What Is A Buy-Sell Partnership Administration Succession Strategy (PASS)?

A Buy-Sell Partnership Administration Succession Strategy (PASS) is a specialized approach for managing the succession of ownership interests in a business partnership, particularly when the business is funded by life insurance. The strategy focuses on ensuring a smooth transition of ownership upon the death, disability, or retirement of a partner, while addressing the tax implications and valuation complexities that can arise during such transitions.

How Does a PASS Strategy Work?

The PASS strategy involves setting up life insurance policies as a funding mechanism to facilitate the transfer of ownership interests among partners. Here’s an overview of how it typically functions:

1. Life Insurance Policies Owned by a Partnership Trust or LLC: In a PASS strategy, instead of each partner individually owning life insurance policies on each other (as in a cross-purchase agreement), a central entity like a trust or a specially formed LLC owns the life insurance policies. This entity is set up specifically to hold life insurance policies on the lives of all partners in the business.
2. Partnership Agreement Includes the PASS Provisions: The partnership agreement outlines the terms for what happens when a partner dies or becomes disabled. It specifies how the life insurance proceeds will be used to buy out the deceased or departing partner’s ownership interest.
3. Life Insurance Proceeds Payout: When a partner dies, the life insurance policy held by the trust or LLC pays out to this entity. The trust or LLC then uses the insurance proceeds to buy out the deceased partner’s share, and the ownership is redistributed among the remaining partners according to the terms of the agreement.
4. Redistribution of Ownership Shares: The remaining partners’ ownership percentages are adjusted according to the buyout terms. The trust or LLC essentially facilitates the transfer, and it ensures that the business remains operational while the estate of the deceased partner is fairly compensated.

Why Use a PASS Strategy?

A PASS strategy offers several advantages for managing the transfer of business ownership:

• Simplified Administration: By having a central entity (trust or LLC) hold the life insurance policies, the complexity of managing multiple policies is reduced. The partnership or the trust manages premium payments, policy updates, and distributions.
• Cost-Effectiveness: Since a single entity owns the policies, it can be more cost-effective than each partner owning individual policies on each other. This structure can reduce the administrative burden and the number of life insurance policies required.
• Fair Valuation and Compensation: The life insurance proceeds ensure that the estate of the deceased partner receives fair compensation for their share of the business, while the remaining partners can continue to operate the business without financial strain.
• Continuity of Business Operations: The PASS strategy helps maintain continuity in the business by providing liquidity to buy out the deceased partner’s shares, avoiding the need to liquidate assets or secure external financing.

How Does the PASS Strategy Address Issues Raised by the Connelly Court Ruling?

The Connelly court ruling highlighted concerns around basis adjustments when life insurance proceeds are used in the buyout of a deceased owner’s shares in a business. Specifically, it clarified how the basis of ownership shares is treated when life insurance proceeds are used in a stock redemption plan. The key issue was that life insurance proceeds received by the company could not be used to increase the remaining owners’ basis in their shares, potentially leading to higher capital gains taxes upon the eventual sale of those shares.

The PASS strategy offers a workaround for these issues by addressing the basis concerns in a few key ways:

1. Centralized Ownership of Policies in a Trust or LLC: Instead of the business itself owning the policies (as in a redemption agreement), the life insurance policies are owned by a separate entity—such as a trust or an LLC. This means that the insurance proceeds are paid to this central entity rather than directly to the business, which can help manage how proceeds are distributed and used.
2. Distribution to Remaining Partners: Because the life insurance proceeds are not flowing directly into the business but are instead used by the trust or LLC to buy out the deceased partner’s shares, the remaining partners can receive a stepped-up basis in the shares they acquire. The purchase of the deceased partner’s interest using life insurance proceeds through the separate entity allows for an adjustment in the basis of the remaining partners’ ownership shares.
3. Avoidance of Basis Erosion: The PASS strategy ensures that the insurance proceeds do not reduce the basis of the remaining partners’ shares, which was a concern highlighted in the Connelly case. By using a separate entity to handle the transaction, the structure of the PASS strategy helps maintain the basis integrity for the remaining partners, potentially reducing future capital gains taxes.
4. Flexibility in Structuring Transactions: With the PASS strategy, the terms of the buyout and the handling of the life insurance proceeds can be tailored to the specific needs of the business and its owners. This flexibility makes it easier to design a plan that is tax-efficient and aligns with the goals of the partnership.

Case Study: PASS Strategy in Action

Scenario: Let’s say three partners—Alice, Bob, and Carol—own a manufacturing business together. To plan for the unexpected, they set up a PASS agreement using an LLC to hold life insurance policies on each partner’s life. Each policy is valued at the estimated market value of each partner’s ownership share in the business.

• Partnership LLC Owns the Policies: The LLC holds the life insurance policies on Alice, Bob, and Carol, and it pays the premiums from contributions made by the business.
• Event of a Partner’s Death: Alice passes away unexpectedly. The life insurance policy on Alice’s life pays out $1 million to the LLC.
• LLC Uses Proceeds for Buyout: The LLC uses the $1 million in life insurance proceeds to buy out Alice’s 33% ownership stake from her estate.
• Ownership Adjustment: Bob and Carol then adjust their ownership stakes, each now owning 50% of the business. The $1 million paid to Alice’s estate fairly compensates her family for her share, and the remaining partners gain a stepped-up basis for the shares they acquire through the transaction.

In this case, the PASS strategy allows for a smooth transition of ownership while addressing tax implications and the need for basis adjustments. It ensures that Bob and Carol don’t face unexpected capital gains taxes due to a lack of basis adjustments, as could have been the case if the business itself had owned the life insurance.

Pros and Cons of the PASS Strategy

Pros:

• Simplified Management: The central entity (trust or LLC) reduces the need for multiple life insurance policies.
• Basis Step-Up Advantage: Helps ensure a stepped-up basis for remaining partners, which can reduce future capital gains taxes.
• Business Continuity: Provides liquidity for buyouts, ensuring the business can continue without the financial strain of purchasing a deceased partner’s interest.
• Customizable for Various Situations: Offers flexibility in structuring the partnership’s transition terms.

Cons:

• Complexity in Setup: Establishing a trust or LLC to hold policies can involve legal and administrative complexity.
• Initial Costs: There may be higher upfront costs for legal and financial structuring.
• Requires Careful Planning: The partnership agreement and the trust or LLC need to be carefully crafted to ensure compliance with tax regulations and the specific needs of the business.

The Buy-Sell Partnership Administration Succession Strategy (PASS) is an effective tool for business owners looking to secure a smooth transition of ownership while navigating the tax complexities highlighted by the Connelly court ruling. By using a trust or LLC to hold life insurance policies and manage the buyout process, the PASS strategy helps protect the remaining partners from adverse tax outcomes and ensures that the business remains intact during a transition. It is particularly advantageous for partnerships where maintaining control, managing tax implications, and ensuring a fair valuation for all parties are essential.while providing for loved ones. By understanding its benefits and limitations, you can make an informed decision and create a legacy that reflects your values and priorities.

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Michiel Laubscher & Laubscher Wealth Management LLC is not an investment advisor and is not licensed to sell securities. None of the information provided is intended as investment, tax, accounting, or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other offerings. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information contained herein is at your own risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Michiel Laubscher & Laubscher Wealth Management LLC does not promise or guarantee any income or specific result from using the information contained herein and is not liable for any loss or damage caused by your reliance on the information contained herein. Always seek the advice of professionals, as appropriate, regarding the evaluation of any specific information, opinion, or other content.