Life Insurance and Trusts for Family Businesses

The Martin Family – Chapter Two

Read Chapter One

Multiple Life Insurance Issues and a Surprise Opportunity

David always followed the same procedures in helping his family business clients:

  1. Assemble complete and accurate facts for the family and the business.
  2. Listen carefully to the short term and long term goals of each key member of the family, seeking clarification when necessary and reconciliation of differing goals, if needed.
  3. Always meet privately with each member of the family working in the family business and, where appropriate, children not working in the business and spouses of all.
  4. Prepare written, detailed suggestions for a lifetime and estate plan identifying steps to be taken using the simplest techniques available to handle each situation. David always asked that this draft plan be carefully reviewed by his clients, especially to make sure the facts were correct; the goals appropriately stated; and, any initial questions on the concepts presented answered.
  5. The important next step was to have the draft plan also reviewed by the client’s attorney, accountant, and insurance advisors as David knew that the best plan would be a team effort as each member of the team has needed expertise.
  6.  Meet with the clients and the key advisors to make sure all agree, not only on the steps to be taken, but also on a time line to get all done with specific assignments and due dates where necessary.
  7.  FOLLOW THROUGH, as many plans and documents just do not get completed. David told his clients that he would be persistent to the point of being rude, if necessary, to get the steps done by the advisors and his clients.
  8. David never wanted to find out that a client died with a plan just sitting on someone’s desk with key documents never executed.

The Martin Family goals were quite similar to those of most wealthy families who own businesses:

  1. Maintain Tom and Mary’s lifestyle for as long as they live.
  2. Allow Tom to control his business entities for as long as he wishes.
  3. Put in place measures which upon Tom’s death allow the continuation of all or part of the businesses, by or for the children, with the flexibility to orderly sell the businesses in stated circumstances.
  4. Treat the children fairly.
  5. Minimize taxes.
  6. Protect assets from creditors and lawsuits.
  7. Provide flexibility in case circumstances change.

The Martin Family had complicated financial and business issues.  In a situation like this it became obvious that the more complicated issues needed to be taken care of one by one. The first issue that needed all the advisors to help with was the life insurance coverage on Tom and Mary’s lives.

In his fact finding process David discovered that between them Tom and Mary had seven life insurance policies with face values totaling $30 million.  Tom owned five of the policies on his life; Mary owned one policy on her life; and, one policy was owned in an irrevocable life insurance trust. Three of the policies were subject to collateral assignments to banks in amounts different than the face value of the policies.  Five of the policies were term policies and two were whole life policies.

The fact that Tom and Mary owned policies on their lives meant that the life insurance proceeds on their deaths would be subject to estate tax, a situation which needed to be corrected.  The collateral assignments posed a problem as did the fact that two of the policies had substantial cash surrender values.

As David thought about what to do (other than ask Tom’s insurance agent for help) he remembered how years before he had often stated to clients that life insurance should be viewed only as a risk management tool covering family cash needs especially in case of the early death of a parent. Inherent in that comment was David’s early career view that life insurance was not a good investment.   Over time, however, insurance companies have improved their life insurance products  including the investment aspects of some  policies and the pricing of policies.  In addition, the tax law, ever complicated, allowed for the estate tax exclusion of life insurance proceeds if careful planning steps were taken.  This generally could not be done with regular “investments”.  A glib way to state it is that a person in a 50% estate tax bracket who takes the correct steps to shield life insurance proceeds from estate tax has a 50% advantage over having a portfolio of securities of an equal dollar amount subject to estate tax.

David and the Martin Family insurance advisor developed the basic concepts of a plan for the insurance.   First, he asked Tom if he could persuade the banks to release the collateral assignments but, if not, ask if they would agree to consolidate all the assignments into one large existing policy which had adequate face value to cover all the security requirements.  Tom was partly successful.  There were two banks involved and neither would permit their assignments to be grouped into the same policy with the other bank, so it was necessary to continue with two encumbered policies, one for the assignments to each bank.   David then suggested that Tom transfer those two policies into a new irrevocable life insurance trust.  One worry was that the assignments might be considered as an incident of ownership and thus cause the policies, even if owned by the trust, to be in Tom’s estate.  David and the advisors knew a defense to that would be that the assignments protected the non- recourse loans of separate business entities and thus Tom did not hold any rights.   However, to be careful, a new trust was decided upon and would be used only for the “assigned” policies so not to possibly taint the other policies if in the same trust. The advisors also knew as soon as the loans were paid off and assignments terminated the incident of ownership issue would disappear.  They also alerted Tom that the gifts of these existing policies would only be effective after three years, another interesting estate tax rule.

Two of these policies were term policies.  The insurance agent’s opinion was that these policies were economically sound and agreed to get the insurance companies to provide the amount of the interpolated terminal reserve (the usual way to value a term policy).  A policy valuation was needed as the transfer to the trust would be a gift to the beneficiaries of the trust, Tom and Mary’s children.   Of course, the trust would have a Crummey Power which is needed to allow the annual premiums, if paid by Tom, to qualify as gifts of a present interest and thus be able to use their annual gift tax exclusions.   It was a surprise to all that one of the policies, a $3 million policy, was stated to have a value of $220,000.  Even the insurance agent was astounded and double checked that opinion with the company’s legal team.  It stood as their opinion so had to be worked with.  This further emphasized that it is crucial to always check the facts as otherwise a serious error could be made.

The plan was to have the other three policies transferred to another new irrevocable life insurance trust.  Here, also, the three year rule would apply.  One of the insurance companies suggested using a form of split dollar insurance to eliminate the three year rule but John and Mary were healthy and the cost of the suggested policy was a lot more expensive so they decided to take the risk of a premature death within the three years.  Tom and Mary used their annual exclusions and a small amount of their lifetime exemptions to  the $30 million of assets from their estates and save up to $15 million in estate taxes.

David made sure that the trusts were drafted; an independent trustee named; the documents executed; and, that the formal steps to transfer the policies were completed.

During the several weeks it took to deal with the life insurance issues Tom called David to say he had an opportunity, again through his bank, to purchase another nursing home complex in Concord, New Hampshire for $5 million.   He asked if David had any suggestions.  By this time two of Tom’s children were working in the business full time and it looked like it would be their careers.   David suggested that Tom form an LLC to make the acquisition and that the ownership of the LLC be predominately held by these two children.  It is always best to eliminate an estate tax problem at the earliest logical time, here at the time of acquisition.  If Tom had been the sole purchaser of the new nursing home  all its value and appreciation until Tom’s death would have gone into his estate.   The LLC documents would give Tom control as the sole “manager” but give the two children almost all the ownership and thus the value of the business David suggested that he balance all this with an appropriate transfer of the ownership of other assets to the child not in the business.

Read Chapter One

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David Hawkes (aka David Reed) is a tax, financial planning, family & small business consulting expert. He has worked with thousands of clients and saved them millions of dollars in taxes over the course of his career. David is also a former minority shareholder of the Boston Red Sox.