Top 10 Uses of Life Insurance in a Family Business Succession Plan
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
A key part of estate planning for business owners who want to keep their
business in the family is deciding when and to whom to transfer the business.
The particular tools and techniques used in a business succession plan will
vary based on the goals and objectives of the four groups affected by the plan:
the senior generation business owner; the junior generation family members
involved in the business; key non-family employees; and family members not
involved in the business. It is important to examine how life insurance plays
an essential role in the typical family business succession plan.
No. 1: Estate liquidity
Some business owners will wait until death to transfer all or most of their
business interests to one or more of their children. If the business owner has
a taxable estate, life insurance can provide the recipients of the business
with the cash necessary to pay estate taxes. Using life insurance to pay estate
taxes is particularly useful for business owners because their ownership
interests cannot be readily liquidated. The children receiving the business may
also need life insurance to pay estate taxes. Usually, the insurance policy
will be owned by an irrevocable life insurance trust so that the beneficiaries
will receive the death proceeds both income and estate tax-free.
No. 2: Buy-sell agreements
A properly designed buy-sell agreement guarantees a market and fair price for a
deceased, disabled or withdrawing owner's business interest. It also ensures
control over the business by the surviving or remaining owners and can set the
value of the business interest for estate tax purposes. Life insurance is the
best way to provide the cash necessary for the business or the surviving owners
to purchase a deceased owner's interest. In many instances, the cash surrender
value in a life insurance policy can also be used (tax-free) to help pay for a
lifetime purchase of a business owner's interest.
No. 3: Estate equalization
A business owner can use life insurance to provide the children who are not
involved with the business with "equitable" tre ATM ent. Leaving the
business to the active children and life insurance to the inactive children
equalizes the inheritances among them. In addition, it avoids the need for the
active children to purchase the interests of the inactive children, perhaps at
a time when the business may be unable to afford it. Depending on the
particular facts and circumstances, the insurance may be owned by an
irrevocable trust for the benefit of the inactive children, and the insured may
be the business owner or the business owner and his or her spouse.
No. 4: Nonqualified deferred compensation plans (NQDC)
A nonqualified deferred compensation (NQDC) plan can be used by a small
business to provide members of the senior generation with death, disability,
and retirement benefits. A NQDC plan may be particularly useful in situations
where the senior members have transitioned the business to the junior members
and are no longer receiving compensation. A NQDC plan also ensures that key
employees remain with the business during the transition period -- a so-called
"golden handcuff." Because life insurance offers tax-deferred cash
value growth and tax-free death benefits, it is the most popular vehicle for
"informally" funding NQDC plan liabilities.
No. 5: Key-person insurance
Many family businesses depend on non-family employees for the company's
continued success. To guard against financial loss due to the absence of a key
employee, and to ensure that the business stays in the family, many companies
take out "key-person" life insurance, disability insurance, or both.
No. 6: Section 303 redemptions
Internal Revenue Code Section 303 enables the estate of a business owner to
remove cash from a corporation with no tax cost. To be eligible for a Section
303 redemption, the stock's value must exceed 35 percent of the shareholder's
estate. Also, the maximum amount that can be redeemed is limited to the amount
of the federal estate tax, state death taxes, funeral and administrative expenses.
The corporation can purchase a life insurance policy on the shareholder's life
to ensure that the corporation has sufficient funds with which to accomplish
the Section 303 redemption.
No. 7: GRATs
With a Grantor Retained Annuity Trust (GRAT), the grantor transfers a business
interest to the child or children active in the business (the
"remaindermen"), while retaining the right to receive a fixed annuity
from the trust for a stated term of years. The longer the stated term and the larger
the annuity, the smaller the taxable gift. At the end of the stated term, the
balance of the trust property passes (gift-tax-free) to the remaindermen. The
risk with a GRAT is that if the grantor dies during the stated term, all of the
assets in the GRAT are included in the grantor's estate for federal estate tax
purposes. But, in such case, by funding an irrevocable life insurance trust for
the benefit of the GRAT's remaindermen, the grantor can leave the business
interest to the GRAT's remaindermen who can then use the life insurance
proceeds to pay the federal estate taxes due. Alternatively, a married grantor
might qualify the assets in the GRAT for the marital deduction and have an ILIT
(for the benefit of the GRAT's remaindermen) use the life insurance proceeds to
purchase the assets from the grantor's estate.
