The Role of Life Insurance in Business Succession Planning

1
The Role of Life Insurance in
Business Succession Planning
Julius H. Giarmarco, Esq.
2
Family Facts

• Father John (age 65)
• Mother Mary (age 65)
• Son Lawrence (age 35)
• Daughter Jennifer (age 30)
• Lawrence is only child active in the family
  business
• Lawrence has 3 children and Jennifer has 2
  children.

3
John Marys Balance Sheet

• Value
• Residence (Joint) 1,000,000
• Vacation Home (Joint) 750,000
• Business (S corp) (John) 5,000,000
• Building (LLC) (John) 2,000,000
• Non-Qualified Investments (Joint) 500,000
• IRAs (John) 750,000
• Life Insurance (John) - 0 -
• Gross Estate 10,000,000

1
1. Cost basis of 500,000 Assume 10 dividend
and 4 principal appreciation.
4
John Marys Objectives

1. Retain control of the S corporation until
   retirement.
2. Pass the entire business to Lawrence at Johns
   death.
3. Retain one or two key-employees to assist in the
   transition period
4. Treat children fairly.
5. Guarantee retirement income.
6. Reduce or eliminate estate taxes.

5
Projected Estate Tax Liability in 2028
Current Net Estate 20,736,000 Existing Life
Insurance - 0 - Total Estate 20,736,000
No federal estate taxes and expenses at first
death
By-Pass Trust and Other Transfers 3,500,000
Estate of Surviving Spouse 17,236,000
After Tax Estate 11,054,800
Federal Taxes 6,181,200 29.8
Distribution to Heirs After Tax
Estate 11,054,800 By-Pass Trust and Other
Transfers 3,500,000 Total 14,554,800
Distribution to Family 70.2
Assumes 4 growth through 2028. Assumes the
estate tax exemption is 3.5M and the estate tax
rate is 45.
6
Options to Pay the Estate Tax if John Mary Do
Nothing

• 1. Good - IRC Section 6166 (5 year deferral 10
  year installment payment of estate tax)
• 2. Better - IRC Section 303 (redemption of stock
  to pay death taxes)
• 3. Best - Irrevocable Life Insurance Trust
• Discounted dollars
• Can purchase assets from estate
• Can loan monies to estate

7
Section 303 Redemption During Johns Lifetime
Insurance Company
Pays Premiums
S Corp
Obtains Life Insurance
John

• If stock interest is more than 35 of adjusted
  gross estate, the estate will qualify for a
  partial redemption.

Insured
8
Section 303 Redemption Upon Johns Death
Insurance Company
Pays Death Benefits
S Corp
Cash

• Partial redemption is not treated as a dividend.
• Family continues to retain an ownership interest.

John
Stock Passes
Some Stock
Johns Living Trust
9
Advanced Techniques to Transfer Business to
Lawrence During Johns Lifetime

1. Private Annuity Sale
2. Self Canceling Installment Note (SCIN)
3. Grantor Retained Annuity Trust
4. Installment Sale to Grantor Trust
5. Charitable Stock Bail Out

10
Private Annuity Sale

• 7520 Rate 5
• FMV of S Corporation 5,000,000
• Johns Basis 500,000
• Payment Period Annual
• Initial Annual Payout 473,979
• Single Life Expectancy (Age 65) 20 Years
• Capital Gain Realized at Time of Sale 4,500,000
• Initial Annuity Payment Breakdown
• Tax-Free Portion 256,410
• Ordinary Income Portion 217,568

11
Bullet Proofing the Private Annuity Sale

• John should consider funding an ILIT (for the
  benefit of Mary) to replace the annuity
  payments in the event of his premature death.
• Lawrence should consider purchasing life
  insurance to provide the funds necessary to
  continue the annuity payments should be
  predecease his father.

12
Self Canceling Installment Note

• 7520 Rate 5
• FMV of S Corporation 5,000,000
• Cost Basis 500,000
• Initial Down Payment 0
• Term of Note 19 Years
• Type of Note Interest Only
• No-Risk-Premium Market Interest Rate 5
• Payment Period Annual

13
Self Canceling Installment Note
Risk Premium

• Principal Interest
• Mortality Risk Premium (Principal) 2,619,628 N/A
• Total Sale Price 7,619,628 5,000,000
• Principal Amount of Note 7,619,628 5,000,000
• Mortality Risk Premium (Interest) N/A 3.5620
• Annual Principal Payments 0 0
• Annual Interest Payments 380,981 428,083
• Balloon Payment at the End of Note 7,619,628 5,0
  00,000
• Total Interest to be Paid 7,238,646 8,133,577
• Total Capital Gain 7,119,628 4,500,000

14
Bullet Proofing a SCIN

• John should consider funding an ILIT (for the
  benefit of Mary) to replace the note payments
  in the event of his premature death.

15
GRATTrust Established
John
GRAT
Transfers S Stock
(can be arranged with no gift tax)
Pays Gift Tax
IRS
16
GRATDuring GRAT Term
John (pays taxes on trust income)
GRAT
Pays Annuity
IF JOHN DIES BEFORE END OF TRUST TERM
Johns Estate
GRAT (portion of property subject to estate
taxes)
17
GRATAt End of GRAT Term
GRAT
If John lives to end of trust term, property in
GRAT is not subject to estate taxes.
Remainder Paid to
Lawrence
18
Grantor Retained Annuity Trust

• 7520 Rate 4.40
• Johns Age 65
• Income Earned by Trust 10.00Annual Growth of
  Principal 5.00
• Term/Number of Payments 10
• Pre-discounted FMV 5,000,000
• Discounted FMV 3,000,000
• Annual Percentage Payout 16.66000

Beginning 5.00 10.00 Annual Year Principal G
rowth Annual Income Payment Remainder 1 5,000,00
0 250,000 512,500 499,800 5,262,700 5 6,316,
539 315,826 647,445 499,800 6,780,012 10 9,4
56,952 472,847 969.337 499,800 10,399,337 Sum
mary 5,000,000 3,408,963 6,988,374 4,998,000
10,399,337
19
Bullet Proofing a GRAT

• John should consider funding an ILIT (for the
  benefit of Lawrence) to provide the funds needed
  to pay estate taxes should John die before the
  end of the GRAT term.

