In many family-owned businesses, the commitment and contributions children make are not equal. Sometimes, this is because older children come into the business earlier than the others and carve out their place. They are often resentful of their younger siblings, who later return expecting to be treated equally when they haven’t earned it. Sometimes, the resentment comes from children who work in different careers but still expect to receive an equal share of the business.
Parents want to do the right thing, and often that means dividing what they have equally among their children. However, dividing the assets among children is often a difficult task when the bulk of the estate is a business. It is not unusual for these issues to break families apart. Instead of being a legacy, the business that the owner has sacrificed so much for is jeopardized. So what is a family business owner to do? The solution may lie in life insurance.
A common situation
Jim is the owner of a successful business. The business is his primary estate asset. Its value, while significant, is less than the $2 million federal estate tax exemption amount. He is married and has two adult children. While his wife, Marie, has been instrumental in the success of the business, she does not want to be dependent on it as her primary source of income at Jim’s death. Their older son, Ed, shares his father’s love for the business, but the younger son, Fred, does not and has chosen another career path. Jim and Marie’s goals are to leave Marie financially secure, leave the business to Ed, and equalize the inheritances of the two sons in their eyes.
If we assume Jim is the first to die, most likely he will want Marie to have the use of all of their assets. That may seem like a good plan, but it will leave Marie with a business that she does not want, and Ed would not own a business that he does want.
Like Jim, Marie wants to treat the two children equally while making sure that Ed receives the business. Unfortunately, if Marie leaves the business to Ed, there will not be sufficient assets to equalize Fred’s inheritance. If she divides the estate equally between them, Ed will have a partner who is not interested in the business and who may be detrimental to its continued success.
To complicate the matter further, once the estate passes to children, it may be subject to estate tax. The question becomes, from which share will the taxes be paid? If paid from non-business assets, Fred could end up with little or none of the estate. And dividing the burden equally between the two of them — which is the likely event — could lead to the end of the business.
Family succession arrangements are never one-size-fits-all
Each situation is unique. In the above scenario, the goal is to pass the business to Ed upon Jim’s death while maintaining Marie’s lifestyle. There are a number of possible ways to structure the arrangement. One strategy involves the use of a life insurance trust in coordination with Jim’s estate documents and a buy-sell agreement.
First, Jim’s estate documents are drafted to provide for the equal passing of his interest in the business to his two sons. Of course this will result in the business interest being included in Jim’s taxable estate, but as long as the value of the business is less than the estate tax exemption amount, it will be sheltered from federal estate taxes.
Next, Jim and Ed enter into a buy-sell agreement in which Ed agrees to buy the business at Jim’s death. Since Ed will acquire half of the business under the terms of the Jim’s estate documents, he will only need funding to acquire the other half of the business from his brother, Fred.
Finally, Jim establishes a life insurance trust with Marie and their sons as beneficiaries. The trust purchases enough life insurance on Jim’s life to help fund the buy-sell. In addition, if there is concern that Marie will not have enough assets to maintain her lifestyle, additional insurance can be purchased to cover this need. The trust document is drafted to provide that a specific amount of the proceeds will be paid to Ed in the event that he exercises the option to buy the business. The balance of the proceeds stays in the trust for the benefit of Marie. If Ed does not exercise the option to buy the business, the trust may provide that the proceeds benefit Marie during her lifetime, with the remainder going to Ed and Fred.
At Jim’s death, assuming Ed exercises his right to purchase the business, the trustee distributes the insurance proceeds to help him acquire the business. Ed acquires the business, and Fred has cash to help equalize his inheritance in the eyes of his parents. Insurance proceeds remaining in the trust are used to help maintain Marie’s lifestyle.
The payoff: the successful transfer of the business, and a family far more likely to live in harmony.
Terri Getman is vice president of advanced marketing for The Prudential Insurance Company of America. She can be reached at terri.getman@prudential.com.