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Special Uses of Life Insurance for Business Owners

Special Uses of Life Insurance for Business Owners

John and Betty Smith own a successful family business that was recently appraised at a value exceeding $15,000,000. While they’re extremely happy about their success, the appraisal results have raised some new concerns.

For one thing, they are now facing the prospect of paying federal estate taxes and state inheritance taxes. They recognize that most of their wealth is tied up in the business, and there’s not a lot of cash available for taxes. And since they want to pass the business to their sons who are currently working with them, they don’t want the business to be sold to pay taxes.

A second concern is that while the business is extremely important to their two sons, their daughter has never been involved, and is not interested in ownership or involvement. In fact, she lives with her husband and children in a different state. John and Betty, however, love their daughter and want her to share equally in their success after they’re gone. They have about $1,500,000 in other assets outside the business, but even if they gave all of those assets to their daughter, it doesn’t come close to matching the value of the business.

The good news is that life insurance might be the solution to both of the Smiths’ concerns!

Using Life Insurance to Equalize the Estate

To solve the problem of a child who is not connected to the business, John and Betty could buy $6 million worth of life insurance, payable to their daughter, in addition to giving her the $1,500,000 of non-business assets. The result is John and Betty’s daughter will receive a total of $7.5 million, the same as ½ of the $15 million company her brothers are inheriting.

However, John and Betty may decide to buy less life insurance. In their case, their two sons have worked for the family business for years, and their efforts have helped the company grow to its present prosperity. Moreover, the brothers will not be inheriting cash. Instead, they’ll get an operating business that will require long hours and difficult decisions in order for them to receive a payoff. Although the financial value to each of the children might match in a spreadsheet, the real life impact of the inheritance would be quite different.

Thus, John and Betty might decide to buy less insurance for their daughter, or divide the insurance proceeds differently. For example, they might decide that their two sons are responsible for 2/3 of the business success – thus $10 million of the $15 million value, in essence, already belongs to them because of their hard work. Thus the sons are only actually inheriting a value of $5 million ($2.5 million each) and therefore a life insurance bequest to their daughter of $1 million (instead of the original $6 million they were contemplating), along with the other non-business assets, would be fair. Each child would receive a value of approximately $2.5 million.

They might also consider getting a life insurance policy with a $4 million death benefit, giving $2 million of the insurance proceeds to their daughter, along with the non-business assets; and $1 million of the insurance proceeds to each of their sons. That way, each child receives a bequest of $3.5 million, but the sons are also receiving liquid assets so that not every bit of their inheritance is tied up in the business.

Only John and Betty can determine what is fair in their family situation. No matter what they decide, the life insurance proceeds will provide cash to the child who won’t inherit the business, and thus help equalize the estate for their three children.

Using Life Insurance to Provide Cash to Pay Taxes

Many business owners find themselves in a similar situation to John and Betty. A successful business might be valued at millions of dollars. Even if a business owner has a sophisticated estate plan, he or she might die with a substantial ownership interest in the company. Depending on estate tax law at the time of death, the estate tax John could be hundreds of thousands, or even millions of dollars.

What’s more, a successful business owner may have relatively little in the way of liquid assets. The estate might own a principal residence and possibly a second home but such assets may be difficult to sell quickly, especially if the real estate market is in a slump at that time.

Many business owners do most of their investing in a tax-favored retirement plan such as a 401(k) or a profit-sharing plan. Those handling the estate could tap that account to pay estate tax, but that would trigger income tax in addition to estate tax. Ideally, such retirement plans should be left intact as long as possible to prolong tax-deferred or tax-free growth for subsequent generations.

If the estate tax is sizable, the estate may have to draw upon credit lines or even sell the company in order to raise enough cash. Assuming that you will have a taxable estate and few liquid assets to pay the estate tax, your best bet may be to buy an insurance policy on your life. Alternatively, the policy might pay after the deaths of you and your spouse (a second-to-die policy), if that’s when a taxable estate
will pass to the next generation. By using life insurance, you can count on the cash from the insurance proceeds coming at the time when money is needed for estate tax.

Generally, estate planning professionals recommend that life insurance policies be held in an irrevocable trust, if estate tax will be an issue. The trustee will apply for the policy and be responsible for the
premium payments; when the insured individual dies, the insurance proceeds will escape income tax and estate tax, assuming the trust has been drafted and funded properly.

This method protects the life insurance and any accumulated values from creditors and predators during your lifetime. Likewise it protects the death benefit when it’s paid, providing an independent objective third-party (the trustee) to use the proceeds as directed by the trust. If money is needed for estate tax, the trustee can use the insurance proceeds to lend money to or buy assets from the estate. Estate assets, including the family business, won’t have to be liquidated to pay estate taxes.


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