Transcript IFRS Diagnostic Workshop

The Role of Life Insurance in
Business Succession Planning
Chicago Estate Planning Council
December 16, 2010
Charles L. Ratner, JD, CLU, ChFC
National Director of Personal Insurance Counseling
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& Young LLP to be used, and cannot be used, by any taxpayer for the purpose of
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The Role of Life Insurance in Business Succession Planning
Topics
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Setting the stage
The threshold inquiries
Techniques for paying large premiums
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The Role of Life Insurance in Business Succession Planning
The importance of setting the stage
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It’s easier to read in unison if you’re on the same page.
The sooner the threshold inquiries are addressed, the
more resourceful the agent can be in the marketplace and
the quicker the client can get the insurance in place.
And, the easier it will be for the advisors to work through
the legal and tax issues associated with the premium
paying strategies the client might consider.
If everyone pushes off the structural issues until
underwriting is done, the client will be under exquisite
pressure to understand some very complicated stuff and
then make big and perhaps irrevocable decisions.
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The Role of Life Insurance in Business Succession Planning
The threshold inquiries
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How much is the client willing to spend on life insurance?
Why is the client buying the insurance?
Who will be the insured?
Who will be the policy owner and beneficiary?
Who will pay the premiums and under what type of
arrangement?
All things considered, what are the most desirable policy
characteristics in the given situation?
How much is the client willing to spend, redux?
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The Role of Life Insurance in Business Succession Planning
How much is the client willing to spend?
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Garçon, the reality check, s’il vous plait!
Sooner or later, it’s going to be about the money, not the
principle of the thing.
So, agent should commence informal underwriting as
soon as possible and then, based upon the preliminary
findings, show the client the “ballpark” cost
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Perhaps per $1 million of coverage
Perhaps under various product types and funding approaches
Better for all concerned to know up-front what the
insurance will (likely) cost so client and planning team can
work with realistic assumptions for the overall economic
and tax cost of the insurance.
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The Role of Life Insurance in Business Succession Planning
Why is the client buying the insurance?
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Financial security for surviving spouse and other
dependents
Liquidity for estate taxes
Equalization among business and non-business children
Default estate plan
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The Role of Life Insurance in Business Succession Planning
Financial security
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See that knee-jerk prescription? Don’t fill it!
Too often, when availability of the marital deduction will
defer taxes to the second death, the tendency is to opt for
survivorship life because it looks “cheaper” than coverage
on one of the spouses.
Just because the client has a successful business and a
large taxable estate doesn’t mean that surviving spouse
will have adequate funds independent of the business.
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Run the numbers! Then get any needed coverage in place,
promptly
If possible, coordinate this coverage with coverage to be used for
other purposes, e.g., estate tax liquidity.
The Role of Life Insurance in Business Succession Planning
Estate tax liquidity
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To begin to determine how much insurance the client
needs (or wants) and for how long he or she will need it,
consider:
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The current estate tax liability and liquidity need plus any current
shortfall in non-tax capital needs
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Be sure to identify all needs for capital and liquidity at each spouse’s
death!
The projected needs under the current plan vs. the ultimate needs
after whatever planning the client is willing to do (if the client even
needs to do any), and
The optimum timing for the liquidity, i.e., how much liquidity at the
business owner’s death vs. at the death of the second of the owner
and surviving spouse to die.
The Role of Life Insurance in Business Succession Planning
Estate tax liquidity (cont.)
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Explore the use of coverage on the business owner so
that a child in the business or the owner’s irrevocable life
insurance trust (ILIT) can buy the stock at the business
owner’s death and remove the growth of the business
(above the growth on the cash proceeds) from the
surviving spouse’s estate.
This approach can offer additional benefits, such as
providing security for the surviving spouse independent of
the business and accelerating equalization between
business and non-business children.
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The Role of Life Insurance in Business Succession Planning
Equalization for non-business child
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This can be a vexing issue that can lead to a series of
difficult discussions that can lead to months, if not years,
of effort to try to figure out how to strike the right balance
between the best interests of the business and
harmonious relationships within the family.
