Planning for the orderly distribution of a client’s assets, balancing the need for control and income while minimizing taxes to be paid to Uncle Sam are fundamental objectives of any estate plan. If the client is also a business owner, then the estate plan has to be married to a succession plan for the firm; drafting them independently of one another, experts caution, only courts trouble.
“The business is often the largest asset in the client’s estate,” says Daniel Prisciotta, a certified financial planner and managing partner of Equity Strategies Group, a Rochelle Park, N.J.-based firm affiliated with Sagemark Private Wealth Services and Lincoln Financial Advisors. “The success or failure of the business often comes down to how well the two plans are developed, coordinated, and executed. To me, they’re inseparable.”
Uncoordinated planning, sources tell National Underwriter, can produce such unintended consequences as legal battles over the control of a business upon an owner’s death because of the naming of different beneficiaries in succession and estate planning documents; an unfair distribution of assets to heirs; a lack of liquidity to pay off estate taxes; inadequate income for a surviving spouse and children; and, ultimately, a collapse of the business.
Among the most common mistakes is the failure to plan adequately for a spouse and children when an owner dies, leaving them dependent on remaining owners for income from the business’s cash flow. Often, for example, business partners will establish a below fair market price for their company to more easily facilitate the buyout of a surviving spouse’s interest upon the death of one or the other partner. This may be fine for the surviving partners, but not necessarily for the surviving spouse, who may wish to sue to recover the lost value and provide for an adequate income.
The likelihood of a lawsuit increases when the spouse is left out of exit planning discussions, an all-too-common occurrence, says Gregory Anderson a chartered financial consultant and principal of Estate Design Group, Scottsdale, Ariz. “This is potentially malpractice for the insurance agent or attorney who spearheads the plan. You absolutely have to do a formal business appraisal at the time of death or when the buy-sell agreement is triggered.”
Also tailor-made for conflict are situations involving “blended families” where a surviving step-parent requires support from a child by a first marriage who inherits the business, and parent owners who set up a plan to distribute estate assets equally–rather than fairly–to surviving children.
Nate Sachs, founder and president of Blueprints for Tomorrow, Scottsdale, Ariz., cites an instance where parents left assets of roughly equal value to their 4 kids: an auto dealership they owned going to two sons; and the property on which the dealership was located to two daughters. Within two years of the parents’ deaths, the 4 siblings had a falling out and the sons moved their dealership across the street, leaving the daughters with an empty lot they were unable to maintain.
“It was a train wreck waiting to happen,” says Sachs. “The 4 siblings should never financially have been in bed together. In retrospect, the parents could have been fair by bequeathing other assets to the girls, such as stock, bonds or the house.”
They could also have equalized the estate by purchasing life insurance, a favored vehicle, experts say, for funding succession and estate planning objectives, in part because of the product’s tax efficiency. Cash values of permanent policies grow tax-deferred. Death benefits go to designated beneficiaries income tax-free. And, when the policy is owned by an irrevocable life insurance trust, proceeds escape estate taxes.
To be sure, other tax-savvy options are available to facilitate a smooth transfer of the business to the next generation. Jeffrey Condon, an attorney and principal of Condon & Condon, Santa Monica, Calif., says he often advises parents to sell a business while they’re alive to an adult child using an installment (or promissory) note. Typically, the financial instrument assigns a fair market value to the business and yields an interest payout equal to the salary the parents would otherwise draw from the firm.
One benefit: The note “freezes” the value of the business for estate tax purposes. So if the company grows in value to $20 million at the time of the parents’ death from $10 million at the time of sale, only $10 million will be subject to tax. If parents don’t need full value for the firm, they can also sell, for example, one half and gift the other half to child, making gifts tax-free using their $13,000 annual exclusion amounts.
Often, however, owners are unwilling to give up control of the business while alive, particularly in cases where they consider a sale premature; hence, the value of life insurance. For pennies on the dollar, sources say, a business owner can purchase a policy to provide the necessary liquidity to cover the estate tax.
Insurance can also be used to provide for a fair distribution of assets to children who will not inherit the business. In the case of the car dealership, says Sachs, the parents could have avoided conflict by bequeathing the dealership and underlying property to the two sons, and by purchasing a policy of equal value for the two daughters.
Life insurance, in conjunction with trust planning, also comes in handy in situations involving blended families. When, says Anderson, estate assets must be divvied up between a second wife and children from a first marriage, one solution is to give the business to the kids and establish an irrevocable life insurance trust of equal value for the second wife, using cash flow from the business to fund the trust. An ILIT, he adds, might also be deemed prudent as a substitute for a qualified terminable interest property (QTIP) trust that provides an income stream for a surviving spouse; and, upon the spouse’s death, a distribution of remaining assets to surviving children.
“If the spouse is not much older than the kids–as is often the case with a second wife–then she may live to age 90 and the kids to age 70 before they receive any distributions,” says Anderson. “Or there may not be sufficient assets in the QTIP to provide for her income needs. In either case, the solution is an ILIT for the spouse.”
Or for the mistress, perhaps. Says Gregory Amundson, chartered financial consultant and principal of Federal Way, Wash.-based Avastia: “One client of mine is supporting a second family on the side as a result of an affair. We established a separate ILIT–of which the client’s wife has no knowledge–for the maintenance and support of the non-spouse and her kids.”
That an insurance professional would engage in secretive planning discussions is par for the course in advisor-client engagements, adds Amundson, who describes the fact-finding process in exit planning cases as a “business transition audit” or “assessment” as to company objectives. Integral to this process, he says, is a determination by the advisor as to the realism of the goals and the owner’s willingness to depart from them to achieve a successful result.
That might mean, for example, jettisoning plans to hand a business over to an owner’s adult child when interviews with key employees suggest that one among them would be better able to manage the business. Should the owner prove resistant to recommendations, the insurance or financial professional might do well to supplement the advisor team–which typically in dual succession/estate planning cases includes an attorney, accountant, business valuation specialist and (as necessary) qualified plan, investment and merger and acquisition professionals–with a psychologist who can address relationship issues. Amundson says he resorted to one with a client who, though on his deathbed, procrastinated in setting up a plan to transfer his firm to his son.
When planning objectives are in dispute–a situation that can lead to “analysis paralysis”–the wise course may be to buy insurance and then try to achieve a consensus on outcomes.
“If it’s money versus planning, do the money first,” says Sachs. “In one case, the client died without any planning or money because of stonewalling by the attorney as to the need for a policy. At least with insurance in force, there’s money, which can solve a lot of ills.”
At other times, the stumbling block is finding a way to pay for the life insurance premiums. Whereas a permanent policy is advisable in estate and trust planning where long-term cash accumulation is a main objective, term insurance, convertible term or a similar policy may be more suitable for a buy-sell agreement where funding a large payout to a surviving spouse at minimal cost is the sole objective. The case for term is all the more compelling in the current economic environment, sources say, when many companies are struggling to maintain cash flow to sustain business operations.
If a low-cost permanent policy is preferred, Prisciotta suggests considering a graded premium universal life contract.
For example, the client might pay $30,000 per year for first 10 years; in the 11th year, the premium rises to $70,000. Alternatively, the client can opt for a “blended” policy that contains some ratio of term to permanent coverage. Some contracts, says Sachs, offer a term component as high as 90%.
“As advisors, we have to offer this as an option to clients,” says Sachs. “If you can find a carrier who will let you blend a guaranteed death benefit product, then I suggest the maximum blend. When life insurance needed for succession and estate tax purposes is bought to die with, and not to accumulate cash value or surrender at a future date, then why pay extra for the permanent coverage?”