the role of life insurance in business succession planning chicago estate planning council december...

The Role of Life Insurance in Business Succession Planning

Chicago Estate Planning CouncilDecember 16, 2010

Charles L. Ratner, JD, CLU, ChFCNational Director of Personal Insurance Counseling


Any tax advice contained in this presentation was not intended or prepared by Ernst & Young LLP to be used, and cannot be used, by any taxpayer for the purpose of

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The opinions expressed in this presentation are those of the presenter and not necessarily those of Ernst & Young LLP.

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Topics

► Setting the stage► The threshold inquiries► Techniques for paying large premiums


The importance of setting the stage

► It’s easier to read in unison if you’re on the same page.► The sooner the threshold inquiries are addressed, the

more resourceful the agent can be in the marketplace and the quicker the client can get the insurance in place.

► And, the easier it will be for the advisors to work through the legal and tax issues associated with the premium paying strategies the client might consider.

► If everyone pushes off the structural issues until underwriting is done, the client will be under exquisite pressure to understand some very complicated stuff and then make big and perhaps irrevocable decisions.


The threshold inquiries

► How much is the client willing to spend on life insurance?► Why is the client buying the insurance?► Who will be the insured?► Who will be the policy owner and beneficiary?► Who will pay the premiums and under what type of

arrangement?► All things considered, what are the most desirable policy

characteristics in the given situation?► How much is the client willing to spend, redux?


How much is the client willing to spend?

► Garçon, the reality check, s’il vous plait!► Sooner or later, it’s going to be about the money, not the

principle of the thing.► So, agent should commence informal underwriting as

soon as possible and then, based upon the preliminary findings, show the client the “ballpark” cost► Perhaps per $1 million of coverage► Perhaps under various product types and funding approaches

► Better for all concerned to know up-front what the insurance will (likely) cost so client and planning team can work with realistic assumptions for the overall economic and tax cost of the insurance.


Why is the client buying the insurance?

► Financial security for surviving spouse and other dependents

► Liquidity for estate taxes ► Equalization among business and non-business children► Default estate plan


Financial security

► See that knee-jerk prescription? Don’t fill it!► Too often, when availability of the marital deduction will

defer taxes to the second death, the tendency is to opt for survivorship life because it looks “cheaper” than coverage on one of the spouses.

► Just because the client has a successful business and a large taxable estate doesn’t mean that surviving spouse will have adequate funds independent of the business. ► Run the numbers! Then get any needed coverage in place,

promptly► If possible, coordinate this coverage with coverage to be used for

other purposes, e.g., estate tax liquidity.


Estate tax liquidity

► To begin to determine how much insurance the client needs (or wants) and for how long he or she will need it, consider:► The current estate tax liability and liquidity need plus any current

shortfall in non-tax capital needs► Be sure to identify all needs for capital and liquidity at each spouse’s

death!► The projected needs under the current plan vs. the ultimate needs

after whatever planning the client is willing to do (if the client even needs to do any), and

► The optimum timing for the liquidity, i.e., how much liquidity at the business owner’s death vs. at the death of the second of the owner and surviving spouse to die.


Estate tax liquidity (cont.)

► Explore the use of coverage on the business owner so that a child in the business or the owner’s irrevocable life insurance trust (ILIT) can buy the stock at the business owner’s death and remove the growth of the business (above the growth on the cash proceeds) from the surviving spouse’s estate.

► This approach can offer additional benefits, such as providing security for the surviving spouse independent of the business and accelerating equalization between business and non-business children.


Equalization for non-business child

► This can be a vexing issue that can lead to a series of difficult discussions that can lead to months, if not years, of effort to try to figure out how to strike the right balance between the best interests of the business and harmonious relationships within the family.

► Consider the benefits and elegant simplicity of using life insurance as either the means for equalizing or the means for preserving certain assets for equalizing, e.g., providing liquidity to preserve deferral of a stretch IRA.


Default estate plan-version 1

► Client understands the impact of estate and income taxes, but is far more concerned about long life at lower yields than estate taxes the children might pay.► “Hey, you read the papers and watch the news. With all that’s

going on out there, would you give away your money?”

► Therefore, client will not rearrange affairs or part with assets to reduce his or her taxable estate.

► However, will part with some income for life insurance to assure inheritance or at least enough liquidity to avert a crisis.


Default estate plan-version 2

► Second verse same as the first, except…► What stops the client from planning is either

► Sheer complexity of the strategies/vehicles proposed by the advisors, or

► Lack of (anything close to) assurances that the strategies will work► Advisors comments seem so…circular.

► Knows insurance will work and is actually (though not actuarially) simple and easy to set up


Who will be the policy owner and beneficiary?