Consider the benefits and elegant simplicity of using life
insurance as either the means for equalizing or the means
for preserving certain assets for equalizing, e.g., providing
liquidity to preserve deferral of a stretch IRA.
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The Role of Life Insurance in Business Succession Planning
Default estate plan-version 1
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Client understands the impact of estate and income taxes,
but is far more concerned about long life at lower yields
than estate taxes the children might pay.
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“Hey, you read the papers and watch the news. With all that’s
going on out there, would you give away your money?”
Therefore, client will not rearrange affairs or part with
assets to reduce his or her taxable estate.
However, will part with some income for life insurance to
assure inheritance or at least enough liquidity to avert a
crisis.
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The Role of Life Insurance in Business Succession Planning
Default estate plan-version 2
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Second verse same as the first, except…
What stops the client from planning is either
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Sheer complexity of the strategies/vehicles proposed by the
advisors, or
Lack of (anything close to) assurances that the strategies will work
Advisors comments seem so…circular.
Knows insurance will work and is actually (though not
actuarially) simple and easy to set up
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The Role of Life Insurance in Business Succession Planning
Who will be the policy owner and
beneficiary?
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In an estate planning context, the default
owner/beneficiary is an ILIT or other entity to keep the
proceeds out of the estate. But an ILIT may be contraindicated if the client, even a wealthy client, wants
absolute control over the policy.
Owner/beneficiary might be child(ren) in the business or
a trust for their benefit so they can buy the stock from
surviving spouse at owner’s death.
Once we know the ownership and beneficiary designation,
we have a start at understanding:
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The economic and tax implications of paying premiums
Implications of the tax economics on product selection and design
The Role of Life Insurance in Business Succession Planning
Who will pay the premiums and under what
type of arrangement?
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What are the client’s expectations and constraints,
economic and otherwise?
What are the economic and tax implications associated
with the premium paying arrangement?
What has to go right for the arrangement to meet the
client’s expectations? What can go wrong?
What would be the desired role of the product in
contributing to success and mitigating downside of the
premium paying arrangement?
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The Role of Life Insurance in Business Succession Planning
What are the right policy characteristics?
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At first blush and all things considered, what are the most
desirable policy characteristics in the given situation?
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Premium flexibility
Guarantees
Control over the investment of the cash value
Cash value accumulation/distribution
The Role of Life Insurance in Business Succession Planning
Overview of techniques for paying premiums
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The simple plan
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Gifts, GRATs and sales to the ILIT
Split-dollar plans
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Endorsement between company and ILIT
Non-equity collateral assignment between company and ILIT
Non-equity collateral assignment between insured and ILIT
Collateral assignment between company and ILIT
Collateral assignment between insured and ILIT
The Role of Life Insurance in Business Succession Planning
The simple plan
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Client establishes the ILIT
Defective trust
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Outright gifts of the premium to the ILIT
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Discuss selection of grantor trust powers
Annual exclusions and/or exemption
Gifts can be from personal funds or Section 162 bonus
plan from client’s company
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The Role of Life Insurance in Business Succession Planning
The simple plan (cont.)
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Client makes substantial tax-free gifts of incomeproducing property to ILIT
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Client establishes a GRAT
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Discountable if possible
Funds GRAT with income-producing property
Names ILIT as remainderman
Advisors assist in identifying property, choice of entity for
transfer, GRAT design, etc.
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The Role of Life Insurance in Business Succession Planning
Selecting the policy for the simple plan
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Consider a term policy until ILIT is funded
Key characteristics of the cash value policy
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Level or increasing death benefit?
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How much flexibility to change premium?
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Can minimize premiums in the early years
Accelerate funding of policy after funding ILIT
Potentially reshape the policy to adapt to changing circumstances
How important are guarantees in this strategy?
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Plenty! Underpinning of strategy is to get the coverage in force at low
premium and let ILIT eventually take over once funded
Flexible premium product funded on current assumptions
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Depends on extent of wealth transfer, etc.