No. 8: Asset protection planning
Businesses assuming the risk of potential environmental contamination (i.e.,
waste hauling, landfills, chemicals, etc.) are subject to liability under
federal and state pollution laws. Moreover, such liability is not limited to
the business itself, as the business owners also may he personally liable under
such laws. As the business passes to the next generation, so does the potential
liability. Life insurance is ideal in this situation. The business owner can
establish an irrevocable life insurance trust to run for the maximum period
permitted by state law (i.e., at least 90 years in most states and in
perpetuity in a handful of states). The trust would provide the business
owner's descendants with income and principal as needed for health, education,
maintenance and support. If properly structured, the assets in the trust cannot
be reached by the beneficiaries' creditors, including state and federal
No. 9: Private annuities and SCINs
With a private annuity, the business owner (the annuitant) sells the business
interest to the child or children active in the business (the purchaser) for an
unsecured promise to make periodic payments to the business owner for the rest
of his/her life (a single life annuity) or for the life of the business owner
and his or her spouse (a joint and survivor annuity). Because the private
annuity is a sale and not a gift, it allows the business owner to remove the business
interest from his or her estate without incurring gift or estate tax. The child
or children purchasing the business interest can fund an irrevocable life
insurance trust for his/her/their family's benefit in order to have the cash to
continue to pay the annuity should he/she/they predecease the business owner.
Conversely, the business owner can fund an irrevocable life insurance trust for
his/her family's benefit as a hedge against the business owner's premature
death. In either case, the amount of life insurance needed would be based on
the present value of the future annuity payments.
When a business owner decides to sell the business to a child in installments,
the promissory note may be a self-canceling installment note (SCIN). With a
SCIN, upon the seller's death, all remaining payments under the note are
canceled, similar to a private annuity. The purchaser must pay a
"premium" for this cancellation feature, either by a higher interest
rate or a higher purchase price. Like a private annuity, a SCIN avoids estate
and gift taxes. Unlike a private annuity, a SCIN allows the seller a security
interest in the transferred business. When using a SCIN, just as with a private
annuity, the business owner can fund an irrevocable life insurance trust for his
or her family's benefit as protection against the business owner's premature
death. Conversely, the purchaser can fund an irrevocable life insurance trust
for the benefit of his/her family so that they will have the cash to continue
to pay the SCIN should the purchaser predecease the seller.
No. 10: Family bank
When the decision is made to leave the business to both active and inactive
children, it is usually advisable to leave only the active children with voting
interests in the business. In addition, "put" and "call"
agreements should be entered into. Usually, a put option requires the business
to purchase all or a portion of the inactive children's interest in the
business upon a set price and terms. Without a put option, there may be no
practical way for an inactive child to benefit from owning the business
interest unless the business is sold. On the other hand, a call option allows
the active children (or the business itself) to purchase the business interests
of the inactive children upon a set price and terms. Without a call option,
there may be no effective way for the active children to avoid conflicts that
can occur between the active children who are receiving salaries and bonuses,
and the inactive children who are not. By having the active children own life
insurance on a senior family member's life, a "bank" is created to
provide the funds to satisfy any such puts and calls. Usually, the policy will
be owned outside of the business entity, such as in a trust for the benefit of
the active children, or by a limited liability company owned by the active
Succession planning seeks to help a business owner confronting many issues.
There is no one-size-fits-all approach to keeping the family business in the
family. The tools and techniques best suited to a particular business are
fact-specific. Life insurance plays an important role in helping a business
survive and thrive as it moves from one generation to the next.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.