Is Life Insurance in the Family Business Dead?

Smart, forward-thinking, successful family business owners typically don’t intend to fail to plan for their business’ smooth continuity, but, still, many fall short. They fail to plan despite both knowing better and being prodded and forewarned (about the pending doom of their estate and legacy) by the advisor community. 

How can we help business owner clients move forward with their succession plans? More proactive teamwork among the family business succession advisory team (collaboration among professional advisors) can lead to better goal clarification, family communication and implemented (not just a nice power point or flow chart) transition plans that result in successfully passing the family business as intended. In fact, two life insurance planning ideas may provide an avenue for collaboration, as they offer practical and actionable strategies that can often help remove a political or emotional hurdle that’s stood in the way of executing planning.  

A Challenging Task

According to an article in Forbes,¹ family businesses account for 50 percent of the U.S. gross domestic product. Some assume this percentage is made up of very small businesses, such as web-based businesses or “mom and pop” stores, but 35 percent of Fortune 500 companies are private companies or public companies in which a family controls the stock. Further, private businesses account for 60 percent of U.S. jobs and 80 percent of all new job creation opportunities.² However, as important as family businesses are to the economy, according to a 2014 PwC survey of business owners, only 66 percent (up from 52 percent in 2012) of business owners have confidence that the next generation (or family) will take over or are even capable of the skills and leadership necessary.³

Despite all the pitches the advisory community likes to make these days to business owners, let’s be honest —family business succession is anything but simple or easy. It can seem overwhelming and daunting to the family business owner. At the very least, it’s hard work, time consuming and often difficult to measure progress —and that’s when a successor is obvious! Business owners are also often unsure about which advisor to start with or who should drive the planning. Further, family business succession is both political and emotional (for example, heirs’ competing interests and concerns over fairness) on top of all of the legal and financial planning factors involved. It’s also really easy to put off: How many buy-sell agreements have lawyers written that have gone unsigned while the client waits for just one more thing to happen before he executes it? Finally, it can take too much attention away from the running and growth of the fundamental business, which is still the day-to-day priority.        

Teamwork Approach  

A family business is ideally served when its advisory team is, in fact, working as a team—truly collaborating, not just working individually with perceived harmony. Having different perspectives represented at the planning table—tax, legal, insurance, financial, valuation and consulting—brings multiple ideas and considerations to the business owner. Although growing, this practice is still not yet common, thus the choice of the word “ideal.”   

Teamwork, and being part of the succession planning team, means that each member not only brings his specific expertise, but also takes the time to get to know the other team members, as this enhances both sharing and trust. In the past, one advisor drove the business succession plan—today, this method is evolving so that any one advisor may play quarterback in the process and planning. Perhaps the consultant, the attorney or the life insurance professional will play the role of quarterback in one succession plan, but he’ll need to then pivot and play offensive line or receiver in other planning cases.  This collaboration is likely to grow, and advisors who can’t triangulate and work well with others may grow in their frustration as the planning world continues to evolve and change. Each advisor will need to be cognizant and honest about whether true teamwork is in place and demand (of the business owner) a structured team and process.    

The same teamwork approach applies to life insurance planning ideas. Life insurance professionals, by bringing a tangible idea to the planning table, can often help drive planning action; however, this mustn’t be done in a vacuum. Determining if life insurance makes economic and planning sense in a family business succession plan takes multiple perspectives. Each advisor (for example, estate law, tax planning, wealth/asset planning, succession consulting, business transaction, valuation and life insurance) may provide insight into the insurance decision-making process that isn’t only essential regarding the value of life insurance in the business owner’s plan, but also helpful in educating the business owner and his family.    

When collaborating about the owner’s succession planning, the team should go beyond maximizing various planning goals. It must also create appropriate expectation management for the business owner, as well as a clear path to the planning’s end and the steps and timing necessary to achieve it.    

Entity Redemption Agreement

The primary reason a family business would consider implementing an entity redemption agreement (that is, a legal agreement obligating the business entity to purchase all or part of an individual owner’s interest in the business for an agreed-on price) with life insurance is to help create liquid dollars for payment of estate taxes due at the death of the current owner(s) so the business isn’t forced to be sold. Liquidity is vitally important in family business succession planning, and finding it often isn’t easy. The planning team can help the business owner plan for, and accept, his business’s value and the reality of taxation, then offer solutions to facilitate that liquidity when it’s needed most.  

