Using Life Insurance and Irrevocable Trusts to Provide Liquidity for the Payment of Estate Taxes

Using Life Insurance and Irrevocable Trusts to Provide Liquidity for the Payment of Estate Taxes

One of the most frequent problems faced by families subject to the Estate Tax (a married couple having made no prior gifts must have a net-worth of over $10,680,000 in 2014 to be subject to the Estate Tax) is how to actually pay the taxes.  Very often a family owned business makes up the bulk value of the estate.  This business is typically not publicly traded, and is not an easy asset to sell quickly for a good price (that is if the family even wants to sell the business, which is often not the case).  If the family does not own other liquid assets sufficient to pay taxes, then they are placed in a very tough situation.

For instance, let’s assume that Bob and Susan own a business that provides a service, such as pest control.  With proper estate planning, upon the first spouse’s death no Estate Taxes will be owed, due to the “Unlimited Estate Tax Marital Deduction.”  However, when the second spouse passes away, there may be taxes owed depending on the values of all of the assets.  If Bob and Susan own a house valued at $1,000,000, vehicles and boats valued at $300,000, checking and savings accounts in the amount of $100,000, brokerage accounts in the amount of $700,000, retirement accounts in the amount of $200,000, and the value of the business for Estate Tax purposes is $15,000,000, then the approximate Estate Tax liability under current law would be $2,648,000.  However, they only have true liquidity in the amount of $800,000.  This presents a real problem for their children.

If Bob and Susan decided to be proactive and insure against this risk, then they may choose to take out a “second to die” life insurance policy with face value of $3,000,000.  Bob and Susan probably feel pretty good about this decision and think that their children will be able to continue the business and pay any required taxes.  However, because they were owners of the life insurance policy, the face value is also included in the calculation of their assets for Estate Tax purposes.  Now the approximate Estate Tax liability would be $3,848,000.  This situation is much better for their kids, but is still troublesome.

The better solution for Bob and Susan would be if they created an Irrevocable Trust (often referred to as an Irrevocable Life Insurance Trust, or ILIT).  They would appoint a third party, such as a trusted friend, relative, or advisor, as Trustee of the ILIT.  The Trustee would purchase the same exact life insurance policy, and would be the legal owner of the policy.  Therefore, the face value of the policy is not included in Bob and Susan’s Estate Tax calculation and the approximate tax liability would be $2,648,000.

The policy would be paid for by gifts to the ILIT made by Bob and Susan.  The ILIT will ultimately benefit their children in the same way that their Revocable Trusts do; however, the Trustee of the ILIT will also be given the power to deal with and do business with the Trustee of the Revocable Trusts, and the Personal Representatives of their Estates.  When the second to die of Bob and Susan passes away, the ILIT will receive a check for $3,000,000.  The Trustee of the ILIT can use that liquidity to purchase unmarketable assets, namely as a portion of the family business, from the Revocable Trusts and/or Estate of the survivor.  Thus, the liquid assets end up in the hands of the person who must pay the taxes, and the children inherit a larger amount than would otherwise be the case.  It is important however, that the ILIT does not require the Trustee to pay the policy proceeds to the Revocable Trust or the Estate of Bob or Susan; otherwise the face value will be included in the Estate Tax calculation.

At the end of the day, $2,648,000 worth of the family business was purchased by the ILIT and is held for the benefit of the children.  The Trustee under the Revocable Trusts used that cash to pay off the Estate Taxes.  The children did not have to dip into their personal assets to pay the taxes, nor did they have to use up all of their parents’ liquid assets, nor did they have to sell the family business for peanuts in a “fire sale.”  This type of planning is a very good solution for many families and is a very flexible estate planning tool.

The Importance of Shareholder Agreements in the  Succession of a Family Business

The Importance of Shareholder Agreements in the Succession of a Family Business

Orlando, FL – Often when a closely-held business (i.e. a non-publicly traded LLC, Partnership, or Corporation, hereinafter “Family Business”) is created there is a single shareholder who owns 100% of the voting units and thus makes all of the decisions concerning the business (hereinafter the “Founder”). As time goes on and this person ages, they will begin to think about their goals for estate planning, as well as what they would like to happen with the business when they are gone.

