, a key employee holds a unique and valuable position, and his or her talent would be not only difficult to replace but also costly to the company in the event of this person’s death.</span></p>

<p><span id="ctl00_Layout_lblContent">Conversely, key employees whose death would have a negative impact are typically not found in businesses where the company spreads its management responsibilities among many people or where a broad management-training program exists. However, a salary replacement plan may still be necessary. (A salary replacement plan is an insurance policy that allocates the proceeds to pay the salary of the replacement of the deceased.)</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Benefits of a Key Person Arrangement</span></h3>

<p><span id="ctl00_Layout_lblContent">In a sole proprietorship, the key person is likely the owner. We have discussed in detail the need for a business owner to have contingency plans for his or her death. Even a sole proprietorship can be large enough to have one or more key people on board, and even though the sole proprietorship is owned by the proprietor, the proprietorship can have other valuable employees who have great knowledge and responsibility in the business. Likewise, a partnership can have key employees who are not partners.</span></p>

<p><span id="ctl00_Layout_lblContent">When such a key person dies, the effect can destroy the ability of the business to run efficiently, even if this person is not the owner. This person can bring great traits and qualities to the business, without which the entire business suffers. For example, increased expenses and smaller profit margins may result, or a reduction in production or sales. Other expenses are costs in locating, hiring, and training the person’s replacement, and these costs can reduce the profits of the business. Usually, during the time when the replacement is being sought, the work normally done by the missing key person is performed by those who are not prepared to handle the situation. They are often not as efficient or effective.</span></p>

<p><span id="ctl00_Layout_lblContent">Even when the replacement person is located, considerable money is likely involved with employment agencies or even relocation expenses. Further, when the replacement person is finally on the job, some time must likely pass before he or she is able to perform efficiently. The replacement’s learning curve may be lengthy.</span></p>

<p><span id="ctl00_Layout_lblContent">To avoid these problems, key employee life insurance is essential. When purchased by the business, the death proceeds of a key employee life insurance can provide a fund for off-setting a decrease in productivity and profits when a key person is no longer on the job.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Insurable Interest</span></h3>

<p><span id="ctl00_Layout_lblContent">Whenever life insurance is purchased, there must be an <strong>insurable interest</strong>; insurable interest requires that a significant relationship exists between the insured and the person, business, or other third party involved in the transaction. The mere existence of an employer-employee relationship does not permit insurable interest. In addition, there must be reasonable grounds to expect some benefit or advantage from the continuance of the life of the insured. Otherwise, the arrangement can appear to be nothing more than a wager by which the benefiting party is directly interested in the early death of the insured.</span></p>

<p><span id="ctl00_Layout_lblContent">A business can purchase key employee life insurance on the life of someone who is active in the business and whose continued activities are reasonably expected to increase the future profits of the business. The business itself has an insurable interest because of the economic benefit it will derive from the continued life of the insured.</span></p>

<p><span id="ctl00_Layout_lblContent">A business owner can also purchase key employee life insurance. When a partnership has an insurable interest in a key person, each partner can also have an insurable interest in that key person, as measured in proportion to each partner’s ownership interest in the business. When a partner is the key person to be insured, the other partners may want to be owners and beneficiaries under the policy, rather than the partnership. This type of arrangement avoids the deceased partner’s estate sharing in the proceeds in proportion to its partnership interest.</span></p>

<p><span id="ctl00_Layout_lblContent">A recent example of life insurance that does not have a basis or reasonable grounds to establish insurable interest is the problems incurred by some large corporations in what was publicized as “Janitors Insurance.” In this instance, policies were purchased on a large number of employees, most of whom were not even aware of the existence of the policies, and the employer was the beneficiary. The employer could not substantiate an insurable interest. The death of any of these employees would not have negative economic consequences on the business.</span></p>

<p><span id="ctl00_Layout_lblContent">With key employee insurance, the beneficiary of the life insurance has reason to anticipate that some economic benefits result from the continuation of the insured’s life. The beneficiary also has reason to believe that these benefits are lost in the event of the insured’s death. In this respect, insurable interest falls under the category of <strong>pecuniary interest</strong>.</span></p>

<p><span id="ctl00_Layout_lblContent">It is held in all states that the requirement of an insurable interest exists only at the time that the life insurance policy is purchased. Insurable interest is not required at the death of a person; therefore, if a key person’s employment is terminated, the business continues to pay the premiums for the policy, and upon the insured’s subsequent death, the business receives the life insurance proceeds tax-free.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Valuation of a Key Person</span></h3>

