The Tax Cuts and Jobs Act of 2017 brought significant changes to federal estate tax law. This legislation dramatically increased the federal gift and estate tax lifetime exemptions to historic levels, climbing to $13.61 million per person in 2024. However, in 2026, these exemptions are scheduled to revert to their previous amounts, adjusted for inflation (likely between $7 million and $8 million).
As this sunset date approaches, holders of significant wealth are increasingly worried about larger estate tax bills starting in 2026. Among those who are particularly concerned are taxpayers with significant illiquid assets, which they fear might have to be sold to cover future estate taxes. Life insurance can play a role in estate planning to address these impending changes, but it must be implemented carefully.
Clarifying misconceptions
As the reduction in estate tax exemptions looms, some individuals may consider purchasing substantial life insurance policies to cover their estates' tax liabilities. However, simply buying insurance “to pay the tax” is rarely, on its own, a helpful solution to the problem. This is because when life insurance is personally owned by the insured, the proceeds are included in the policyholder’s estate for federal estate tax purposes. Therefore, for people likely to owe federal estate taxes at death, simply obtaining insurance to cover the tax can inadvertently increase their taxable estate, compounding the problem the insurance was intended to solve.
Consider the case of a taxpayer who estimates that there will be a $5 million federal estate tax owed when they pass away and purchases a $5 million life insurance policy to cover the tax. This action will increase their estate's taxable amount by $5 million. At the current 40% tax rate, the policy would add approximately $2 million to their estate tax bill. Therefore, to cover the estimated $5 million tax entirely with life insurance proceeds, the individual would need to purchase a policy with a death benefit of about $8.4 million to account for the additional tax liability. In many situations, the cost of insurance will not justify the additional coverage needed to cover the tax liability.
A more tax-efficient strategy
A more tax-efficient method for using life insurance to fund estate tax obligations is through an irrevocable life insurance trust (ILIT). Life insurance purchased, owned and payable to an ILIT is not included in the taxable estate for federal estate tax purposes if properly administered. In the previous example, if the policy is owned by a properly administered ILIT, the death benefit would not be included in the taxable estate, keeping the tax obligation at $5 million.
This presents another challenge, however: Although policy ownership through an ILIT will not increase the size of the insured's estate, it is not as easy to use the policy's death benefit to pay the estate tax obligation as it would be if the policy were held in the insured's name. To make this strategy work, the ILIT's trustee should either loan cash to the estate or purchase estate assets (including any business interests owned in the estate), providing liquidity to pay the tax liability.
Keep in mind that contributions to the ILIT, including policy premium payments, are considered taxable gifts for federal gift tax purposes. Individuals should carefully consider whether such gifts will use part of their gift tax exemption, especially with the scheduled reduction in the exemption. It is crucial for anyone considering an ILIT to consult with their financial advisors and estate planning counsel to ensure the trust is properly administered and the strategy is suitable for their situation.
Deferring estate tax
Alternatively, life insurance may not be necessary to pay an estate tax bill, even when an illiquid asset like an operating business makes up most of the estate's value. In some circumstances, the IRS permits the payment of estate tax over time, which can alleviate the immediate financial burden on an estate and an underlying business.
Internal Revenue Code (IRC) Section 6166 allows the executor to defer federal estate tax on a closely held business if certain conditions are met. The business must represent at least 35% of the decedent’s adjusted gross estate, and the decedent must have owned at least 20% of the business. If eligible, the executor can defer estate tax payments for up to 14 years, with primarily interest-only payments due in the initial years.
To qualify, the business must be actively engaged in trade or business and the estate must appraise the business promptly to meet IRS requirements. If successful, this deferral can provide significant relief, allowing the business to continue operations without financial strain from immediate estate tax obligations and thereby avoiding the need for insurance payouts to provide additional liquidity.
Moreover, in addition to the Section 6166 deferral, there are alternatives to purchasing insurance to assist with potential estate tax obligations (such as certain loan arrangements). Business owners should carefully review all options for dealing with potential estate tax liabilities in consultation with their financial advisors and estate planning counsel.
Insurance's role in buy-sell agreements
Life insurance can be used for other planning purposes beyond funding estate tax obligations. For instance, a business owner may not want their ownership in the business to pass to their heirs, whether spouses, children or others. Instead, the goal may be for the remaining active owners to buy out the deceased owner’s interest, providing liquid assets to the heirs. Life insurance can be a useful way to fund these agreements. In these arrangements, the business or its owners purchase policies on each owner to ensure sufficient liquidity to buy out the deceased owner’s interest. This helps prevent surviving owners from having to manage the business with unintended partners.
Assume a family business valued at $80 million is owned and run by four siblings, each with an equal ownership interest. A buy-sell agreement could stipulate that the business purchase a $20 million policy on each sibling's life. Upon an owner’s death, the business would use the insurance proceeds to purchase the deceased sibling's interest for $20 million.
There are additional considerations, particularly for family-owned companies. Owners must determine a fair price for the business. If the business grows faster than anticipated or decreases in value, the proposed purchase price may not reflect the fair market value of the deceased owner's interest, potentially causing disputes among family members.
The U.S. Supreme Court issued a landmark decision June 6, 2024 in Connelly, as Executor of the Estate of Connelly v. United States, holding that life insurance proceeds should be included in a corporation's valuation, increasing the estate tax liability. So, in the hypothetical above, the business' value would increase to $100 million upon the death of the first sibling, despite the obligation to buy the deceased owner's interest.
Estate equalization
One additional consideration that business owners may struggle with occurs when their estates are largely illiquid and they have multiple children but do not want to give equal ownership of the business to all of their children. Life insurance can play a helpful role by providing liquidity to financially equalize their estate distributions. This process involves taking out a life insurance policy (preferably through an ILIT) and naming the heirs who will not inherit shares as beneficiaries.
For example, if a business is valued at $8 million and the owner has three children but only one is set to inherit and run the business, the owner could purchase a $16 million life insurance policy. The proceeds from this policy would be divided equally among the two children who are not receiving the business.
However, while this approach works well on paper, it is often difficult to implement a truly equal distribution when using both liquid and illiquid assets. In the situation at hand, although the owner may value the business at $8 million today, it is impossible to accurately predict what the business will be worth at the time of the owner's death. As with the buy-sell agreement, the insurance policy also may be insufficient to fully equalize if the value of the business continues to grow. There is no magic bullet to solve this problem. Open dialogue among family members is essential to give heirs a greater chance of family harmony in the face of a disproportionate outcome.
Navigating the complexities of estate planning for family businesses amid falling lifetime exemptions requires careful consideration and strategic use of tools like life insurance. While life insurance can sometimes inadvertently increase estate tax liabilities, properly structured solutions such as Irrevocable Life Insurance Trusts (ILITs) and leveraging IRC Section 6166 can mitigate these issues. Buy-sell agreements funded by life insurance smooth business transitions and estate equalization provides fair distribution of assets among heirs. Proper planning in consultation with financial advisors and estate planning professionals will ensure these strategies are tailored to your unique situation, ensuring your business's legacy endures and your family's future is secure.