Generally people tend to favor splitting up all of their assets equally among their descendants. However, when the largest asset is the Family Business, resolving these matters may become very complicated. For instance, it is common that certain children will be involved in the Family Business, while others have nothing to do with it. Further, between the children who are involved in the Family Business, there will often be different degrees of involvement, skill, and dedication. Other issues that frequently arise involve children who have substance abuse problems, or mental health issues. Additionally, there is always the possibility that one or more children will go through a divorce, which could create the risk of ownership of the company being transferred to an ex-spouse. It is also not uncommon for a non-family member to be involved in the Family Business. The Founder may wish to reward their hard work and dedication with partial ownership and/or control of the company.

The purpose of creating a unified Estate and Succession Plan, including a Shareholder Agreement (or Operating Agreement or Partnership Agreement, as the case may be), is to avoid as many of these issues as possible on the front end. Doing so is both good for the family and good for the business. By and large the most important issue for the continued success of the Family Business comes down to who controls the company. Therefore, it is often advisable for the Founder to recapitalize the Family Business into voting and non-voting units. This helps to facilitate the goal of the children having “equal” inheritances in terms of value, while ensuring the Family Business will continue to operate and prosper by allowing control of the company to be separated from the right to income generated by it.

The Shareholder’s Agreement is important because it creates the rulebook for governing the company and will be the foundation moving forward. Dividing control of the Family Business will depend on a variety of factors including the nature of the business, and the experience, age, education, and responsibility of the family members. There are many different ways to define control. On one end of the spectrum, one child will have total control of the Family Business (i.e. control of day-to-day business operations, and the right to do anything with the business that they please). This model works as a continuation of the one created by the Founder. However, the success of the company will depend solely on that one child, and this situation is very likely to create disharmony and friction among the family members. When voting power is shared among family members there can be many different arrangements.

Toward the middle of the spectrum, one child may have a majority of voting power, and thus that child will have control of day-to-day business operations. Other issues may be left to a majority vote, which that child would solely determine, giving them an additional level of control but not total control. And, certain “Issues of Major Importance” will require a “super majority” vote, so that at least one other child joins and agrees with the majority holder.

At the other end of the spectrum, one child may be given 50% or less voting power, and have control of day-to-day business operations as president or director, but other items will be put to a majority or super majority vote, depending on the particular issue.

There can be many Issues of Major Importance, depending on the nature of the business and how the voting control is divided, but often the issues that will be put to a majority or super majority vote include the following:

  • Sale or disposition of substantially all of the company’s property, or of any property in excess of a certain value;
  • Entering into a lease;
  • Creating, modifying , or terminating any agreement affecting compensation of an officer or manager of the company;
  • Incurring or refinancing debt;
  • Mergers and joint ventures;
  • Amendments to the Operating Agreement;
  • Filing bankruptcy;
  • Dissolution or Liquidation of the company;
  • Issuing additional units in the company;
  • Hiring of family members;
  • Changing the nature of the business;
  • Purchasing property in excess of a certain amount; and
  • Making distributions or payments to owners or employees of the company in excess of a certain amount, or percentage of book value.

Other issues that the Shareholders Agreement addresses include what events trigger rights to a put or call on voting and/or non-voting units. These can include:

  • The permanent mental disability of a shareholder;
  • The death of a shareholder (the terms can vary depending on whether life insurance was purchased to facilitate a buyout or not;
  • Divorce or separation of a shareholder;
  • Retirement of a shareholder;
  • Involuntary transfers of units; and
  • Transfers of units in breach of the Agreement.

Additionally, the Shareholders Agreement may contain provisions known as “Drag Along / Come Along” rights. The former allows the majority holder to force the minority holder(s) to agree to a sale even if they do not wish to sell. While the latter allows a minority holder who does want to sell to benefit from the same terms that the majority holder has agreed to, even if the buyer is otherwise uninterested in purchasing the minority interest.

The Shareholders Agreement is important due to the wide variety of issues it addresses and because it has the ability to act as a referee among the family members. Thus, no one family member has to “be the bad cop;” the rules are simply the rules and the whole family must follow and respect them. In addition to creating the Shareholders Agreement, it is often advisable for the Founder of the business to begin transitioning control and/or decision making authority away from themselves while they are still alive. This method will allow the people succeeding to control of the company to have a safety net, as well as to allow suppliers, contractors, employees, and clients to get to know the new players in the game. The ultimate goal is for a seamless transition of the Family Business upon the death of the Founder and for its continued success thereafter.