<p><span id="ctl00_Layout_lblContent">How much life insurance should a key person purchase? Many formulas can be used for valuing a key person, and no single formula is accepted as the best in every situation. Because the principal purpose of key person life insurance is to indemnify the business for the economic loss that it would suffer as a result of the death of the key person, the formula that best fits the structure of the business operation and the key person’s relationship to the success of the ongoing concern is preferable. The objective is to place the value of the key person in his or her relationship to the business, which can be a highly biased issue.</span></p>

<p><span id="ctl00_Layout_lblContent">Valuing a key person is much like valuing a business—it is more of an art than a science. One or more of the following formulas should provide a useful approach in determining the value of the key person:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>multiple of salary</strong>—Because salaries paid to the key person are generally an indicator of his or her value, a factor ranging from 3 to 10 times annual salary can be used. Often, the higher the salary, the higher the multiple that is used. However, in some circumstances the key person’s salary may be lower than the industry standard. Therefore, the position or contributions being made to the business must be considered to determine the multiple of salary that should be considered.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>business life value</strong>—The business must estimate the loss to annual earnings if the key person were to die. This annual loss is discounted by a selected interest rate for present value and is then multiplied by the number of years the key person would have worked until retirement. For example, consider a key person who was age 40 at death and the annual estimated loss was calculated to be $50,000. If the selected interest rate for present value factor were 10%, then the discounted annual loss to earnings would be $4,538 X 25 (years to retirement), or $113,450 as the value for the amount of life insurance.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>contribution to profits</strong>—This formula evaluates and then capitalizes the key person’s contribution to profits to determine the value. For example, the book value of a business is $1,000,000 and the expected rate of return on book value for that type of business is 9%. The expected rate of return would then be $90,000. However, the profits of the corporation are $200,000. The difference between the profits of $200,000 and the expected rate of return of $90,000 is $110,000. This is referred to as <strong>excess earnings</strong>, which reflect the success of the operations to that of the norm. If the key person is assumed to have contributed to 50% of the excess earnings success, then 50% of the $110,000, or $55,000, is factored into the capitalization formula to determine the key person value. Given these factors, the formula is:</span></li>

</ul>

<table align="center" border="0" cellpadding="0" width="300">

<tbody>

<tr>

<td>

<span id="ctl00_Layout_lblContent">$55,000</span></td>

<td>

<span id="ctl00_Layout_lblContent">(50% of $110,000)</span></td>

</tr>

<tr>

<td>

<span id="ctl00_Layout_lblContent"><u>X 8.33</u></span></td>

<td>

<span id="ctl00_Layout_lblContent">(capitalization factor)</span></td>

</tr>

<tr>

<td>

<span id="ctl00_Layout_lblContent">$458,150</span></td>

<td>

<span id="ctl00_Layout_lblContent">key person value</span></td>

</tr>

</tbody>

</table>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>discount of business</strong>. This formula is a simple discount to the value of the business as a result of the key person’s death. If the business value is $500,000, and the impact upon death of the key person is a discount of the value by 30%, then the value of the key person is $500,000 X 30%, or $150,000.</span></li>

</ul>

<h3>

<span id="ctl00_Layout_lblContent">Tax Issues of Key Person Insurance</span></h3>

<p><span id="ctl00_Layout_lblContent">In most circumstances, when a business secures key person insurance, the business entity generally pays the premiums and is the owner and beneficiary of the policy. Under this arrangement, no income tax deduction is permitted for paying the premiums. However, the premiums paid are also not treated as taxable income to the insured. In addition, any death proceeds of a key person insurance policy are tax-free, even if the key person is no longer employed with the business.</span></p>

<p><span id="ctl00_Layout_lblContent">In cases where an insured key employee terminates his or her relationship with the employer, he or she has various alternatives for disposing of the life insurance policy. Remember, the policy does not have to be surrendered. The business can continue to own the policy and to make the payments. However, care should be taken, because the insurable interest consideration could still apply. Each individual situation determines if the business can continue the policy without adverse consequences. The best course of action could be to surrender the policy to the insurance company for its cash surrender value. Then if the insured needs additional personal life insurance, the company can sell the policy to him or her.</span></p>

<p><span id="ctl00_Layout_lblContent">Whether the key person life insurance policy is surrendered or sold, the tax issues must be considered. Upon surrender or sale, if the amount the company receives exceeds its premium cost, this excess is taxable to the business as ordinary income in that year. If the policy has paid dividends, those dividends must be used to reduce the premiums paid to determine the policy’s cost basis.</span></p>

<p><span id="ctl00_Layout_lblContent">The federal estate tax law allows the death proceeds of a life insurance policy to be included in the gross estate of the insured under certain conditions. These conditions are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">if the proceeds are payable to or for the benefit of the insured’s estate; and</span></li>

