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The Role of Life Insurance in Business Succession Planning

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  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 & Mary’s 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 & Mary’s Objectives • Retain control of the S corporation until retirement. • Pass the entire business to Lawrence at John’s death. • Retain one or two key-employees to assist in the transition period • Treat children fairly. • Guarantee retirement income. • Reduce or eliminate estate taxes.

  5. Projected Estate Tax Liability in 2028 No federal estate taxes and expenses at first death Current Net Estate $20,736,000 Existing Life Insurance - 0 - Total Estate $20,736,000 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 John’s 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 John’s 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 John’s Living Trust

  9. Advanced Techniques to Transfer Business to Lawrence During John’s Lifetime • Private Annuity Sale • Self Canceling Installment Note (“SCIN”) • Grantor Retained Annuity Trust • Installment Sale to Grantor Trust • Charitable Stock Bail Out

  10. Private Annuity Sale §7520 Rate 5% FMV of S Corporation $5,000,000 John’s 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 PrincipalInterest 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 $5,000,000 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 John’s 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% John’s Age 65 Income Earned by Trust 10.00%Annual 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 YearPrincipalGrowthAnnual IncomePaymentRemainder 1 $5,000,000 $250,000 $512,500 $499,800 $5,262,700 5 $6,316,539 $315,826 $647,445 $499,800 $6,780,012 10 $9,456,952 $472,847 $969.337 $499,800 $10,399,337 Summary $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 (10% x $5,000,000 = $500,000 less 40% discount = $300,000) • $500,000 FMV • 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 John’s life or John and Mary’s joint life. Trust’s Cash Flow $450,000 ($120,000) $330,000 • Paying IDIT’s 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 Mary’s 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 John’s Death Insurance Company Pays Death Benefits S Corp Option to Purchase Must Purchase John Lawrence 1st 3rd Stock Passes Option to Purchase 2nd John’s 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. Tax-deductible bonus from employer to key employee. 1 Bonus dollars fund a life insurance policy owned by the key employee. Key employee is taxed on the bonus as ordinary income. 2 Key employee uses the financial asset values to supplement retirement income or provide survivor benefits. 3 Executive Bonus Company Insurance Company 2 1 3 Key Employee

  27. Employer promises to provide future retirement benefit. 1 Employer may purchase life insurance to “informally” fund benefits. 2 Asset values help pay benefits and/or recover costs. 3 Benefits are paid based on contractual specifications. 4 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 A face amount and premium for a life insurance policy is determined and the employer lends this premium to the employee. 1 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 employer’s 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 & Mary’s 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. FLLC’s/FLP’s Investments: A survivorship policy on John and Mary’s lives.

  33. Family Bank Indicated Use: When shares in the Company are transferred (either during John’s lifetime or death) to both children. Purpose: To provide funds for Lawrence to “call” Jennifer’s shares, or for Jennifer to “put” her shares to Lawrence.

  34. “When I go, I plan on taking at least two of my estate-tax lawyers with me.”

  35. The End. Thank You!

  36. The Role of Life Insurance in Business Succession Planning Julius H. Giarmarco, Esq.