Ensuring Fairness in Legacy: The Power of Life Insurance in Estate Equalization
Every Child Is Different
More than 70 percent of family-owned businesses do not survive the transition to the second generation. In most cases, the insurmountable obstacle is either a lack of sufficient cash to pay expenses or family discord. A good succession plan should address both of these issues.
A family business does not mean the entire family is involved, and this is often a source of family discord. Some children join the family enterprise, while others pursue different career paths—often professions that are completely unrelated to the family business. These heirs have diverse financial needs, goals, and objectives. Family members working in the business want to inherit the business, while children outside the business may have a greater need for cash to buy a home, put a child through college, or perhaps invest in another business.
Succession planning is often more complicated in a family business because of the relationships and emotions involved, and because the business owner, as a parent, may not be comfortable discussing topics such as aging, death, and financial affairs.
Succession and estate planning involves business owners making complicated choices, especially when they want to treat each child fairly.
- Should parents give each child an equal share of the business? This can lead to conflicts. Children who are working in the business may resent having to buy out those who are not. They may struggle to come up with the money to purchase their siblings’ business interests while keeping the company viable.
- Should parents give each child an equal share of the estate? This can also lead to conflicts when parents leave the business to the children who are working in it and leave the remaining assets to the other children. Since the business frequently makes up a disproportionate amount of the overall estate, the division of assets will not be equal.
Not Equal, but Equitable
Life insurance is, of course, the ideal solution to this not-uncommon problem. A business owner can:
- bequeath the business to children who have chosen to remain active in the company
- purchase a life insurance policy on the business owner’s life and name the inactive family members as the beneficiaries of the policy (or, let inactive children purchase a policy while the business owner gifts the premiums using annual gift tax exclusions)
- use life insurance proceeds (along with any other additional estate assets) to provide an inheritance that mirrors the value of the family business for family members who are pursuing other careers
Although inheritances may not be equal, they can be equitable, which maintains peace in the family. Of course, communication is one of the keys to making this arrangement work. Business owners should discuss their plans with their children and explain the reasoning behind their choices.
Estate Equalization: An Example
David, a widower, built a thriving real estate business over his lifetime. His daughter, Julie, has contributed greatly to the growth of the company, forging key business relationships and bringing in new clients. David’s son, Josh, moved across the country to pursue his career as a civil engineer. He does not plan to become active in the family business.
David’s current net worth is $5 million—the $3 million business and $2 million in his home and investments. If he leaves the business to Julie and everything else to Josh, Josh will end up inheriting $1 million less than Julie. If he splits the business evenly between the two, Julie will be forced to find a way to buy Josh’s shares.
Instead, David has Josh purchase a $1 million life insurance policy on his life, and David gifts the premiums to Josh using the annual gift tax exclusion. (This setup keeps the death proceeds out of David’s estate.) The life insurance proceeds plus the home and investment portfolio will provide an inheritance for Josh that is roughly equal to Julie’s shares of the business.