► In an estate planning context, the default owner/beneficiary is an ILIT or other entity to keep the proceeds out of the estate. But an ILIT may be contra-indicated if the client, even a wealthy client, wants absolute control over the policy.

► Owner/beneficiary might be child(ren) in the business or a trust for their benefit so they can buy the stock from surviving spouse at owner’s death.

► Once we know the ownership and beneficiary designation, we have a start at understanding:► The economic and tax implications of paying premiums► Implications of the tax economics on product selection and design


Who will pay the premiums and under what type of arrangement?

► What are the client’s expectations and constraints, economic and otherwise?

► What are the economic and tax implications associated with the premium paying arrangement?

► What has to go right for the arrangement to meet the client’s expectations? What can go wrong?

► What would be the desired role of the product in contributing to success and mitigating downside of the premium paying arrangement?


What are the right policy characteristics?

► At first blush and all things considered, what are the most desirable policy characteristics in the given situation?► Premium flexibility► Guarantees► Control over the investment of the cash value► Cash value accumulation/distribution


Overview of techniques for paying premiums

► The simple plan► Gifts, GRATs and sales to the ILIT

► Split-dollar plans► Endorsement between company and ILIT► Non-equity collateral assignment between company and ILIT► Non-equity collateral assignment between insured and ILIT► Collateral assignment between company and ILIT► Collateral assignment between insured and ILIT


The simple plan

► Client establishes the ILIT► Defective trust

► Discuss selection of grantor trust powers

► Outright gifts of the premium to the ILIT► Annual exclusions and/or exemption

► Gifts can be from personal funds or Section 162 bonus plan from client’s company


The simple plan (cont.)

► Client makes substantial tax-free gifts of income-producing property to ILIT► Discountable if possible

► Client establishes a GRAT► Funds GRAT with income-producing property► Names ILIT as remainderman

► Advisors assist in identifying property, choice of entity for transfer, GRAT design, etc.


Selecting the policy for the simple plan

► Consider a term policy until ILIT is funded► Key characteristics of the cash value policy

► Level or increasing death benefit?► Depends on extent of wealth transfer, etc.

► How much flexibility to change premium?► Plenty! Underpinning of strategy is to get the coverage in force at low

premium and let ILIT eventually take over once funded► Flexible premium product funded on current assumptions

► Can minimize premiums in the early years► Accelerate funding of policy after funding ILIT► Potentially reshape the policy to adapt to changing circumstances

► How important are guarantees in this strategy?► Not important and potentially counter-productive in this strategy


Split-dollar life insurance plans

► How a plan established after September 17, 2003 is taxed generally depends on which party “owns” the policy.► If the employer owns the policy, then the economic benefit regime

(Section 61) applies.► Traditional endorsement

► If the employee (or a trust) owns the policy, then the loan regime (Section 7872) applies.► Collateral assignment

► There are exceptions for plans in which the employee or trust owns the policy but has only the death benefit and no access to cash value.► Non-equity collateral assignment


Endorsement split-dollar

► Company is owner, beneficiary and premium payer.► Insured designates beneficiary for portion of death benefit.

► Insured has imputed income for the economic benefit of

the insurance protection, less any contribution. ► Presumably use Table 2001 until further notice, though one-year

term rates may be appropriate per Rev. Rul. 2003-105

► Insured may transfer endorsement rights to ILIT. ► Any imputed income is also a gift to the ILIT

► Endorsement plans are still sound but…► Not where plan will remain in place as long as insured lives► Income and gift tax implications of an increasing economic benefit

make endorsement plan impractical


Non-equity collateral assignment

► Designed as an economic benefit arrangement► Used where tax economics of the economic benefit

regime will be better than the loan regime at the outset► Can be particularly attractive with a survivorship policy► Like any economic benefit split-dollar arrangement, there

is a need to plan ahead!


Non-equity collateral assignment (cont.)

► ILIT owns policy► Company advances premiums► Company entitled to all cash value ► Company is secured by “bare-bones” collateral

assignment► Employee reports imputed economic benefit

► Table 2001 or insurer’s one-year term cost


Non-equity collateral assignment (cont.)