<li><span id="ctl00_Layout_lblContent">if the insured at the time of his or her death possessed any incidents of ownership in the policy, regardless of the beneficiary.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">Generally, “incidents of ownership” in this sense refers to the right of the insured or his or her estate to the economic benefits of the policy. Therefore, included in this definition is the right to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, and to obtain from the insurer a loan against the surrender value of the policy.</span></p>

<p><span id="ctl00_Layout_lblContent">When a sole proprietorship or partnership is the owner and beneficiary of the policy and the insured possesses no incidents of ownership, no portion of the proceeds is included in the insured’s gross estate for federal estate tax purposes.</span></p>

<p><span id="ctl00_Layout_lblContent">When a partner is a key person, and because a partnership is considered a separate legal entity distinguishable from the individual partners, incidents of ownership in a life insurance policy possessed by the partnership do not apply to the individual partners. So, when a life insurance policy on the life of a partner is owned by and payable to the partnership, and all premium payments are paid out of partnership funds, the death proceeds are <em>not </em>included in the deceased partner’s gross estate. However, the proceeds the partnership receives are included as a partnership asset when valuing the insured partner’s interest in the partnership for federal estate tax purposes.</span></p>

<p><span id="ctl00_Layout_lblContent">The sale or transfer of a policy between a partnership and the partners generally does not create a “transfer-for-value” incident.</span></p>

<p><span id="ctl00_Layout_lblContent">The insured key employee may live to his or her normal retirement age. In such a case, the need for indemnity no longer exists. The business has various options for the disposition of a key employee policy:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">The business can continue to pay the insurance premiums and receive the proceeds tax-free upon the death of the former key person.</span></li>

<li><span id="ctl00_Layout_lblContent">The policy can be offered to the retiring key person at its present value. This person may need additional personal life insurance protection, or perhaps this person is uninsurable.</span></li>

<li><span id="ctl00_Layout_lblContent">The company can surrender the policy to the life insurance company for its cash surrender value.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">The cash values of the policy can be used to fund a non-qualified deferred compensation plan. Such a plan provides benefits to the key employee only in the event he or she lives to retirement.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">3 - </span><span id="ctl00_Layout_lblChapterName">The Split-Dollar Concept</span></h2>

<p><span id="ctl00_Layout_lblContent">We have discussed in detail how life insurance can be used in business to fund a buy-sell arrangement in the event of the death of a business owner, and we have presented the advantages of using life insurance to protect the business against the loss of a key person. Another use for life insurance in business is the split-dollar insurance plan.</span></p>

<p><span id="ctl00_Layout_lblContent">Split-dollar is an arrangement that allows a person who needs insurance protection to secure it at a cost that is less than it would be if this person had to purchase the insurance on his or her own. This concept refers to the division, or split, of the insurance proceeds. In most cases, the individual splits the premium payments with another individual or entity. These two parties share in the proceeds of the insurance based on the arrangement that they have entered into.</span></p>

<p><span id="ctl00_Layout_lblContent">In some arrangements, one of the parties can contribute the entire premium while the insured makes no contribution to the premium at all. This type of split-dollar arrangement is referred to as a <strong>non-contributory split-dollar plan</strong>, or in the case of an employer, an <strong>employer pay-all plan</strong>.</span></p>

<p><span id="ctl00_Layout_lblContent">A split-dollar plan incorporates the use of permanent life insurance, not term life insurance. Some potential situations where split-dollar plans could be used are the following:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">An employer offers split-dollar insurance as a fringe benefit for certain employees.</span></li>

<li><span id="ctl00_Layout_lblContent">A split-dollar arrangement provides a salary continuation plan to the surviving spouse of a key employee.</span></li>

<li><span id="ctl00_Layout_lblContent">A corporation establishes a split-dollar arrangement with a stockholder to provide personal insurance protection at a reasonable cost.</span></li>

<li><span id="ctl00_Layout_lblContent">A split-dollar plan funds a cross-purchase buy-sell arrangement.</span></li>

<li><span id="ctl00_Layout_lblContent">An owner of a sole proprietorship enters into a split-dollar arrangement with the key employee who is the designated purchaser of the proprietorship upon the death of the sole proprietor.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">Of course, the split-dollar insurance plan has other uses, too. Any company can limit split-dollar arrangements to executives or to any class of employees that it chooses.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">The Two Basic Styles of Split-Dollar Design</span></h3>

