What Is An Endorsement Split-Dollar Arrangement?

A buy-sell strategy using an endorsement split-dollar arrangement is a sophisticated method for funding buy-sell agreements, especially when using life insurance policies to facilitate the transition of ownership upon the death or exit of a business owner. This strategy involves a split-dollar life insurance policy arrangement between the business and its owners, where the costs and benefits of the policy are divided according to a predefined agreement. Let’s dive into what an endorsement split-dollar arrangement is, how it works, and how it can address the tax implications raised by the recent Connelly court ruling.

What is an Endorsement Split-Dollar Arrangement?

An endorsement split-dollar arrangement is a type of life insurance policy arrangement where a business (often an employer) owns a life insurance policy on the lives of its owners or key employees and endorses a portion of the policy’s death benefit to the insured person’s beneficiary. The business retains ownership and control of the policy, but the insured individual (or their family) benefits from a part of the death proceeds upon the insured’s death.

In the context of a buy-sell agreement, this type of arrangement is used to fund the purchase of the deceased owner’s shares. Here’s how it typically works:

1. Policy Ownership and Premiums: The business purchases a life insurance policy on each owner, pays the premiums, and retains ownership of the policy. The business is typically the primary beneficiary.
2. Endorsement Agreement: The business enters into an endorsement agreement with the insured owner, specifying that a portion of the death benefit will be paid to the deceased owner’s estate or designated beneficiary.
3. Death Benefit Allocation: Upon the death of an insured owner, the life insurance proceeds are split:

• A portion goes to the business to fund the buyout of the deceased owner’s shares.
• The remaining amount goes directly to the deceased owner’s beneficiaries, as outlined in the endorsement.

1. Buy-Sell Execution: The business uses its portion of the life insurance proceeds to redeem (buy back) the deceased owner’s shares from their estate, ensuring a smooth transition of ownership.

Why Use an Endorsement Split-Dollar Strategy in a Buy-Sell Agreement?

This approach is popular for several reasons:

• Cost Efficiency: The business pays for the policy premiums, reducing the financial burden on individual owners. This can be more manageable than having each owner purchase separate policies in a cross-purchase agreement.
• Control: The business retains control over the life insurance policy, allowing for easier management of premium payments and beneficiary designations.
• Simplified Administration: This strategy simplifies the process of using life insurance to fund a buy-sell agreement, as the policy ownership remains centralized with the business.

Impact of the Connelly Ruling on Split-Dollar Arrangements

The recent Connelly ruling has brought up challenges related to how life insurance proceeds are treated in buy-sell agreements, specifically regarding the basis adjustment for remaining shareholders when life insurance is used to fund a buyout.

In the context of stock redemption (where the company buys back the shares of the deceased owner), the ruling clarified that life insurance proceeds received by the business do not result in a basis step-up for the surviving owners. This means that the remaining shareholders could face higher capital gains taxes when they eventually sell their shares, as their basis in the shares remains the same.

How an Endorsement Split-Dollar Strategy Addresses Connelly Concerns

An endorsement split-dollar arrangement can be structured to mitigate some of the basis issues highlighted by the Connelly ruling. Here’s how this strategy can address the potential tax implications:

1. Direct Benefit to the Beneficiaries: In an endorsement split-dollar arrangement, a portion of the death benefit is directly allocated to the deceased owner’s estate or beneficiaries, rather than being paid solely to the business. This means that part of the life insurance proceeds can reach the heirs directly, potentially reducing the estate’s reliance on a stock redemption payout.
2. Reduced Impact of Redemption Rules: Because the life insurance proceeds are split between the business and the deceased’s beneficiaries, the amount used by the business for the stock redemption is lower than in a traditional stock redemption arrangement. This can limit the impact of the basis adjustment issue since only part of the proceeds is used for the redemption.
3. Flexibility in Structure: By carefully designing the endorsement agreement, businesses can adjust the percentage of the death benefit that goes to the estate versus the business. This flexibility allows for better planning around basis adjustments and tax consequences.
4. Hybrid Structure for Basis Management: An endorsement split-dollar arrangement can be combined with elements of a cross-purchase agreement to further manage the basis issues. For instance, while the business retains control over the life insurance policy and receives a portion of the death benefit, the remaining shareholders might use personal funds or separate policies to fund part of the buyout. This creates a scenario where some of the ownership transfer involves a direct purchase between surviving shareholders, allowing for a basis step-up for that portion of the purchase.

Example of an Endorsement Split-Dollar Strategy in Practice

Scenario: Three owners—Alex, Bella, and Charlie—own equal shares in a business. The company purchases life insurance policies on each of them, paying the premiums and owning the policies. The business sets up an endorsement split-dollar agreement, which designates that 50% of each policy’s death benefit will be paid directly to the deceased owner’s beneficiaries, while the remaining 50% will go to the company.

• Triggering Event: Alex dies. The life insurance policy on Alex has a death benefit of $1 million.
• Death Benefit Allocation: According to the endorsement agreement, $500,000 goes directly to Alex’s beneficiaries, while the remaining $500,000 goes to the company.
• Buy-Sell Execution: The company uses its $500,000 portion of the death benefit to redeem Alex’s shares from his estate.
• Outcome: Bella and Charlie now own 50% each of the company, with their ownership percentage increased due to the redemption of Alex’s shares.

Advantages of the Endorsement Split-Dollar Buy-Sell Strategy

• Direct Benefit to Heirs: A portion of the death benefit can directly support the deceased owner’s heirs or estate, reducing reliance on the buyout payout.
• Simplified Policy Management: The business retains control of the life insurance policies, simplifying the administrative burden compared to individual cross-purchase policies.
• Mitigates Tax Impact: By reducing the amount used for stock redemption, the arrangement can mitigate the effects of the Connelly ruling regarding basis adjustments.

Disadvantages of the Strategy

• Complexity in Structuring: An endorsement split-dollar arrangement requires careful structuring to ensure the appropriate allocation of benefits and compliance with tax regulations.
• Potentially Higher Premiums: Because the business is funding the policies, the cost can be higher compared to individual owners managing their own policies.
• No Full Basis Step-Up: While the strategy can help mitigate some basis issues, it may not fully resolve them if a significant portion of the life insurance proceeds is used for a redemption.

A buy-sell agreement using an endorsement split-dollar arrangement offers a way for businesses to use life insurance policies for ownership transition while addressing some of the challenges highlighted by the Connelly ruling. By allocating part of the life insurance proceeds directly to beneficiaries and only using a portion for stock redemptions, businesses can reduce the adverse effects of not having a basis adjustment for remaining shareholders. However, this strategy requires careful planning and consultation with legal and tax professionals to ensure that it aligns with the business’s succession goals and minimizes tax consequences.as the business owners understand the tax implications. By not expecting a basis adjustment from the life insurance proceeds, businesses can avoid potential pitfalls and maintain a smooth ownership transition process. For those seeking a more flexible approach, combining elements of stock redemption with cross-purchase options (hybrid agreements) may provide a tailored solution that balances simplicity with tax efficiency. Consulting with tax and legal professionals is critical to ensure that the chosen structure aligns with the business’s goals and circumstances.

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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.