the role of life insurance in business succession planning julius h. giarmarco, esq
TRANSCRIPT
The Role of Life Insurance in Business Succession
Planning
Julius H. Giarmarco, Esq.Julius H. Giarmarco, Esq.
Family FactsFamily Facts
Father:Father: John (age 65)John (age 65)
Mother:Mother: Mary (age 65)Mary (age 65)
Son:Son: Lawrence (age 35)Lawrence (age 35)
Daughter:Daughter: Jennifer (age 30)Jennifer (age 30)
Ø Lawrence is only child active in the family Lawrence is only child active in the family businessbusiness
Ø Lawrence has 3 children and Jennifer has 2 Lawrence has 3 children and Jennifer has 2 children.children.
John & Mary’s Balance SheetJohn & Mary’s Balance Sheet
ValueValueResidence (Joint)Residence (Joint) $1,000,000$1,000,000Vacation Home (Joint)Vacation Home (Joint) $750,000$750,000Business (S corp) (John)Business (S corp) (John) $5,000,000$5,000,000Building (LLC) (John)Building (LLC) (John) $2,000,000$2,000,000Non-Qualified Investments (Joint)Non-Qualified Investments (Joint) $500,000$500,000IRAs (John)IRAs (John) $750,000$750,000Life Insurance (John)Life Insurance (John) - 0 -- 0 -Gross EstateGross Estate $10,000,000$10,000,000
1
1. Cost basis of $500,000; Assume 10% dividend and 4% principal appreciation.
John & Mary’s ObjectivesJohn & Mary’s Objectives
1.1. Retain control of the S corporation until Retain control of the S corporation until retirement.retirement.
2.2. Pass the entire business to Lawrence at Pass the entire business to Lawrence at John’s death.John’s death.
3.3. Retain one or two key-employees to Retain one or two key-employees to assist in the transition periodassist in the transition period
4.4. Treat children fairly.Treat children fairly.5.5. Guarantee retirement income.Guarantee retirement income.6.6. Reduce or eliminate estate taxes.Reduce or eliminate estate taxes.
Projected Estate Tax Liability in 2028Projected Estate Tax Liability in 2028Current Net Estate $20,736,000Existing Life Insurance - 0 -Total Estate $20,736,000
By-Pass Trust andOther Transfers
$3,500,000
After Tax Estate$11,054,800
Estate ofSurviving Spouse
$17,236,000
Federal Taxes$6,181,200
29.8%
Distribution to HeirsAfter Tax Estate $11,054,800By-Pass Trust and Other Transfers 3,500,000Total $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%.
No federal estate taxes and expenses at first
death
Options to Pay the Estate Tax if Options to Pay the Estate Tax if John & Mary Do NothingJohn & Mary Do Nothing
1.1. Good -Good - IRC Section 6166 (5 IRC Section 6166 (5 year deferral; 10 year installment year deferral; 10 year installment payment of estate tax)payment of estate tax)
2.2. Better -Better - IRC Section 303 IRC Section 303 (redemption of stock to pay death (redemption of stock to pay death taxes)taxes)
3.3. Best - Best - Irrevocable Life Irrevocable Life Insurance TrustInsurance Trust Discounted dollarsDiscounted dollars Can purchase assets from estateCan purchase assets from estate Can loan monies to estateCan loan monies to estate
Section 303 Redemption Section 303 Redemption During John’s LifetimeDuring John’s Lifetime
S Corp
John
Insurance Company
• If stock interest is more than 35% of adjusted gross estate, the estate will qualify for a partial redemption.
Obtains Life Insurance
Insured
Pays Premiums
Section 303 Redemption Section 303 Redemption Upon John’s DeathUpon John’s Death
S Corp
John
Insurance Company
• Partial redemption is not treated as a dividend.
• Family continues to retain an ownership interest.