<p><span id="ctl00_Layout_lblContent">Split-dollar life insurance has two major styles:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent"><strong>endorsement split-dollar design</strong>—Using this style of split-dollar life insurance arrangement, the employer applies for and owns the life insurance on the insured employee. Because the employer owns the policy, the employer is responsible for paying all premiums. The employer and the employee can enter into a split-dollar arrangement in which the employer allows the employee to split an agreed amount of the death benefit and to name a beneficiary to receive that stated amount as a death benefit. The employee’s rights are protected by an endorsement that is filed with the insurance company.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>collateral assignment split-dollar design</strong>—Using this style of split-dollar life insurance arrangement, the employee applies for and owns his or her own life insurance policy. The employee designates his or her own personal beneficiary to receive the death benefit proceeds. The employee is also responsible for paying all premiums. The employer and the employee can enter into a split-dollar arrangement in which the employer agrees to pay a stated amount of the premium in return for certain guarantees in the sharing of the life insurance proceeds. This arrangement protects the amount of premium the employer has committed to.</span></li>

</ol>

<h3>

<span id="ctl00_Layout_lblContent">ERISA Guidelines</span></h3>

<p><span id="ctl00_Layout_lblContent">Split-dollar insurance plans are generally considered welfare benefit plans under ERISA and are subject to the following requirements:</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent"><strong>reporting and disclosure</strong>—The type of split-dollar plan dictates the guidelines for compliance.</span>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent">A non-contributory, employer-pay-all endorsement style split-dollar plan for a select group of management or highly compensated employees is exempt from the reporting and disclosure requirements, except that the Secretary of Labor can request plan documents at any time, and the documents must be provided upon the request.</span></li>

<li><span id="ctl00_Layout_lblContent">A contributory collateral assignment style split-dollar plan having less than 100 participants is also exempt from the Reporting and Disclosure requirements, except that the Secretary of Labor can request plan documents at any time, and the documents must be provided upon the request. In addition, the employer must provide the employee with a summary plan description, which can be satisfied by providing a copy of the agreement and policy ledgers.</span></li>

</ol>

</li>

<li><span id="ctl00_Layout_lblContent"><strong>participation and vesting</strong>—Does not apply.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>funding</strong>—Does not apply.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>fiduciary responsibility</strong>—Can comply by naming the employer through one of its officers as the plan fiduciary. Requirements can be satisfied in a properly drafted split-dollar agreement.</span></li>

<li><span id="ctl00_Layout_lblContent"><strong>administration and enforcement</strong>—Requirements can be satisfied in a properly drafted split-dollar agreement.</span></li>

</ul>

<h3>

<span id="ctl00_Layout_lblContent">Tax Consequences of Split Dollar Plans</span></h3>

<p><span id="ctl00_Layout_lblContent">Under current regulations by the Internal Revenue Service, an employer can establish a split-dollar arrangement in one of two ways:</span></p>

<p> </p>

<p> </p>

<ol>

<li><span id="ctl00_Layout_lblContent"><strong>economic benefit regime</strong>—This is a straightforward method of providing the employee the advantage of death benefit protection at a cost that may be unavailable if the employee were to purchase insurance on his or her own. The economic benefit regime is used in conjunction with the endorsement style of split-dollar arrangement. The employer typically pays the entire premium and owns all of the policy cash value. The net amount of death benefit coverage provided to the employee each year constitutes a current economic benefit to that employee, and therefore, a calculated amount must be attributed as income for that year. The employee is responsible for paying taxes to the IRS on this attributed income. The current economic benefit is generally calculated by taking the amount of the net death benefit coverage provided that year to the Table 2001 rates as published. The per-thousand units of net death benefit protection multiplied by the rate-per-thousand in the 2001 Table produces the employee’s imputed income. For example, if the employee was age 45, his or her rate-per-thousand in the 2001 Table would be $1.53. If the employee had $100,000 of net death benefit protection in the year of calculation, his or her current economic benefit would be $1.53 X 100, or $153.00</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">The employer has no tax deduction for this attributed income amount.</span></p>

<p> </p>

<p> </p>

<ol>

<li value="2"><span id="ctl00_Layout_lblContent"><strong>loan regime</strong>—This method is generally used in conjunction with the collateral assignment style of split-dollar arrangement, or any arrangement in which the insured acquires an equity advantage without contributing to the premiums. The employer premiums are treated as loans to the employee, and the policy is collaterally assigned to the employer to secure the responsibility of the loan. Depending on the agreement, the employee either: (a) pays to the employer the market rate of interest on these loans; or (B) receives as additional compensation an amount equal to the foregone interest.</span></li>

</ol>

<p><span id="ctl00_Layout_lblContent">These regulations apply to split-dollar insurance plans that were entered into after September 17, 2003. For split-dollar insurance plans that were entered into before September 18, 2003, a number of transition guidelines must be followed that relate to the number of revenue rulings issued by the Internal Revenue Service between 1964 and 2003. Some final pending regulations will clarify a few remaining issues.</span></p>

