Life Insurance Can Benefit Succession Plan (published in the San Diego Business Journal)

Life Insurance Can Benefit Succession Plan (published in the San Diego Business Journal)

Using life insurance in family business succession and estate planning

often presents challenges for family business owners as they strive to plan for business continuity while generating accessible wealth for their families. Ensuring that their companies and estates have sufficient liquidity to meet their liabilities in the face of increasing tax rates and limited borrowing availability places additional pressures on family business owners. Fortunately, the incorporation of life insurance into a business owner’s succession plan can address a majority of these concerns, often in a tax-efficient manner.

Life insurance offers several benefits not associated with other investments. Death benefits paid under a life insurance policy generally are not subject to income taxes. If properly owned, they can also be estate tax free.

With thoughtful planning and the use of specially-designed life insurance policies, the value of the business can be protected and family harmony preserved. In fact, life insurance is commonly used by the owners of successful companies to accomplish a variety of important business perpetuation and estate planning objectives.

Funding a succession plan.

Owners of privately-held businesses have worked hard over their lives to build enterprise value, and they want to preserve it for themselves and their families. Unfortunately, much of that value can be lost when the owner retires, becomes disabled, or dies.

Privately-held businesses should have a written succession plan in place that provides a legal mechanism for the transition of ownership under these circumstances without having to liquidate the company. Once such an agreement is finalized, the promises in it become legally binding. An insurance policy on the life of the business owner provides the buyer with the financial means to follow through on the agreement; without it, it could be just an empty promise.

Insurance on the life of each owner is the best way to fund a succession plan, because it provides the cash needed by the company or the surviving shareholders to purchase the departing owner’s interest in the business. The cash value in a life insurance policy, which grows tax-deferred, is
accessed to pay for a lifetime purchase of an owner’s interest, while the death benefit is used to fund a purchase if the owner dies.

If policies are company-owned, multiple policies may be used to fund this lifetime buyout, meaning that the insured doesn’t have to match the payee.

Equalizing an estate.

Business owners can use life insurance to provide equitable treatment to those children who are not involved in the business. Leaving the company to the children who are actively involved in its operations and the life insurance to the children who are not can equalize the inheritances among all of the children and reduce friction. This structure also avoids the need for the active children to purchase the interests of the inactive children, which may occur at a time when the business is unable to afford it.

Creating estate liquidity.

If the deceased owner’s estate is subject to estate tax, which is generally due nine months after date of death, the heirs may be forced to liquidate business interests in order to pay the tax bill. But it can be challenging for anyone to command a fair price for a decedent’s illiquid business interest when it must be made liquid quickly and when there is no readily accessible market for the sale of most closely-held companies.

However, by insuring the business owner’s life, the value of the business can be preserved because the policy death benefit will provide the heirs with enough cash to pay the estate taxes rather than forcing them to liquidate business interests.

Typically, the insurance policy will be owned by an irrevocable trust so that the heirs will receive the death proceeds both income and estate tax free.

An insurance policy on the owner’s life can also be beneficial to the heirs in generating the highest return for the sale of the business. The insurance provides the family with financial flexibility they need while searching for a satisfactory price. It delivers cash needed by the heirs to operate the business and bridge the gap between the owner’s death and the sale of the business.

Providing executive benefits.

A nonqualified deferred compensation (NQDC) plan can be used by family businesses to provide members of the senior generation with death, disability and retirement benefits. It may be particularly meaningful for the senior members who have transitioned the business to the junior members and are no longer receiving compensation from the business but still desire income to meet their retirement needs.

A NQDC plan is also useful to ensure that key employees remain with the business, especially during sensitive periods of generational transition. A NQDC plan is often referred to as a “golden handcuff” because it incentivizes key talent to stay and perform to specific metrics in exchange for a promise of future benefits by the employer.

Because it offers both tax-deferred cash value growth and tax-free death benefits, life insurance is the most popular vehicle used for generating the cash necessary for the businesses to meet its NQDC plan obligations and recover the costs associated with providing the benefits to the key employee and his family.

Managing key-person risk.

Many family businesses depend on non-family employees, such as a lead salesperson or CFO, for the company’s continued success. To guard against financial harm to the business due to the loss of an indispensable key employee, the company will insure their lives. The insurance provides cash to the business to compensate for lost revenue as well as the time and resources needed to hire a competent replacement.

Call to action.

If you own a closely-held business, strategically-designed life insurance can be an essential tool to protect your wealth and accomplish your succession and estate planning goals in a tax-efficient manner. The peace of mind that you will gain by knowing that the value of your hard work will be preserved for you and your family is invaluable. Contacting and working with competent legal, tax, and insurance professionals who understand your business and communicate regularly on your behalf is the first place to start.