Stock Passes
Pays Death Benefits
John’s Living Trust
Some Stock
Cash
Advanced Techniques to Transfer Advanced Techniques to Transfer Business to Lawrence Business to Lawrence During John’s LifetimeDuring John’s Lifetime
1.1. Private Annuity SalePrivate Annuity Sale
2.2. Self Canceling Installment Note (“SCIN”)Self Canceling Installment Note (“SCIN”)
3.3. Grantor Retained Annuity TrustGrantor Retained Annuity Trust
4.4. Installment Sale to Grantor TrustInstallment Sale to Grantor Trust
5.5. Charitable Stock Bail OutCharitable Stock Bail Out
Private Annuity SalePrivate Annuity Sale
§§7520 Rate7520 Rate 5%5%FMV of S CorporationFMV of S Corporation $5,000,000$5,000,000John’s BasisJohn’s Basis $500,000$500,000Payment PeriodPayment Period AnnualAnnualInitial Annual PayoutInitial Annual Payout $473,979$473,979Single Life Expectancy (Age 65)Single Life Expectancy (Age 65) 20 Years20 YearsCapital Gain Realized at Time of SaleCapital Gain Realized at Time of Sale $4,500,000$4,500,000
Initial Annuity Payment BreakdownInitial Annuity Payment BreakdownTax-Free PortionTax-Free Portion $256,410$256,410Ordinary Income PortionOrdinary Income Portion $217,568$217,568
Bullet Proofing the Bullet Proofing the Private Annuity SalePrivate Annuity Sale
Ø John should consider funding an ILIT (for John should consider funding an ILIT (for the benefit of Mary) to “replace” the the benefit of Mary) to “replace” the annuity payments in the event of his annuity payments in the event of his premature death.premature death.
Ø Lawrence should consider purchasing Lawrence should consider purchasing life insurance to provide the funds life insurance to provide the funds necessary to continue the annuity necessary to continue the annuity payments should be predecease his payments should be predecease his father.father.
Self Canceling Installment NoteSelf Canceling Installment Note
§§7520 Rate 7520 Rate 5%5%FMV of S CorporationFMV of S Corporation $5,000,000$5,000,000Cost BasisCost Basis $500,000$500,000Initial Down PaymentInitial Down Payment $0$0Term of NoteTerm of Note 19 Years19 YearsType of NoteType of Note Interest OnlyInterest OnlyNo-Risk-Premium Market Interest RateNo-Risk-Premium Market Interest Rate 5%5%Payment PeriodPayment Period AnnualAnnual
Self Canceling Installment NoteSelf Canceling Installment Note
PrincipalPrincipal InterestInterest
Mortality Risk Premium (Principal)Mortality Risk Premium (Principal) $2,619,628$2,619,628 N/AN/A
Total Sale PriceTotal Sale Price $7,619,628$7,619,628 $5,000,000$5,000,000
Principal Amount of NotePrincipal Amount of Note $7,619,628$7,619,628 $5,000,000$5,000,000
Mortality Risk Premium (Interest)Mortality Risk Premium (Interest) N/AN/A 3.5620%3.5620%
Annual Principal PaymentsAnnual Principal Payments $0$0 $0$0
Annual Interest PaymentsAnnual Interest Payments $380,981$380,981 $428,083$428,083
Balloon Payment at the End of NoteBalloon Payment at the End of Note $7,619,628$7,619,628 $5,000,000$5,000,000
Total Interest to be PaidTotal Interest to be Paid $7,238,646$7,238,646 $8,133,577$8,133,577
Total Capital GainTotal Capital Gain $7,119,628$7,119,628 $4,500,000$4,500,000
Risk Premium
Bullet Proofing a SCINBullet Proofing a SCIN
John should consider funding an ILIT (for John should consider funding an ILIT (for the benefit of Mary) to “replace” the note the benefit of Mary) to “replace” the note payments in the event of his premature payments in the event of his premature death.death.
GRATGRATTrust EstablishedTrust Established
John GRATTransfers S Stock
IRS
Pays Gift Tax(can be arranged with no gift tax)
GRATGRATDuring GRAT TermDuring GRAT Term
John(pays taxes on trust income)
GRATPays Annuity
John’s Estate
GRAT(portion of property
subject to estate taxes)
IF JOHN DIES BEFORE END OF TRUST TERM
GRATGRATAt End of GRAT TermAt End of GRAT Term
GRAT
Remainder Paid to
Lawrence
If John lives to end of trust term, property in GRAT is not subject to estate taxes.