<p><span id="ctl00_Layout_lblContent">Premiums the employer pays for split-dollar life insurance plans are not tax deductible. The recovery of policy cash values to satisfy the loan under the collateral assignment arrangement is not taxable as income to the employer; neither are the death proceeds. Policy dividends are assumed to be paid to the employer and are usually not taxable until the policy is surrendered. The employer can use the dividends to reduce premiums or to purchase paid-up-additions to the policy.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">The Use of Split-Dollar for Buy-Sell Arrangements</span></h3>

<p><span id="ctl00_Layout_lblContent">The split-dollar insurance plan can be used as a method for funding a buy-sell agreement. The style of split-dollar arrangements should be coordinated with the client’s objectives and the type of buy-sell agreement being considered.</span></p>

<p><span id="ctl00_Layout_lblContent">If the type of buy-sell agreement being considered is that of a stock redemption entity plan, a collateral assignment style of split-dollar would not be effective. However, an endorsement style of split-dollar could combine the repurchase of shares from the stockholder’s estate and provide for additional life insurance benefits for the personal needs of the stockholder.</span></p>

<p><span id="ctl00_Layout_lblContent">For example, consider a buy-sell agreement that values the stockholder’s shares of the business at $500,000. In addition, the stockholder needs personal life insurance in the amount of $400,000. Where the corporation may purchase $500,000 of life insurance on the stockholder to cover the buy-sell agreement alone, it would now purchase $900,000 on the stockholder and enter an endorsement style of split-dollar insurance for the amount of $400,000. The stockholder would have the current economic benefit on $400,000 attributed as income each year, but not on the $500,000 of coverage retained by the employer. Upon the death of the stockholder, the employer receives $500,000 of death benefit proceeds tax-free to satisfy the terms of the stock redemption entity buy-sell agreement, and the stockholder’s named beneficiary receives the $400,000 of death benefit proceeds tax free via the policy endorsement.</span></p>

<p><span id="ctl00_Layout_lblContent">If the type of buy-sell agreement being considered is that of a cross-purchase arrangement, both a collateral assignment style of split-dollar and an endorsement style of split-dollar could be effective. As in the previous example, assume that the value of the stockholder’s shares of the business is $500,000, but now we have two equal stockholders in the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">With a collateral assignment style of split-dollar insurance plan as the method of funding the agreement, the difference is that the stockholders are the owners and the beneficiaries of the policy on each other’s lives. Under this scenario, the loan regime applies to the owner of the policy, even though the insured is the other stockholder. The owner of the policy is responsible for the loan, not the insured or the beneficiary. Upon the death of one of the stockholders, the surviving stockholder receives the death benefit proceeds tax-free, settles the outstanding balance of the loan to the corporation, and uses the balance of the death benefit proceeds to satisfy the terms of the cross-purchase buy-sell agreement.</span></p>

<p><span id="ctl00_Layout_lblContent">With the endorsement style of split-dollar insurance plan as the method of funding the agreement, the employer applies for and owns a $500,000 policy on each of the stockholders. Each stockholder names the other stockholder as the beneficiary of the policy. Under this scenario, the economic benefit regime applies, and income is attributed to the stockholder on the life of the other individual insured stockholder.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">4 - </span><span id="ctl00_Layout_lblChapterName">The Section 162 Executive Bonus Plan</span></h2>

<p><span id="ctl00_Layout_lblContent">The Section 162 Executive Bonus plan is also referred to as an <strong>executive equity plan</strong>, <strong>executive bonus plan</strong>, or <strong>executive retirement bonus plan</strong>. The 162 executive bonus plan refers to section 162(a)(1) of the Internal Revenue Code, which authorizes a business deduction for salaries or other compensation as reasonable allowances for personal services actually performed.</span></p>

<p><span id="ctl00_Layout_lblContent">The executive bonus plan allows a corporation to provide needed life insurance protection for the selected employees on a tax-deductible basis for the employer. The employer has total discretion as to the selection of employees who participate in the plan, which may include both stockholder employees and non-stockholder employees.</span></p>

<p><span id="ctl00_Layout_lblContent">Under the executive bonus plan, the employee purchases and owns the permanent life insurance policy, and then enters into an agreement with the employer. The employer pays the entire premium on the policy to the insurance company, and attributes those payments to the employee as “other compensation” on the employee’s W-2 statement. This compensation is subject to Social Security (FICA) taxes as well as the Federal Unemployment (FUTA) tax.</span></p>