Not important and potentially counter-productive in this strategy
The Role of Life Insurance in Business Succession Planning
Split-dollar life insurance plans
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How a plan established after September 17, 2003 is taxed
generally depends on which party “owns” the policy.
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If the employer owns the policy, then the economic benefit regime
(Section 61) applies.
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If the employee (or a trust) owns the policy, then the loan regime
(Section 7872) applies.
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Collateral assignment
There are exceptions for plans in which the employee or trust
owns the policy but has only the death benefit and no access to
cash value.
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Traditional endorsement
Non-equity collateral assignment
The Role of Life Insurance in Business Succession Planning
Endorsement split-dollar
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Company is owner, beneficiary and premium payer.
Insured designates beneficiary for portion of death benefit.
Insured has imputed income for the economic benefit of
the insurance protection, less any contribution.
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Insured may transfer endorsement rights to ILIT.
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Presumably use Table 2001 until further notice, though one-year
term rates may be appropriate per Rev. Rul. 2003-105
Any imputed income is also a gift to the ILIT
Endorsement plans are still sound but…
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Not where plan will remain in place as long as insured lives
Income and gift tax implications of an increasing economic benefit
make endorsement plan impractical
The Role of Life Insurance in Business Succession Planning
Non-equity collateral assignment
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Designed as an economic benefit arrangement
Used where tax economics of the economic benefit
regime will be better than the loan regime at the outset
Can be particularly attractive with a survivorship policy
Like any economic benefit split-dollar arrangement, there
is a need to plan ahead!
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The Role of Life Insurance in Business Succession Planning
Non-equity collateral assignment (cont.)
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ILIT owns policy
Company advances premiums
Company entitled to all cash value
Company is secured by “bare-bones” collateral
assignment
Employee reports imputed economic benefit
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Table 2001 or insurer’s one-year term cost
The Role of Life Insurance in Business Succession Planning
Non-equity collateral assignment (cont.)
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At earlier of when policy is on cusp of equity or economic
benefit will exceed interest cost, change to loan regime
Initial loan will be for aggregate premiums advanced
Subsequent premium payments will be loans
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Discussed infra
Unless insured will die in the split-dollar saddle, as it were
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Need exit strategy because ILIT has no equity
Must fund ILIT, so consider current or deferred gifts and sales
The Role of Life Insurance in Business Succession Planning
Private non-equity collateral assignment
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Similar to the corporate version, but the insured (or
insured and spouse) are the collateral assignees
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Or the insured’s trust is assignee
Need to consider virtually all of the same factors in the
design of the plan, the policy and the exit strategy as
discussed in compensatory version
In PLRs 200825011 and 200910002, the IRS considered
proposed private non-equity collateral assignment
arrangements.
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Economic benefit regime will govern
No incidents of ownership
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The Role of Life Insurance in Business Succession Planning
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Collateral assignment split-dollar
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Loan regime governs
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Company is lending the premiums to the policyholder
No economic benefit determined by term costs
No taxation of equity
Each premium is a new loan, governed by terms and rate(s) at
time of loan
If loan does not provide for sufficient interest, Section 7872 belowmarket loan rules apply
The Role of Life Insurance in Business Succession Planning
Collateral assignment split-dollar (cont.)
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Key planning issues
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What type of loan, i.e., demand, term or term as demand?
Charge AFR or impute interest?
Pay charged interest currently or accrue it until roll out?
Should loan be secured?
What’s the exit strategy?
What’s the right policy?
The Role of Life Insurance in Business Succession Planning
Collateral assignment split-dollar (cont.)
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Demand loan at AFR
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Interest paid or accrued at or above blended rate
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Blended rate for 2010-2011 is 0.59%
Short-term rate currently attractive
But unpredictable long-term cost
By the way…the company can “call” the loan
Below-market demand loan
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Interest imputed annually at blended rate
Same disadvantages as to unpredictability
The Role of Life Insurance in Business Succession Planning
Collateral assignment split-dollar (cont.)