Grantor Retained Annuity TrustGrantor Retained Annuity Trust§§7520 Rate 7520 Rate 4.40%4.40%
John’s AgeJohn’s Age 6565
Income Earned by TrustIncome Earned by Trust 10.00%10.00%Annual Growth of PrincipalAnnual Growth of Principal 5.00%5.00%
Term/Number of PaymentsTerm/Number of Payments 1010
Pre-discounted FMVPre-discounted FMV $5,000,000$5,000,000
Discounted FMVDiscounted FMV $3,000,000$3,000,000
Annual Percentage PayoutAnnual Percentage Payout 16.66000%16.66000%
BeginningBeginning 5.00%5.00% 10.00%10.00% AnnualAnnualYearYear PrincipalPrincipal GrowthGrowth Annual IncomeAnnual Income PaymentPayment
RemainderRemainder
11 $5,000,000$5,000,000 $250,000$250,000 $512,500$512,500 $499,800$499,800$5,262,700$5,262,700
55 $6,316,539$6,316,539 $315,826$315,826 $647,445$647,445 $499,800$499,800$6,780,012$6,780,012
1010 $9,456,952$9,456,952 $472,847$472,847 $969.337$969.337 $499,800$499,800$10,399,337$10,399,337
SummarySummary $5,000,000$5,000,000 $3,408,963$3,408,963 $6,988,374$6,988,374 $4,998,000$4,998,000$10,399,337$10,399,337
Bullet Proofing a GRATBullet Proofing a GRAT
John should consider funding an ILIT (for John should consider funding an ILIT (for the benefit of Lawrence) to provide the funds the benefit of Lawrence) to provide the funds needed to pay estate taxes should John die needed to pay estate taxes should John die before the end of the GRAT term.before the end of the GRAT term.
John
• Paying IDIT’s income taxes is equivalent of tax-free gift
• John retains control as 10% voting shareholder
• John receives $170,000 annually (from interest payment and $50,000 of dividends on the 10% voting shares)
• John pays income taxes of $210,000 ($500,000 x 42%) - for annual “short fall” of $40,000 ($210,000 – $170,000)
Grantor / Dynasty Trust
• $500,000 FMV
• $4,000,000 FMV
• Trust earns 10% on $4,500,000 = $450,000/ year
Trust pays interest only for 20 years of $120,000 annually
($2,400,000 x 5%)
John gifts 10% of S Corp stock(10% x $5,000,000 = $500,000 less 40% discount = $300,000)
John sells 80% of S Corp stock(80% x $5,000,000 = $4,000,000
less 40% discount = $2,400,000)
Trust’s Cash Flow$450,000
($120,000)$330,000
Installment Sale to a Installment Sale to a Grantor TrustGrantor Trust
• 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.
Charitable Stock Bail OutCharitable Stock Bail Out
John
Charitable Remainder
Unitrust
S Corp
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.
3. Stock is transferred from the trust to the S corp in exchange for cash.
4. Life insurance can be purchased to “replace” the wealth passing to the CRT.
““Wait and See” Buy-Sell AgreementWait and See” Buy-Sell AgreementDuring LifetimeDuring Lifetime
Business
John
Insurance Company
Lawrence
AgreementPays
PremiumsPays
Premiums
Each Shareholder Obtains Life Insurance On The Other
““Wait and See” Buy-Sell AgreementWait and See” Buy-Sell AgreementUpon John’s DeathUpon John’s Death
S Corp
John
Insurance Company
Stock Passes
Pays Death Benefits
John’s Living Trust
MustPurchase
Lawrence
Option to Purchase
1st
Option to Purchase
2nd
3rd
Why Use Life Insurance to Fund Why Use Life Insurance to Fund Buy-Sell Agreement?Buy-Sell Agreement?
Ø Creates a lump sum of cash when Creates a lump sum of cash when needed.needed.
Ø Results in a quick settlement of the buy-Results in a quick settlement of the buy-sell transaction.sell transaction.