<p><span id="ctl00_Layout_lblContent">Because the employee owns the policy, and the employer has no rights or benefits in the policy, a written agreement is not required to be executed, as would be the case in a split-dollar life insurance plan,. However, it is always in the best interest of any planning activity to have some documentation to verify the intent of the activity taking place. Therefore, a resolution by the Board of Directors, or an agreement between the employer and employee would be beneficial, especially if the IRS attempts to treat the bonuses as non-deductible dividends to the stockholder employees.</span></p>

<p><span id="ctl00_Layout_lblContent">The executive bonus plan is only effective in conjunction with a C corporation because of the separate tax status that the C corporation enjoys as an independent entity. Neither the S corporation, partnership, or sole proprietorship can use the executive bonus plan, because they are pass-through entities and do not hold their own tax-bracket status.</span></p>

<p><span id="ctl00_Layout_lblContent">The advantages of the executive bonus plan are it</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">is easy to install;</span></li>

<li><span id="ctl00_Layout_lblContent">provides a tax deduction to the employer;</span></li>

<li><span id="ctl00_Layout_lblContent">can be selective in participation;</span></li>

<li><span id="ctl00_Layout_lblContent">provides death benefit protection and cash value accumulation to the employee;</span></li>

<li><span id="ctl00_Layout_lblContent">provides a life insurance policy to the employee that is unencumbered (the employer has no rights or benefits in the policy); and</span></li>

<li><span id="ctl00_Layout_lblContent">multiple policies can be paid with one business check from the employer.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">Executive bonus plans are most attractive when the employee-stockholder’s marginal tax bracket is lower than that of the corporation’s marginal tax bracket, because then a method is available in which the employee-stockholder can withdraw profits from the corporation in a reduced tax bracket environment.</span></p>

<p><span id="ctl00_Layout_lblContent">The executive bonus plan is also attractive to employee participants when they compare the tax liability due on the premium income against the cash value increase in that year. For example, if the premium imputed income was $2,000, and the employee participant was in the 25% marginal tax bracket, the tax liability is $500. If the policy cash value, which is owned by the employee participant, increased by $900 in that year, the increase in cash value more than offsets the tax liability on the attributable premium income.</span></p>

<p><span id="ctl00_Layout_lblContent">Because the employee participant owns the unencumbered policy and its cash value, the employee can access a portion of the cash value, tax-free, to pay for the income tax liability on the attributable premium income.</span></p>

<p><span id="ctl00_Layout_lblContent">As with life insurance proceeds in general, the death benefit proceeds of policies under an executive bonus plan are received by the named beneficiary income-tax free.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">5 - </span><span id="ctl00_Layout_lblChapterName">Deferred Compensation Arrangements</span></h2>

<p><span id="ctl00_Layout_lblContent"><strong>Deferred compensation arrangements </strong>allow an employer to defer income for selected management or highly compensated employees until after retirement. Under the deferred compensation arrangement, the employer has no current tax deductions to the agreement, and the employee has no current tax liability to the agreement. Employer tax deductions are postponed until the benefits are actually paid to the employee at some future time, generally at retirement. The employee’s tax liability is also postponed until the benefits are actually paid out to him or her at some future time.</span></p>

<p><span id="ctl00_Layout_lblContent">Under the typical deferred compensation arrangement, the employer promises to pay the selected employee a specified or unspecified amount for a fixed period of time or for life. The trigger to start these payments is usually stated in the agreement, and can be retirement or separation from service.</span></p>

<p><span id="ctl00_Layout_lblContent">The deferred compensation arrangement is a non-qualified plan, which means that the employer does not receive a tax deduction for the arrangement; the employer can be selective in who participates; and certain exemptions apply under the ERISA act. Two broad categories of a deferred compensation arrangement are (1) <strong>pure deferred compensation </strong>and (2) <strong>salary continuation </strong>plans. The fundamental difference between the two is that the pure deferred compensation plan generally encompasses an employee electing not to receive current income, whereas the salary continuation plan is provided by the employer as an additional benefit to all other current forms of compensation. The taxation of the two categories is similar.</span></p>

<p><span id="ctl00_Layout_lblContent">The general rules of the deferred compensation arrangement are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">the participants in the plan have the status of a general unsecured creditor of the employer and that the plan merely constitutes a promise of payment in the future;</span></li>

<li><span id="ctl00_Layout_lblContent">a provision is included stating the intention of the parties and that the plan be unfunded for tax and ERISA purposes;</span></li>

<li><span id="ctl00_Layout_lblContent">a provision is included stating the time and method of paying the deferred compensation in relation to each event that triggers the distribution, such as retirement or death; and</span></li>

