One of the most common concerns that an owner of a closely-held business faces regarding business succession is liquidity. How can the future owners of the business, be they family or key employees, pay the owner or his family the fair market value of the business? How can a business continue when an owner dies prematurely? One answer is to use life insurance. This article will highlight how insurance policies can play a central role in a succession plan that preserves the value and integrity of the business, while maintaining family unity.
How can life insurance help preserve a business when the owner dies? Upon the death of the owner, the fair market value of the business is included as part of the owner’s taxable estate. Without proper planning, the resulting estate tax liability could require that the owner’s estate sell the business, sometimes at a heavily discounted value due to the loss of the owner and time constraints imposed by the IRS. Also, without proper planning, the death of the owner could cause the business to fail to meet its financial obligations. Life insurance can used to address these two internal business problems.
Rather than liquidating part of the business, the Owner could generate new wealth through life insurance. Generally, life insurance proceeds owned by the insured are part of the insured’s taxable estate. To avoid this inclusion, the Owner can establish a separate entity, an irrevocable life insurance trust (ILIT), to purchase and own the life insurance policy. If the Owner does not actually own the life insurance policy, then the policy proceeds are excluded from the Owner’s taxable estate. Then, when Owner dies, the trustee of the ILIT can be used to acquire business interests from the Owner’s estate, thus transferring liquidity to the estate, which, in turn, can use the liquidity to pay estate taxes without having to sell the business interests to a third party.
When the Owner establishes the ILIT, the Owner can address any number of issues that are important to the business and to Owner’s family. These issues can include internal ownership and control issues associated with the business, and the external estate planning concerns that the Owner may have with regard to his family.
Life insurance can also provide working capital upon the death or disability of the Owner or another key employee. Note that the insurance proceeds received by the business are not taxable to the business; however, the premium payments are also not deductible. The taxation of business owned insurance depends on the type of entity the business is; thus, partnerships and LLCs are subject to different tax schemes than C corporations. It is important to get the advice of an accountant before purchasing life and disability insurance through the business.
A buy-sell agreement between the Owner and any future owners of the business can also be facilitated with insurance proceeds. Should some key employees be interested in acquiring the business, but lack sufficient funds, they can purchase life insurance on the Owner’s life or disability insurance in case of the Owner’s disability. That would provide them with liquidity to purchase the business from the Owner or the Owner’s estate.
However, a host of uncertainties may make such a plan undesirable. Alternatively, a revocable stock purchase trust can be structured by the Owner to require (i) the trust’s acquisition of business interests from the Owner or the Owner’s estate in return for the insurance proceeds and (ii) the management and distribution of such interests until such time that the buyers are identified and ready to take over. Key employees may change over time and a trust allows for flexibility to adapt to unforeseen circumstances.
From an external perspective, a tricky situation for the Owner arises when some but not all of the Owner’s children are active in the business. How can the Owner plan to treat all children equally when most of the Owner’s assets is tied up in the business? Life insurance on the Owner’s life, held in an ILIT, can create wealth to create a more fair estate distribution to the Owner’s inactive children. These children could be identified as the beneficiaries of such a trust.
A succession plan requires careful consideration of the degree of control the Owner wishes to maintain at present and during retirement; the persons best suited to succeed the Owner; the Owner’s income needs during retirement or disability; the needs of the Owner’s family; and the Owner’s estate tax situation. The above insurance-based plans need to be structured carefully to avoid unintended, undesirable income, gift, or estate tax consequences and to make use of the tax benefits that could be incorporated into a succession plan, such as gifting discounts, low interest promissory notes and trusts. Given all the available legal and financial tools, the Owner of a closely-held business can develop a good business succession plan.