Traditionally, under Internal Revenue Code Section 2042, the proceeds (death benefits) of a life insurance policy owned by an individual are included in that individual’s estate, regardless of whom the beneficiary is. However, life insurance owned by a business on an individual owner or keyperson generally isn’t includible in the insured’s estate, provided the insured doesn’t retain or exercise powers that would constitute incidents of ownership. In addition, life insurance benefits payable to the business are typically received free of income tax. Although remote, exceptions do occur, so careful planning here is important.⁴  

The proceeds of life insurance owned by a business, however, are typically includible as an operating asset in the valuation of the business.⁵ Therefore, using life insurance as a financial tool inside the family business for succession success has often gone unexplored given the valuation challenges (that is, the concern that the death proceeds will add to the value of the family

enterprise, thus negating the benefits of the life insurance liquidity). Instead of focusing on the family business as a potential owner of life insurance, many business owners have used traditional irrevocable life insurance trusts (ILITs) in concert with a gifting strategy to fund liquidity needs at death.  

Combining With Buy-Sell Agreement 

Using life insurance in a family business in concert with a buy-sell agreement isn’t a new or esoteric idea. The idea of using an entity redemption agreement in concert with a buy-sell agreement expands this type of planning, and two Tax Court cases can guide the succession team to explore this avenue if the family business circumstances allow for similar tax treatment.  

In Estate of Blount v. Commissioner⁶ and Estate of Cartwright v. Comm’r,⁷ the U.S. Court of Appeals for the Eleventh and Ninth Circuits, respectively, ruled that if a valid and binding buy-sell agreement obligates the business to buy the owner’s shares (typically from the owner’s estate), then the life insurance doesn’t increase the value of the business. The fair market value of the family business isn’t increased by the value of the insurance (the death benefit amount) because it’s offset by the obligation to purchase shares under the entity redemption buy-sell agreement. The buy-sell agreement acts like a receivable, and the business must execute the purchase; the life insurance isn’t treated like other operating assets because of the binding agreement. This result assumes that the amount of the death proceeds are less than, or equal to, the entity redemption agreement obligation. If the proceeds exceed the obligation, there could be an impact on the value of the business to the extent of the excess proceeds.

As the 11th Circuit noted in Blount:

Even when a stock-purchase agreement is inoperative for purposes of establishing the value of the company for tax purposes, the agreement remains an enforceable liability against the valued company … To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value.⁸

The advisory team must determine whether the client’s circumstances would allow for such an arrangement. That said, Blount and Cartwright provide strong evidence to consider the use of an entity redemption agreement with life insurance as a planning avenue in an S corporation, partnership or closely held limited liability company (LLC). Closely held corporations or C corporations have added challenges, however, with this strategy.  

How it works. The agreement itself is a legal requirement that the business must purchase part, or all, of the stock at the time of the business owner’s death. The amount of business interest to be redeemed is often equal to the estate tax projected.  

The family business applies for and owns a life insurance policy on the business owner’s life. The business pays the policy premiums and is the policy’s beneficiary; the premiums aren’t deductible. It’s also possible to use a survivorship (second-to-die) policy, which would insure both the business owner and his spouse. When the business owner, or both the business owner and his spouse, dies, the business receives the life insurance proceeds (death benefit), in most cases, income tax-free. Then, pursuant to the entity redemption agreement requirement, the business purchases, using the cash from the insurance policy proceeds, the agreed-on business interest from the business owner’s estate. The estate’s executor then has cash that may be used to settle estate tax obligations and other settlement costs, and the business may re-distribute shares to the remaining owners or hold them.  

What does the life insurance provide to a family business? Acquiring life insurance inside the business using an entity redemption agreement can be a straightforward way to help provide liquid dollars for payment of federal and/or state estate taxes. Its lack of complexity may minimize planning delays, and cash can become available for the premium payments, all of which can help a business owner take planning action. Using a redemption agreement also reduces or eliminates the use of personal assets (cash) to pay for life insurance premiums to perpetuate the family business. There’s also no need to use the gift and generation-skipping transfer tax exemptions.  