<li><span id="ctl00_Layout_lblContent">if the plan refers to an informal funding device or trust, additional requirements must be satisfied.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">The American Jobs Creation Act of 2004 imposed additional requirements to avoid<strong>constructive receipt </strong>issues. (<strong>Constructive receipt </strong>refers to any statement of ownership or allocation to the participant or in the participants name.) Internal Revenue Code Section 409A establishes six events in which the participant can receive a distribution of previously deferred compensation. These six events are</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">separation from service;</span></li>

<li><span id="ctl00_Layout_lblContent">date of disability;</span></li>

<li><span id="ctl00_Layout_lblContent">death;</span></li>

<li><span id="ctl00_Layout_lblContent">fixed time (or pursuant to a fixed schedule) as specified in the plan at the date of deferral;</span></li>

<li><span id="ctl00_Layout_lblContent">a change in the ownership of the employer and effective control of employer assets, as provided in the regulations; and</span></li>

<li><span id="ctl00_Layout_lblContent">the occurrence of an unforeseen emergency.</span></li>

</ul>

<h3>

<span id="ctl00_Layout_lblContent">Funded and Unfunded Arrangements</span></h3>

<p><span id="ctl00_Layout_lblContent">When a deferred compensation arrangement is established, it is either an <strong>unfunded arrangement </strong>or a <strong>funded arrangement</strong>. As a general rule, in an <strong>unfunded arrangement</strong>, the employee participant has no vested position in the assets that the employer may have set aside for the purpose of the arrangement. The employee participant will not have a constructive receipt. Further, the employee cannot be given any interest in any trust, annuity, escrowed account, or life insurance contract.</span></p>

<p><span id="ctl00_Layout_lblContent">A deferred compensation arrangement can be <strong>informally funded</strong>, for example, through the use of a <strong>rabbi trust</strong>, in which the employer sets aside assets so that the employee participants see that assets have been deposited for the future use of the deferred compensation arrangement. However, the employee participants can have no interest of ownership or vesting in the rabbi trust, and all assets must be the employer’s property, subject to the creditors of the corporation.</span></p>

<p><span id="ctl00_Layout_lblContent">An employer can informally fund a deferred compensation arrangement through the purchase of life insurance contracts or annuities without adverse tax consequences to the employee, as long as the employee has no interest in the contracts, and the contracts remain as unrestricted assets of the employer.</span></p>

<p><span id="ctl00_Layout_lblContent">If the deferred compensation arrangement grants the employee participants a vested interest, rights of ownership, or other forms of a secured interest, the plan becomes a<strong>formally funded </strong>arrangement for tax and ERISA requirement purposes. In some instances, employee participants are not always comfortable in an arrangement of promise without some form of security interest to protect against default on the promise or to protect against the loss of the employer’s assets to creditors. In these cases, using a <strong>secular trust </strong>is instituted, allowing the employee participants to have a vested interest in the assets of the trust. Although this gives the employee participants some protection against the assets held in the trust, the vested interest is a form of constructive receipt, which creates a tax liability to the employee participant.</span></p>

<p><span id="ctl00_Layout_lblContent">Special care must be given if one of the employee participants is a controlling stockholder in the corporation. Because the controlling stockholder can remove any restraints or restrictions, the IRS may challenge that there is constructive receipt—that any restrictions are a thin veil because the controlling stockholder can access the assets at any time. No barrier or firewall of restriction exists. The IRS has not made any advanced rulings in regard to this issue; therefore, it is difficult to eliminate these concerns. Numerous structure and tax issues must be recognized in establishing a deferred compensation arrangement, and competent tax and legal counsel should be sought.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Benefits of Deferred Compensation Arrangements for Key Personnel</span></h3>

<p><span id="ctl00_Layout_lblContent">The use of life insurance in a deferred compensation arrangement has a number of benefits for the employer and for the key personnel of the business. As an informally funded plan, the employee has no rights or interest in the asset. Therefore, the employee participant has no current tax liability. However, the cash value assets of the policy are clearly visible in the annual statements, allowing the employee participant to view the accumulation of funds that are being set aside for the purpose of the future distribution.</span></p>

<p><span id="ctl00_Layout_lblContent">The employer can structure the unfunded deferred compensation arrangement in such a way as to keep the focus of key personnel on the loss of future benefits should they consider leaving the firm. Of course, the provision in the agreement must be crafted so that it does not conflict with the regulations as set forth by the American Jobs Creation Act of 2004.</span></p>

<p><span id="ctl00_Layout_lblContent">In most cases, the key personnel of an employer are highly salaried and in the maximum income tax bracket margin. Deferring income to a future time when the employee participant is in a lower tax bracket margin can be an attractive benefit.</span></p>

