Business Planning – Managing Value through Life Insurance

Overview

Business Planning – Case Studies

• Life Insurance Funded Buy-Out
• Family Equalization with Life Insurance

Planning the Business Succession

• Advisor Team
• Information Needed
• Product Guidance

Maintaining the Plan

Take-Aways

• Business Planning Information/Intake Checklist
• Sample Client Audit/Review Letter

Insurance Funded Buy-Out

Facts

• $100 million S corporation (“S Co.”)
• Owned equally by 3 founders: X, Y and Z
• No current plans to sell S Co.

Objectives

• Facilitate shareholder buy-out at death/disability
  • Money/liquidity is always an issue
• Avoid conflicts in buy-out funding
  • Upfront cash vs. deferred, longer term-payments from notes
• Implement valuation plan to value shares
  • Discounts for minority interests, premiums for control?
• Provide funding for premium payments
  • Parity among shareholders whose ages/health may vary
• Minimize estate tax impact of life insurance proceeds on value of business and shareholders’ estates
  • Corporate owned – estate inclusion at corporate value level

The Plan

• Separate ILITs
  • X, Y, & Z each execute irrevocable life insurance trusts (ILITs)
    – Other shareholders must review/approve ILIT form
  • ILIT terms require trustee to:
    – Use life insurance proceeds (up to policy’s face) to buy deceased shareholder’s shares
    -Distribute purchased shares to remaining shareholders
    -Distribute remaining proceeds to designated ILIT beneficiaries
• Life Insurance
  • Each ILIT buys a $33 million policy on its shareholder
• Shareholder’s Agreement (SA)
  • Allows sale of deceased shareholder’s shares to his ILIT
  • Allows distribution of shares from ILIT to remaining shareholders
  • Requires S Co. or other shareholders to buy any remaining shares of deceased shareholder
    – Takes effect only after ILIT uses all proceeds to buy shares
    – S. Co./shareholder may fund their purchases with cash, guaranteed promissory notes, based on SA
• Valuation Set by SA
  • Critical to set value for shares
    – Determines liquidity/funding needs
  • SA provides that fair market value:
    – Is determined by independent expert chosen from agreed-to list of appraisers
    – Does not reflect minority discounts / control premiums

The Plan – Why?

• Estate Tax Benefits
  • Keeps policy proceeds/cash values out of S Co. and owners’ estates
  • Fixes estate tax value of shares
  • Solves shareholders’ estate liquidity concerns
• Income Tax Benefits
  • Shares purchased by ILIT and distributed to other shareholders receive new tax basis equal to purchase price
  • Basis increase = capital gains tax savings at later sale of shares
• Conflict Avoidance
  • “Automatic” buy-out implementation – policy proceeds pass to ILIT, not other shareholders, so no need to wait on individual actions
  • Pre-set valuation method for shares avoids value disagreements

Funding

• Establish 162 bonus plan for each shareholder
• Funds insurance purchase
• Credit for compensation paid

Disability Plan

• Insurance: Each shareholder buys personal disability insurance
  • Serves financial planning purposes
• Redemption: S Co. redeems 20% of shareholder’s shares upon disability
  • Converts balance to non-voting shares with limited veto powers

Family Equalization with Insurance

Facts

• Father is owner of S corporation
• Has four children
  • Three actively employed by business
  • One daughter is not (passive)
• Father will not allow a current change of control or reduction in his profit allocation
  • Limited lifetime estate/succession planning options
• Wants to treat all children equally

Objectives

• Liquidity
  • Estate tax exposure based on father’s retention of business
  • Buy-out funding for passive daughter
• Buy-out Planning for Next Generation
  • Children/owners work out decision-making process while dad is alive
  • Obtain life insurance funding for anticipated business successionwhile they are young and healthy
• Flexibility in Exit Strategy
  • Father may consider sale of business to third party
  • Buy-out/funding arrangement must adapt to change in exit plan

Proposal

• Use term product to fund buy-sell if father proposes to sell business in short-term
• Consider mix with a permanent product if plan is to have a legacy based component
• While going through underwriting/examinations, look at survivorship coverage for estate plan and disability insurance
• Ensure all term coverage is convertible to preserve insurability and provide flexibility if exit strategy changes
• Insurance to buy-out daughter/father should be guaranteed to avoid later conflict/litigation

Form Advisory Team

Get Advisors in Place Early

• Successful plan requires multi-prong, coordinated approach
  • Producer – insurance planning/coverage needs
  • Attorney – structure implementation/documentation
  • Accountant – tax treatment and reporting
  • Other – financial advisors, appraisers, etc. depending on goals

Get Information

Business Structure & Ownership

• Entity – Type, Location, Organizational Documents
  • C corp., S corp., partnership/LLC – can affect tax issues
  • Domicile – state tax impact
  • Governing documents – By-laws, partnership/operating agreements
• Owners – Number and Percentage Ownership (e.g., cap table)
  • Multiple, equal owners – more coverage and cooperation to create succession structure
  • Single, majority owner – more flexibility, but consider minority rights, need for equalizing distributions, etc.
• Business – Type
  • Service or product oriented
  • Key employees
  • Corporate, regulatory and/or security requirements – government contractor? Franchise holder?

Goals

• Business Financial
  • Maximum income now, reinvest for growth, or make attractive for sale?
• Anticipated Successors
  • Transfer to other owners
  • Transfer to family members or key employees
  • Sale to third party
• Personal
  • Financial – retirement, what family needs/wants now
  • Estate – what and how much to provide to family later
• Timeframe
  • Expected time for exit – during life or at death in months, years?

Existing Arrangements

• Current Coverage in Place
  • Policy information
    – Type, face amount, cash value, premiums, loans
    – Insured, owner, beneficiary
    – Intended purpose: buy-out funding, keyman, split-dollar, etc.
  • Policy performance review/audit
• Related agreements/arrangements
  • Existing shareholders, buy-sell and/or trust agreements
  • Split dollar, 409A, etc. and prior tax reporting under arrangements
• Employer-Owned Life Insurance (EOLI – IRC §101(j))
  • Notice and consent documents – critical, as limited options to correct if proper notice and consent not provided and obtained
  • Prior reporting of EOLI policies by business

  Suggested Product Options for Business

  • Convertible level term for younger owner/key person
  • Permanent, survivorship coverage for family (allocate more here for investment component)
  • Growing face value for appreciating businesses
  • Return of premium riders to address split-dollar issues

  Guidance on Existing Coverage

  • 1035 exchange
  • Surrender
  • Keep
  • Reduce face amount

  Maintaining the Succession Plan

  Provide On-Going Support

  Post-closing support is critical to succession planning:

  • Plan and coverage must adapt to changes in:
    • Business value and ownership (owner departure/entry)
    • Owner’s age and health status/condition (e.g., quit smoking, illness)
    • Tax laws
  • Need continual monitoring to maintain and meet objectives:
    • Monitoring cost of insurance for split-dollar plans
    • Tracking term conversion rights
    • Reviewing and providing updates on policy performance (e.g., is cash value product performing to meet deferred comp objectives?)
    • Provide reminders of reporting requirements to attorneys/CPAs
    • Apprise of carrier changes (crediting rates, pricing, risk classifications)
  • Coordinate with other advisors to remain updated on technical and business developments
  • Consider a “tickle” system for annual review of plans/products