Estate planning often presents challenges for family business owners as they strive to protect business continuity and provide accessible wealth for their families. The prospect of increasing tax rates, as well as limited credit availability, also place pressures on owners to ensure that their companies and estates have sufficient liquidity to meet their liabilities. The incorporation of life insurance into a business owner's succession plan can address these concerns, often in a tax-efficient manner.
Life insurance offers several benefits not associated with other investments. Death benefits paid under a life insurance policy generally are not subject to income tax. In addition, life insurance offers a hedge against the unexpected death of the insured, providing an immediate and substantial source of tax-free liquidity for the family business and/or the owner's estate, a feature not offered by other investment products.
Life insurance also can protect owners against potential changes in the federal estate tax. Although this tax currently is repealed for 2010, it is scheduled to reappear in 2011. In the interim, Congress may pass legislation that reinstates the estate tax for 2010, perhaps retroactive to January 1. With proper planning, life insurance can be sheltered from any such reinstatement while providing additional, liquid funds to cover potentially higher tax liabilities.
Uses for life insurance
Business continuity: A family business may experience significant economic decline after the loss of a key owner or employee. Life insurance can minimize the impact and support the company's credit needs.
Retirement planning: Life insurance can provide a source of retirement funds so a business owner need not rely on business earnings to support his or her retirement. A policy that accrues cash value allows the owner to borrow against that value without recognizing taxable income (depending on the type of policy). Any loan that remains outstanding at the insured's death reduces the death benefit paid out under the policy but should not result in taxable income.
Liquidity: Many business owners have most of their wealth concentrated in the business. Unless an estate has access to other liquid assets, the payment of taxes or expenses due at the owner's death can force liquidation of the business. Life insurance provides immediate liquidity for the owner's estate, protecting the business from a fire sale.
Wealth transfer: Life insurance can increase the value of an owner's estate, adding capital for family members or replacing wealth expended by the owner during life or by the owner's estate at death to cover taxes and expenses.
Buyout planning: Buy-sell agreements provide a framework for the buyout of an owner upon death, disability or withdrawal, either by the family business or the remaining owners. Using life insurance in this context provides the business or the remaining owners with funds to buy out the deceased owner's interests. A policy with a cash surrender feature may provide another source of funds to assist with buyouts during an owner's lifetime.
Family equalization: With life insurance, the owner can leave the business interests solely to the active children and provide an equal cash benefit to the non-active children, or create a separate fund that active children can use to buy out the non-active children.
Appropriate coverage
Insurance coverage typically falls into two broad categories: term insurance and permanent insurance. Term insurance solely provides insurance protection against the insured's unexpected death, typically at a fixed premium for a specified number of years. Permanent insurance, such as a whole life or universal life policy, provides an investment component in addition to the insurance protection, which generates a cash value for the policy. This cash value grows income-tax-free for as long as it remains invested under the policy.
Term coverage may be most appropriate for needs expected to terminate within a set period, such as key-man insurance, which becomes unnecessary upon departure of the key person. Permanent insurance generally will best suit an owner's wealth transfer and liquidity needs at death, or retirement planning during the owner's life.
Planning alternatives
Designating who owns and benefits from a life insurance policy depends on the purposes the coverage will serve and the ability to avoid estate taxation of the insurance proceeds in the owner's estate. Typically, this means someone other than the owner, such as the business, the other owners or a trust, will be the policy owner and beneficiary.
Policy held by business/owners. When the policy will provide liquidity directly to the business—for example, in order to redeem an owner's interests at death or to provide coverage for loss of a key employee —the policy may name the business as both the owner and the beneficiary. If the business is the beneficiary, the policy proceeds should not be included in the insured owner's estate. The policy will be considered a business asset, and the receipt of insurance proceeds upon the owner's death may increase the value of the business (and the owner's proportionate interest) for federal estate tax purposes, resulting in increased estate tax liability (assuming reinstatement of the federal estate tax). Planning the buyout using a buy-sell agreement may mitigate this issue if the agreement can be structured to fix the federal estate tax value of the deceased owner's interest.
Alternatively, buyouts may be structured so the remaining owners buy the deceased owner's interest. The remaining owners may be the owners and beneficiaries of policies insuring the deceased owner, each using insurance proceeds to acquire the deceased owner's interest.
In any case, buyout arrangements funded with life insurance should contain provisions to ensure that the coverage is sufficient to fund the buyout and to address allocation of the insurance proceeds (what portion will fund an immediate buyout; how any excess proceeds will be used, etc.). These agreements should also ensure compliance with tax code requirements for business-owned life insurance in order to protect the income-tax-free nature of the death benefits.
Policy held in trust. Life insurance acquired by an owner to provide estate liquidity, to benefit family members or otherwise to support estate planning should be held through an irrevocable trust. If properly structured, the irrevocable trust can control the disposition of the insurance proceeds and protect them from estate tax. Using an irrevocable trust can provide predictable tax results, whether or not the federal estate tax is reinstated.
The owner can customize the trust terms to achieve succession goals. For example, at the owner's death, the trust agreement can authorize the trustee to make loans to or buy assets from the owner's estate (including the owner's business interest), providing a tax-free source of liquidity to the estate. If the owner wants to equalize the inheritance between active and non-active children, the trust can be created solely for the benefit of the non-active children, or the active children can be allowed to access the funds to buy out the non-active children.
Holding life insurance through a trust provides flexibility with regard to paying premiums. Owners can fund premiums to the trust via gifts, loans or a combination, or by implementing more sophisticated funding techniques. For example, the owner could sell assets to the trust in exchange for an interest-only promissory note, bearing interest at a set federal rate and providing for a final balloon payment of principal. If the assets produce sufficient income, the trust can use the income to pay both the interest on the note and the policy premiums.
Many life insurance products can be customized to suit an owner's goals. It is critical that owners identify their needs and work with both experienced estate planning advisers and insurance agents to review the alternatives, select the best coverage and incorporate that coverage into their succession plan.
Jennifer M. Smith is an associate in the Wealth Management Group in the Tysons Corner office of Greenberg Traurig LLP. Her practice concentrates on estate, tax and insurance planning for high-net-worth individuals, with a focus on planning for closely held business owners (www.gtlaw.com).