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Term loan at AFR
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Pay or accrue interest at AFR for the given term
Term can be for X years or at death
Can fix the interest rate upfront so no volatility
If interest is accrued, can repay at death
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But, will need an increasing death benefit or return of premium option
to keep the ILIT whole
Will increase the cost of the policy significantly
Will increase dependence on policy performance
The Role of Life Insurance in Business Succession Planning
Collateral assignment split-dollar (cont.)
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Below-market term loan
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Can fix the interest rate upfront at time of loan
If interest is accrued, can repay at death
Entire benefit to be received over the term of the loan is
accelerated to the first year for income and gift tax purposes
Benefit is the difference between the amount of the loan and the
present value of that amount discounted back for the term at the
applicable rate
The Role of Life Insurance in Business Succession Planning
Collateral assignment split-dollar (cont.)
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What’s the exit strategy?
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Will loan be repaid during insured’s lifetime or will plan and insured
be rolled out at same time?
If planning on a lifetime roll out, need an exit strategy even more
than with “old” split-dollar
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Used to be able to predict the economic and tax cost of a plan. Not
anymore!
Imperative to mitigate the risk of rising rates and lessen dependence
on policy performance by funding the ILIT
The Role of Life Insurance in Business Succession Planning
Collateral assignment split-dollar (cont.)
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The policy
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Does insured want ILIT to have a level death benefit net of the
loan?
Will interest be paid, accrued or imputed? If accrued, will policy
generate enough death benefit to handle the loan?
Assuming plan will be terminated during lifetime, what’s the exit
strategy?
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Flexible premium product funded on current assumptions
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Will policy finance its own roll out from cash value, fund the ILIT so
policy can be left intact or maybe some of both?
Gives flexibility to adjust premiums to achieve targeted objective or to
adapt to changing circumstances
The Role of Life Insurance in Business Succession Planning
Private premium financing
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Arrangement between insured/donor and ILIT
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Insured lends funds to ILIT for premiums
Loan can be demand or term
Loan can be at AFR or below-market per Section 7872
Note included in insured’s estate
The Role of Life Insurance in Business Succession Planning
Private premium financing (cont.)
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Key design issues
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Type of loan?
Should insured lend annually or make a one-time loan?
Pay interest currently or accrue it?
Should the insured be the lender?
Should the loan be secured?
What is the right type of policy and how should it be designed?
What’s the exit strategy (other than death)?
The Role of Life Insurance in Business Succession Planning
Private premium financing (cont.)
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Should insured lend annually or make a one-time loan?
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Annual loans
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Substantial one-time loan
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Ties up less capital, but
ILIT can’t fund policy quickly
Lock in rate that ILIT can pay currently or accrue for repayment with
principal at death
Still have to be careful about MEC issues
If client is older, consider using proceeds of loan to buy SPIA to
generate cash for premiums
The Role of Life Insurance in Business Succession Planning
Private premium financing (cont.)
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Will the ILIT pay interest or let it accrue for eventual
repayment with loan principal?
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Pay or impute interest?
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Pay interest currently or accrue it?
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Gift tax considerations may govern and require payment or accrual of
interest to avoid Section 7872
Cash flow considerations
If accrued, loan could outperform policy, leaving too little death benefit
The Role of Life Insurance in Business Succession Planning
Private premium financing (cont.)
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The policy
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Many of same suitability and design issues as collateral
assignment split-dollar
Flexible premium product funded on current assumptions
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Can minimize loans in the early years, which correspondingly reduces
gift tax cost of interest on loans
Higher cash values can facilitate roll out without gifts
Accelerate funding of policy after funding ILIT
Flexibility to reshape the policy to adapt to changing circumstances
Exit strategy?
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Lifetime roll out from cash values, ILIT funding or both?
The Role of Life Insurance in Business Succession Planning
Private premium financing (cont.)
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Exit strategy
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Need a game plan for repaying the loan before the tax economics
of the interest costs turn the strategy upside down
Over-fund the policy?
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Fund the ILIT
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Expensive and increases dependence on policy performance
Gifts
GRATs
Sales
The Role of Life Insurance in Business Succession Planning