Closely held corporation dynamics. In a C corporation, planners need to be aware that the death benefits (proceeds) may trigger the alternative minimum tax (AMT) in the amount above the C corporation’s basis in the policy (the premiums paid), that is, the difference between the death benefits and premiums paid. One potential solution is to acquire additional life insurance to address the AMT, but that creates an additional expense. Further complicating the C corporation planning dynamics are the redemption rules that commonly require that a shareholder’s entire interest be redeemed to qualify for capital gains tax treatment. A partial redemption may result in the C corporation’s shareholder having the entire redemption taxed as high as 20 percent, as if it’s being treated as a dividend. A major exception to this treatment is an IRC Section 303 partial redemption⁹ for the purposes of paying federal estate taxes. An additional C corporation issue with the entity redemption agreement is that surviving business owners don’t receive a step-up in their cost basis through this plan. Although they own a higher amount of the business after the redemption, that amount will be subject to higher taxes when it’s sold or passed on.  

The step-up issue can exist with any type of business entity. However, with pass-through entities, the receipt of the life insurance proceeds causes a pro rata basis increase, and it may even be possible, in some situations, to obtain a full basis increase for the surviving owners. The basis increase is limited to the amount of the life insurance proceeds, so the arrangement would have to be fully funded with life insurance for it to even be possible for the surviving owners to get a full basis increase, but with thoughtful planning, it’s possible.    

Combining the entity redemption agreement with traditional ILIT planning. It’s important that you continue to monitor this strategy, as you’ll want to ensure that the amount of the redemption does, in fact, cover the estate tax due. Combining entity redemption with traditional ILIT planning, in which gifts (annual or lifetime exclusion) are made into a trust that’s acquiring life insurance, as well as with other planning techniques, can produce the most favorable outcome for the family business. As with any existing life insurance that you consider, you’ll also need to monitor the transfer-for-value rules. Indeed, along with the advisory team, you should determine the appropriateness of this strategy according to the business owner’s specific circumstances, before discussing it at length with the client. 

Using a Grantor Trust 

The American Taxpayer Relief Act of 2012 (ATRA) made notable changes in the lifetime gifting limits for U.S. taxpayers. In 2016, an individual may gift, during his lifetime or at death, $5.45 million (or $10.9 million for a couple) without estate or gift tax consequences.   Individuals may also gift $14,000 (in 2016) to individuals annually, on top of their lifetime exclusion amount.  

Many successful Americans created so-called “2012 grantor trusts.” These trusts were created and funded with gifts in 2012 (or 2011) with the thought that the law may change in 2013, but gifts made prior to Jan. 1, 2013 would be grandfathered. The law didn’t revert back to a $1 million exemption, and the lifetime exclusion limits were indexed for inflation, using the consumer price index for the annual calculation. The increased gifting limits have become a central estate-planning dynamic, and there’s an opportunity to capitalize on them for business succession planning.  

Family business equalization using the grantor trust. Family business owners, whether they have their entire lifetime exclusion amount remaining or have already gifted to a grantor trust using the lifetime exemption gift limits—can consider grantor trust planning as a means to equalize wealth transfer to heirs when the intent is to have only those children, or family members, working in the family business receive the stock ownership in the business. Centralizing the business interests in those who work in the business is a common succession strategy. And, using lifetime exclusion gifting can help achieve this goal. Adding life insurance inside the grantor trust to enhance, or leverage, the trust assets can aid this approach.  

To illustrate this idea, consider a family business worth $10 million owned by a couple who have two adult children, one who works in the business and is capable of running it someday, and another who’s enjoying a different career with no interest in the family business. Ideally, the couple would like the family business decision making and control (that is, the company stock) to be with the child working in the business, but they want to be fair to their other child. Can a grantor trust, life insurance or a combination play a role here?

Combined grantor trust and ILIT. The couple isn’t ready to give up control of the business just yet, so they create a grantor trust for the benefit of the child working in the business and place $8 million of the family business stock in it. At the same time, they create an ILIT for the benefit of the other child and gift $2 million to it, which the trust uses to acquire an $8 million survivorship policy on both their lives. This combined use of a grantor trust and an ILIT helps the couple achieve both their business and estate-planning objectives. They’ve given away $10 million of their lifetime exemption, but because of the leverage of the life insurance, they’ve given both children the same amount. 