Ø Generally, an income tax free death Generally, an income tax free death benefit.benefit.
Ø Income tax free access to cash values for Income tax free access to cash values for a lifetime buy-out.a lifetime buy-out.
Key EmployeesKey Employees
Ø Company can purchase life insurance on the Company can purchase life insurance on the lives of its key employees to guard against lives of its key employees to guard against financial loss.financial loss.
Ø Company can provide key employees with an Company can provide key employees with an executive bonus.executive bonus.
Ø Company can implement a non-qualified Company can implement a non-qualified deferred compensation plan to attract and retain deferred compensation plan to attract and retain key employees.key employees.
Ø Company can assist key employees in Company can assist key employees in purchasing life insurance through a split-dollar purchasing life insurance through a split-dollar plan.plan.
Executive BonusExecutive Bonus
CompanyInsurance Company
Key Employee
12
3
1 Tax-deductible bonus from employer to key employee.
2 Bonus dollars fund a life insurance policy owned by the key employee. Key employee is taxed on the bonus as ordinary income.
3 Key employee uses the financial asset values to supplement retirement income or provide survivor benefits.
Non-Qualified Deferred Non-Qualified Deferred Compensation PlanCompensation Plan
CompanyInsurance Company
Key Employee
1
2
3
1 Employer promises to provide future retirement benefit.
2 Employer may purchase life insurance to “informally” fund benefits.
3 Asset values help pay benefits and/or recover costs.
4
4 Benefits are paid based on contractual specifications.
Split Dollar PlanSplit Dollar Plan
CompanyKey
Employee
InsuranceCompany
1
3
1 A face amount and premium for a life insurance policy is determined and the employer lends this premium to the employee.
2 The loaned premium is used to pay for the life insurance policy. The employee owns the policy.
3 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.
2
Split Dollar PlanSplit Dollar Plan
CompanyKey
Employee
InsuranceCompany
1
3
4
4 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.
2
5
5 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.
Estate EqualizationEstate Equalization
John and Mary can leave Jennifer their non-John and Mary can leave Jennifer their non-business assets.business assets.
John and Mary can “make up” the difference John and Mary can “make up” the difference by funding a survivorship ILIT for the benefit by funding a survivorship ILIT for the benefit of Jennifer.of Jennifer.
Estate EqualizationEstate EqualizationJohn & Mary
InsuranceCompany
John & Mary’s Estate
IRS
ILIT fbo Jennifer
1. John & Mary create an irrevocable trust, and make gifts of life insurance premiums to the trust.
2. Pays Insurance Premium.
3. Pays death benefit upon death of John & Mary – income and estate tax free!
4. Transfers Cash.
5. Transfers Assets.
6. Pays Debts and Taxes.
Family BankFamily Bank
StructureStructure::A family LLC or family limited partnership.A family LLC or family limited partnership.
Members/PartnersMembers/Partners::Lawrence and Jennifer.Lawrence and Jennifer.
Capital ContributionsCapital Contributions::Either gifts from John and Mary and/or contributions Either gifts from John and Mary and/or contributions directly from Lawrence and Jennifer.directly from Lawrence and Jennifer.
FLLC’s/FLP’s InvestmentsFLLC’s/FLP’s Investments::A survivorship policy on John and Mary’s lives.A survivorship policy on John and Mary’s lives.
Family BankFamily Bank
Indicated UseIndicated Use::When shares in the Company are transferred (either When shares in the Company are transferred (either during John’s lifetime or death) to both children.during John’s lifetime or death) to both children.
PurposePurpose::To provide funds for Lawrence to “call” Jennifer’s shares, To provide funds for Lawrence to “call” Jennifer’s shares, or for Jennifer to “put” her shares to Lawrence.or for Jennifer to “put” her shares to Lawrence.
“When I go, I plan on taking at least two of my estate-tax lawyers with me.”
The End.The End.Thank You!Thank You!
The Role of Life Insurance in Business Succession
Planning
Julius H. Giarmarco, Esq.Julius H. Giarmarco, Esq.