► At earlier of when policy is on cusp of equity or economic benefit will exceed interest cost, change to loan regime

► Initial loan will be for aggregate premiums advanced► Subsequent premium payments will be loans

► Discussed infra

► Unless insured will die in the split-dollar saddle, as it were► Need exit strategy because ILIT has no equity ► Must fund ILIT, so consider current or deferred gifts and sales


Private non-equity collateral assignment

► Similar to the corporate version, but the insured (or insured and spouse) are the collateral assignees► Or the insured’s trust is assignee

► Need to consider virtually all of the same factors in the design of the plan, the policy and the exit strategy as discussed in compensatory version

► In PLRs 200825011 and 200910002, the IRS considered proposed private non-equity collateral assignment arrangements.► Economic benefit regime will govern► No incidents of ownership


Collateral assignment split-dollar

► Loan regime governs► Company is lending the premiums to the policyholder► No economic benefit determined by term costs► No taxation of equity► Each premium is a new loan, governed by terms and rate(s) at

time of loan ► If loan does not provide for sufficient interest, Section 7872 below-

market loan rules apply


Collateral assignment split-dollar (cont.)

► Key planning issues► What type of loan, i.e., demand, term or term as demand? ► Charge AFR or impute interest?► Pay charged interest currently or accrue it until roll out?► Should loan be secured?► What’s the exit strategy? ► What’s the right policy?



► Demand loan at AFR► Interest paid or accrued at or above blended rate

► Blended rate for 2010-2011 is 0.59%► Short-term rate currently attractive ► But unpredictable long-term cost► By the way…the company can “call” the loan

► Below-market demand loan ► Interest imputed annually at blended rate► Same disadvantages as to unpredictability



► Term loan at AFR► Pay or accrue interest at AFR for the given term► Term can be for X years or at death► Can fix the interest rate upfront so no volatility ► If interest is accrued, can repay at death

► But, will need an increasing death benefit or return of premium option to keep the ILIT whole

► Will increase the cost of the policy significantly ► Will increase dependence on policy performance



► Below-market term loan► Can fix the interest rate upfront at time of loan ► If interest is accrued, can repay at death► Entire benefit to be received over the term of the loan is

accelerated to the first year for income and gift tax purposes► Benefit is the difference between the amount of the loan and the

present value of that amount discounted back for the term at the applicable rate



► What’s the exit strategy? ► Will loan be repaid during insured’s lifetime or will plan and insured

be rolled out at same time?► If planning on a lifetime roll out, need an exit strategy even more

than with “old” split-dollar► Used to be able to predict the economic and tax cost of a plan. Not

anymore! ► Imperative to mitigate the risk of rising rates and lessen dependence

on policy performance by funding the ILIT



► The policy► Does insured want ILIT to have a level death benefit net of the

loan?► Will interest be paid, accrued or imputed? If accrued, will policy

generate enough death benefit to handle the loan?► Assuming plan will be terminated during lifetime, what’s the exit

strategy?► Will policy finance its own roll out from cash value, fund the ILIT so

policy can be left intact or maybe some of both?► Flexible premium product funded on current assumptions

► Gives flexibility to adjust premiums to achieve targeted objective or to adapt to changing circumstances


Private premium financing

► Arrangement between insured/donor and ILIT► Insured lends funds to ILIT for premiums► Loan can be demand or term► Loan can be at AFR or below-market per Section 7872► Note included in insured’s estate


Private premium financing (cont.)

► Key design issues► Type of loan?► Should insured lend annually or make a one-time loan?► Pay interest currently or accrue it? ► Should the insured be the lender?► Should the loan be secured?► What is the right type of policy and how should it be designed?► What’s the exit strategy (other than death)?



► Should insured lend annually or make a one-time loan?► Annual loans

► Ties up less capital, but► ILIT can’t fund policy quickly

► Substantial one-time loan► Lock in rate that ILIT can pay currently or accrue for repayment with

principal at death► Still have to be careful about MEC issues► If client is older, consider using proceeds of loan to buy SPIA to

generate cash for premiums



► Will the ILIT pay interest or let it accrue for eventual repayment with loan principal? ► Pay or impute interest?

► Gift tax considerations may govern and require payment or accrual of interest to avoid Section 7872

► Pay interest currently or accrue it? ► Cash flow considerations► If accrued, loan could outperform policy, leaving too little death benefit



► The policy► Many of same suitability and design issues as collateral

assignment split-dollar► Flexible premium product funded on current assumptions

► Can minimize loans in the early years, which correspondingly reduces gift tax cost of interest on loans

► Higher cash values can facilitate roll out without gifts► Accelerate funding of policy after funding ILIT► Flexibility to reshape the policy to adapt to changing circumstances

► Exit strategy?► Lifetime roll out from cash values, ILIT funding or both?



► Exit strategy► Need a game plan for repaying the loan before the tax economics

of the interest costs turn the strategy upside down► Over-fund the policy?

► Expensive and increases dependence on policy performance► Fund the ILIT

► Gifts► GRATs► Sales

the role of life insurance in business succession planning chicago estate planning council december...

Documents

role of life insurance

client willing

ernst young llp

threshold inquiries

tax issues

tax advice

large premiums

facsimile transmission