This example is purposefully designed to be simple to illustrate a planning idea and doesn’t intend to understate the complexity involved in family business succession planning. The demonstration is plausible and helps show how a family business owner can get over objective hurdles using grantor trusts and life insurance as planning tools to attempt to equalize business and estate planning among heirs. In this case, one heir received cash and the other the business interest. 

Existing grantor trusts. Since 2012, many grantor trusts were created and funded with both liquid and non-liquid assets, such as private business interests. As grantors and trustees now examine the mix of assets in these trusts, they commonly consider the asset allocation, taxation and diversification. They should also consider how the trust aids in business succession planning. Perhaps business interests could be swapped for other assets, or life insurance could be acquired to take care of children not working in the family business, like in the example above. It’s possible, although tricky, that a child working in a family business who’s also a beneficiary of a grantor trust could opt out as a beneficiary of the trust and accept company stock as a gift, while the trust uses insurance to equalize the other siblings.   

Even though the assets are out of the grantor’s estate, there are both income tax and liquidity issues to be considered. Grantor trust income is often taxed to the grantor himself, and ATRA increased income tax rates. Therefore, it’s worthwhile to explore if life insurance’s tax advantages can play an enhancement role as an asset in the trust: It can reduce taxation, as the cash value grows inside life insurance tax deferred. Further, life insurance provides guaranteed liquidity (cash) in the trust at death.  This can prove particularly valuable if death occurs at a time when other assets or a business interest are difficult to sell; cash at the death of the grantor(s) can prove important as the estate is settled and the family business is being transitioned.  

A Key Role

Three years have passed since ATRA was enacted, yet business owners and the advisors who guide them are only at the front end of exploring the significant planning opportunities that are now available for succession planning.  

Although these recent tax law changes have alleviated some of the need family businesses have for liquidity at death, the answer to the article headline’s question is a resounding, “NO.” In fact, today’s life insurance products, which are more flexible and less costly than ever, can add significantly to solving succession problems that exist, as the two examples demonstrated. Life insurance has a key role to play in the family business, but its use and power is best determined when life insurance experts work as part of a true advisory team. That team will continue to grow in its importance to the business owner, and the more they genuinely collaborate to explore options, the more success family businesses will have in continuing their important work into the next generation.  

Endnotes

1. Michael Evans, “5 Steps To Create A Viable Succession Plan For Your Family Business,” Forbes (Aug. 28, 2013). 

2. Ibid.

3. PwC’s 2014 Family Business Survey, www.pwc.com/gx/en/services/family-business/family-business-survey.html.  

4. Non-inclusion in an estate of life insurance owned by a business, established by Estate of Knipp v. Commissioner, 25 T.C. 153 (1955), in which the Tax Court held that 10 life insurance policies owned by a partnership on the life of a decedent who owned a 50 percent interest in the partnership weren’t includible in the decedent’s estate because the individual decedent had no power to exercise the rights of ownership in the policies. Revenue Ruling 83-147 further adopted the Knipp rationale. Further, Knipp held that it’s not whether the business owns the policy, it’s whether the individual had powers and rights over the policy that constituted incidents of ownership. 

5. Estate of Huntsman v. Comm’r, 66 T.C. 861 (1976). Treasury Regulations Section 20.2031-2(f) provides that in addition to the typical factors considered in determining the value of stock in a closely held corporation, life insurance policies payable to, or for the benefit of, the corporation shall be considered in the same manner as other non-operating assets.  

6. Estate of Blount v. Comm’r, 428 F.3d 1338 (11th Cir. 2005).

7. Estate of Cartwright v. Comm’r, 183 F.3d 1034 (9th Cir. 1999).

8. Blount, supra note 6. 

9. Internal Revenue Code Section 303 is a special provision passed by Congress that allows a shareholder’s estate, or heir, to sell to the closely held corporation enough stock to pay funeral expenses, estate administration costs and federal and state death taxes without treating the transaction (sale) as a dividend (taxed) to the redeeming shareholder.