Common use of Planning Considerations Clause in Contracts

Planning Considerations. In planning the buyout provisions in shareholder, partnership or operating agreements, Code Section101(j) adds a new level of analysis to the equation. Complying with the notice and consent requirements is an easy first step. Even so, the impact of excess insurance proceeds should be addressed when one is relying on the exception for amounts paid to an insured's heirs under Code Section 101(j)(2)(B). In such a case, whether the entity or the family of the deceased principal receives the proceeds can affect whether the excess insurance proceeds will be included or excluded from gross income as the proceeds are excluded from gross income to the extent of the amount paid to the heirs. However, if the entity retains excess insurance, it may be included in gross income unless another exception applies to exclude the insurance proceeds. The benefits and risks of alternative sources of funding a buy out should also be weighed. While life insurance can be a ready source of liquidity, the tax considerations discussed above along with the insurability of the principals and the need for a constant stream of up-front cash payments for premiums may not make economical sense for every client. When life insurance contracts are not attractive, other alternatives exist to fund a buyout. A cash buyout avoids the tax risks associated with Section 101(j), but requires that the business have a significant cash reserve on hand to satisfy the buyout, which when depleted may affect the operations or credit worthiness of the business. The entity could borrow funds to avoid using its own cash, but the risk is whether credit will be available or at a reasonable interest rate. Installment payments are a practical solution where the installments are tied to the valuation of the consideration, which can be partially based on the projected cash flow of the business. If the projected cash flow, however, does not follow suit, the payees will be exposed to the general credit risk of the entity or the personal guarantees of the other principals. Finally, the business may self-fund with an investment fund. This may allow the business to better manage its cash reserves and be prepared to be liquid. However, this also requires an up-front diversion of cash from the business operations and tax on the distributions and appreciation of the investments. Overall, life insurance contracts continue to be an attractive solution for funding buyout provisions in shareholder, partnership and operating agreements.Careful planning is required where a life insurance contract can be deemed an EOLI contract to avoid the negative income tax consequences that would inadvertently interfere with an otherwise prudent plan. ATTORNEYS MENTIONED