It is common that one of the largest assets in a family business owner’s estate is his or her interest in the family business. This situation can be problematic because the owner’s interest in the company is included in the value of the owner’s gross taxable estate. The estate is required to pay debts, expenses, and taxes based on the taxable estate figure—requiring liquid assets when necessary. If needed, the liquidation of an interest in a business may involve acquiring an appraisal of the decedent’s interest and selling all or a portion of it at fair market value, both of which may need to happen within fifteen months after death.
Finding an interested buyer to purchase the owner’s share in a family owned business is arduous and possibly implausible. Additionally, an outside investor who becomes a major stakeholder may not be the best fit for the family business. Here is where an irrevocable life insurance trusts (ILIT) may be useful. This trust owns the life insurance policy for the business owner, completely removing it from their estate and reducing the gross taxable value. It also allows for an immediate payout, which can be used to pay debts and taxes after the owner has passed. The ILIT may, therefore, create a win-win situation: not increasing the overall taxable estate while setting aside protected funds to pay whatever debts and taxes may come due.
Here is what is required to set up an ILIT:
- The trust must be created first, naming the beneficiaries, a trustee, and the circumstances under which the trust is distributed.
- Second, the business owner gifts to the trustee of the ILIT the amount that will be owed for the initial premium on the policy.
- Third, the trustee of the trust buys the life insurance policy on the life of the business owner, using the funds gifted to the ILIT. This step takes special care to avoid any “incidents of ownership” on the business owner’s behalf. If the owner keeps the right to assign, cancel, revoke, or change the policy, the life insurance amount will be pulled back into the taxable estate. Most of this can be avoided by naming a trustee that is not the business owner or the business owner’s spouse.
- The trustee buys the policy and pays its ongoing premiums in a special way. The business owner gifts the amount owed on the policy to the trustee, with most or all of this gift immediately available for the benefit of each beneficiary. Thus, each gift to the trust qualifies for the annual gift tax exclusion. The trustee then notifies each beneficiary that a gift has been received on their behalf, and, unless a beneficiary elects to receive their gift, the trustee will invest the funds (usually by paying the premiums).
- After the business owner’s death, the trustee collects the death benefit proceeds on the insurance policy, making them available to pay taxes and expenses, and then administers the rest of the funds as instructed under the ILIT.
Irrevocable life insurance trusts are a valuable method for providing liquidity to the estate of the owner of a family business. By not having to sell the business in order to pay estate taxes, the trust has protected the business, not increased the taxable estate, and picked up the tab for the estate tax owed.