<h3>

<span id="ctl00_Layout_lblContent">Salary Continuation Plans</span></h3>

<p><span id="ctl00_Layout_lblContent">A <strong>salary continuation plan </strong>is a form of deferred compensation arrangement in that it is a non-qualified plan with respect to tax issues and ERISA guidelines. The salary continuation plan is an agreement that the employer will continue paying a salary to the employee participant in the event of certain triggers. These triggers could be disability, death, etc. This arrangement is also referred to as a <strong>death benefit only </strong>plan. The language in the agreement must specifically deny the employee participant any rights or vested interest in the policy. Unless this language is in the agreement, the IRS can challenge constructive receipt or vested interest, which would then be taxable income.</span></p>

<p><span id="ctl00_Layout_lblContent">The primary difference between the salary continuation plan and the pure deferred compensation arrangement is that the salary continuation plan does not reduce compensation for services rendered by the employee participant. The salary continuation plan is an additional benefit to employees who have been selected by the employer to participate in the plan.</span></p>

<h4>

<span id="ctl00_Layout_lblContent">Insured vs. Uninsured Plans</span></h4>

<p><span id="ctl00_Layout_lblContent">The salary continuation plan can be unfunded or funded, just like the deferred compensation arrangement. The most common approach to the salary continuation plan is to purchase life insurance on the employee participants so that the employer has the funds to meet the obligations of the plan. The purchase of life insurance policies is considered an informally funded plan as long as the employee participants have no rights, vested interest, or claim to the assets. In addition, the cash value assets of the policies are considered to be the assets of the employer and are available for attachment by creditors of the employer.</span></p>

<p><span id="ctl00_Layout_lblContent">For the employer, using life insurance to fund the plan is attractive, because the premiums create a systematic savings plan to accumulate the funds for future pay-out of the terms of the agreement. The life insurance policies also provide cash value, which is treated as assets on the books of the employer. Although the employer cannot take a tax deduction for the premiums paid, the death benefit proceeds are received income-tax free. However, the death benefit proceeds can impact the corporate Alternative Minimum Tax. The employer’s payment to the deceased employee’s survivor are tax deductible to the employer in the years paid. If the trigger for the salary continuation plan is disability or retirement, the employer can access the cash value of the policy to fund the payments.</span></p>

<p><span id="ctl00_Layout_lblContent">If the salary continuation plan is not insured by a life insurance policy, the funds are not guaranteed to be available when needed. The employer would have to use assets that may be needed for the operations of the business, or the employer could be forced to borrow the money. Moreover, the employee participant may need the funds to be paid as stipulated in the agreement, and the lack of funds by the employer to satisfy the agreement could create a hardship for the employee participant.</span></p>

<p> </p>

<p> </p>

<h2>

<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">6 - </span><span id="ctl00_Layout_lblChapterName">Corporate Owned Life Insurance</span></h2>

<p><span id="ctl00_Layout_lblContent">Corporate Owned Life Insurance (COLI) policies were developed for corporations to informally fund or to recover the costs of non-qualified benefit plans. Non-qualified benefit plans provide income and benefits to key executives and to highly compensated employees beyond that which is available through the use of qualified plans.</span></p>

<p><span id="ctl00_Layout_lblContent">COLI products and plans generally provide</span></p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<p> </p>

<ul>

<li><span id="ctl00_Layout_lblContent">high early cash values ranging from 50% to 90% of premiums paid;</span></li>

<li><span id="ctl00_Layout_lblContent">guaranteed issue underwriting considerations;</span></li>

<li><span id="ctl00_Layout_lblContent">change of insured provisions;</span></li>

<li><span id="ctl00_Layout_lblContent">levelized commissions;</span></li>

<li><span id="ctl00_Layout_lblContent">flexibility in funding benefits from cash value and death benefit proceeds;</span></li>

<li><span id="ctl00_Layout_lblContent">enhanced limited pay or premium vanish features;</span></li>

<li><span id="ctl00_Layout_lblContent">contract guarantees on mortality and expense charges; and</span></li>

<li><span id="ctl00_Layout_lblContent">guarantees on credited interest rates.</span></li>

</ul>

<p><span id="ctl00_Layout_lblContent">Corporations use COLI policies to fund deferred compensation plans, salary continuation plans, key executive benefits, and other advanced planning concepts. Use of COLI plans with policy loans can require that existing plans be re-evaluated because of current restrictions on the corporate tax deduction for interest paid on policy loans</span></p>

</div>

</div>

</div>

<p> </p>

</div>

<p> </p>

 

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