20
Installment Sale to a Grantor Trust
John
Grantor / Dynasty Trust
John gifts 10 of S Corp stock

• John retains control as 10 voting shareholder

• 500,000 FMV

(10 x 5,000,000 500,000 less 40 discount
300,000)

• John receives 170,000 annually (from interest
  payment and 50,000 of dividends on the 10
  voting shares)

John sells 80 of S Corp stock

• 4,000,000 FMV

(80 x 5,000,000 4,000,000 less 40 discount
2,400,000)

• Trust earns 10 on 4,500,000 450,000/ year

Trust pays interest only for 20 years of 120,000
annually

• John pays income taxes of 210,000 (500,000 x
  42) - for annual short fall of 40,000
  (210,000 170,000)

(2,400,000 x 5)

• Trust can use the excess cash flow of
  320,000/year to purchase life insurance on
  Johns life or John and Marys joint life.

Trusts Cash Flow 450,000 (120,000) 330,000

• Paying IDITs income taxes is equivalent of
  tax-free gift

21
Charitable Stock Bail Out
John
1. John transfers his voting shares to Lawrence
and his non-voting shares to the CRT, leaving
Lawrence the sole shareholder. This terminates
Subchapter S election.
2. John receives a charitable income tax
deduction and income for the rest of his and
Marys lives.
Charitable Remainder Unitrust
3. Stock is transferred from the trust to the S
corp in exchange for cash.
S Corp
4. Life insurance can be purchased to replace
the wealth passing to the CRT.
22
Wait and See Buy-Sell AgreementDuring Lifetime
Insurance Company
Business
Agreement
Pays Premiums
Pays Premiums
John
Lawrence
Each Shareholder Obtains Life Insurance On The
Other
23
Wait and See Buy-Sell AgreementUpon Johns
Death
Insurance Company
Pays Death Benefits
S Corp
Must Purchase
Option to Purchase
John
Lawrence
1st
3rd
Stock Passes
Option to Purchase
2nd
Johns Living Trust
24
Why Use Life Insurance to Fund Buy-Sell Agreement?

• Creates a lump sum of cash when needed.
• Results in a quick settlement of the buy-sell
  transaction.
• Generally, an income tax free death benefit.
• Income tax free access to cash values for a
  lifetime buy-out.

25
Key Employees

• Company can purchase life insurance on the lives
  of its key employees to guard against financial
  loss.
• Company can provide key employees with an
  executive bonus.
• Company can implement a non-qualified deferred
  compensation plan to attract and retain key
  employees.
• Company can assist key employees in purchasing
  life insurance through a split-dollar plan.

26
Executive Bonus
Company
Insurance Company
2
1
3
Key Employee
27
Non-Qualified Deferred Compensation Plan
2
Company
Insurance Company
3
1
4
Key Employee
28
Split Dollar Plan
1
Company
Key Employee
3
2
Insurance Company
1
A face amount and premium for a life insurance
policy is determined and the employer lends this
premium to the employee.
The loaned premium is used to pay for the life
insurance policy. The employee owns the policy.
2
The employee executes a collateral assignment on
the policy to secure the employers loan. Annual
interest on the loan is assessed at an
appropriate interest rate, often the Blended
Annual Rate or Long-Term Applicable Federal Rate,
as published by the Internal Revenue Service. The
interest is usually treated as bonused income to
the employee.
3
29
Split Dollar Plan
1
Company
Key Employee
3
4
2
Insurance Company
5
The portion of the cash value or death benefit
assigned to the employer to repay the loan is
paid off at retirement or death, from the cash
values, if available. Death benefit may be
forgiven by the employer.
4
After paying off the loan to the employer and
terminating the assignment, the employee may
access policy values to supplement his/her
retirement income or pass tax free death benefits
to his/her descendants.
5
30
Estate Equalization

• John and Mary can leave Jennifer their
  non-business assets.
• John and Mary can make up the difference by
  funding a survivorship ILIT for the benefit of
  Jennifer.

31
Estate Equalization
John Mary
1. John Mary create an irrevocable trust, and
make gifts of life insurance premiums to the
trust.
2. Pays Insurance Premium.
Insurance Company
ILIT fbo Jennifer
3. Pays death benefit upon death of John Mary
income and estate tax free!
4. Transfers Cash.
John Marys Estate
5. Transfers Assets.
6. Pays Debts and Taxes.
IRS
32
Family Bank

• Structure
• A family LLC or family limited partnership.
• Members/Partners
• Lawrence and Jennifer.
• Capital Contributions
• Either gifts from John and Mary and/or
  contributions directly from Lawrence and
  Jennifer.
• FLLCs/FLPs Investments
• A survivorship policy on John and Marys lives.

33
Family Bank

• Indicated Use
• When shares in the Company are transferred
  (either during Johns lifetime or death) to both
  children.
• Purpose
• To provide funds for Lawrence to call
  Jennifers shares, or for Jennifer to put her
  shares to Lawrence.

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The End. Thank You!
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The Role of Life Insurance in
Business Succession Planning
Julius H. Giarmarco, Esq.