The Role of Life Insurance in Business Succession Planning Julius H. Giarmarco, Esq. Family Facts Father: John (age 65) Mother: Mary (age 65) Son: Lawrence (age 35) Daughter: Jennifer (age 30) Ø Lawrence is only child active in the family business Ø Lawrence has 3 children and Jennifer has 2 children. John & Mary’s Balance Sheet Value Residence (Joint) $1,000,000 Vacation Home (Joint) $750,000 1 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. Cost basis of $500,000; Assume 10% dividend and 4% principal appreciation. John & Mary’s Objectives 1. Retain control of the S corporation until retirement. 2. Pass the entire business to Lawrence at John’s 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. Projected Estate Tax Liability in 2028 No federal Current Net Estate $20,736,000 estate taxes and Existing Life Insurance -0- expenses at first Total Estate $20,736,000 death By-Pass Trust and Estate of Other Transfers Surviving Spouse $3,500,000 $17,236,000 After Tax Estate Federal Taxes $11,054,800 $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%. 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 Section 303 Redemption During John’s Lifetime Insurance Company Pays Premiums S Corp Obtains Life Insurance • If stock interest is John more than 35% of adjusted gross Insured estate, the estate will qualify for a partial redemption. Section 303 Redemption Upon John’s Death Insurance Company Pays Death Benefits S Corp Cash • Partial redemption is John not treated as a dividend. Stock Passes Some Stock • Family continues to retain an ownership John’s interest. Living Trust Advanced Techniques to Transfer Business to Lawrence During John’s 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 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 Bullet Proofing the Private Annuity Sale Ø John should consider funding an ILIT (for the benefit of Mary) to “replace” the annuity payments in the event of his premature death. Ø Lawrence should consider purchasing life insurance to provide the funds necessary to continue the annuity payments should be predecease his father. 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 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 $5,000,000 Total Interest to be Paid $7,238,646 $8,133,577 Total Capital Gain $7,119,628 $4,500,000 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. GRAT Trust Established John Transfers GRAT S Stock (can be Pays Gift Tax arranged with no gift tax) IRS GRAT During GRAT Term John (pays taxes on Pays GRAT trust income) Annuity IF JOHN DIES BEFORE END OF TRUST TERM GRAT (portion of property John’s Estate subject to estate taxes) GRAT At End of GRAT Term If John lives to end of GRAT trust term, property in GRAT is not subject to estate taxes. Remainder Paid to Lawrence 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 Year Principal Growth Annual Income Payment Remainder 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 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. Installment Sale to a John Grantor Trust Grantor / Dynasty Trust John gifts 10% of S Corp stock • John retains control (10% x $5,000,000 = $500,000 • $500,000 FMV as 10% voting less 40% discount = $300,000) shareholder • John receives John sells 80% of S Corp stock $170,000 annually • $4,000,000 FMV (from interest (80% x $5,000,000 = $4,000,000 payment and $50,000 less 40% discount = $2,400,000) of dividends on the • Trust earns 10% on 10% voting shares) Trust pays interest only for 20 years of $120,000 annually $4,500,000 = • John pays income $450,000/ year taxes of $210,000 ($2,400,000 x 5%) ($500,000 x 42%) - for • Trust can use the annual “short fall” of excess cash flow of $40,000 ($210,000 – Trust’s Cash Flow $320,000/year to $170,000) $450,000 purchase life • Paying IDIT’s income ($120,000) insurance on taxes is equivalent of $330,000 John’s life or John tax-free gift and Mary’s joint life. Charitable Stock Bail Out 1. John transfers his voting shares to Lawrence John 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 Charitable Mary’s lives. Remainder Unitrust 3. Stock is transferred from the trust to the S corp in exchange for S Corp cash. 4. Life insurance can be purchased to “replace” the wealth passing to the CRT. “Wait and See” Buy-Sell Agreement During Lifetime Insurance Company Business Pays Pays Premiums Agreement Premiums John Lawrence Each Shareholder Obtains Life Insurance On The Other “Wait and See” Buy-Sell Agreement Upon John’s Death Insurance Company Pays Death Benefits S Corp Option to Must Purchase Purchase John Lawrence 1st 3rd Stock Passes Option to 2nd Purchase John’s Living Trust Why Use Life Insurance to Fund Buy-Sell Agreement? Ø Creates a lump sum of cash when needed. Ø Results in a quick settlement of the buy- sell transaction. Ø Generally, an income tax free death benefit. Ø Income tax free access to cash values for a lifetime buy-out. Key Employees Ø Company can purchase life insurance on the lives of its key employees to guard against financial loss. Ø Company can provide key employees with an executive bonus. Ø Company can implement a non-qualified deferred compensation plan to attract and retain key employees. Ø Company can assist key employees in purchasing life insurance through a split-dollar plan. Executive Bonus Insurance Company Company 2 1 3 Key Employee 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 Compensation Plan 2 Insurance Company Company 3 1 4 Key Employee 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 Benefits are paid based on contractual specifications. Split Dollar Plan 1 Key Company 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. 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. Split Dollar Plan 1 Key Company Employee 3 4 2 Insurance 5 Company 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. 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 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. 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 ILIT fbo Company Jennifer 3. Pays death benefit upon death of John & Mary – income and estate tax free! John & Mary’s Estate 6. Pays Debts and Taxes. IRS 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. 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. “When I go, I plan on taking at least two of my estate-tax lawyers with me.” The End. Thank You! The Role of Life Insurance in Business Succession Planning Julius H. Giarmarco, Esq.