Key Person Life Insurance & the ILIT

Key person life insurance is surely not a topic foreign to a typical business owner.  Businesses large and small commonly use key person life insurance to fund any number of agreements and protect against the loss of revenue or increased costs due to one’s untimely passing.  Most frequently for small businesses, key person life insurance ensures that sufficient capital is available to purchase a deceased owner’s shares or units upon their death.  In this manner, the owner’s heirs get value from the shares, and control is retained by the parties best suited to handle it. 

What many owners do not know is that there can be significant tax advantages to holding the life insurance in a particular manner; namely, an irrevocable life insurance trust (ILIT).  ILIT’s are a familiar tool used in many individual estate plans, but they are often overlooked in business succession planning despite their significant advantages.

The ILIT has benefits both for family businesses, as well as for businesses with a number of co-owners.  Due to the tax advantages of stepped-up basis, it is not uncommon for a business with several owners to enter a cross-purchase buy-sell agreement and fund the arrangement with life insurance policies that each owner holds on the other owners’ lives.  In almost every such instance, the insurance proceeds are ultimately included in the policy owner’s estate.  By holding the life insurance policies in an ILIT and using the proceeds to purchase the deceased co-owner’s business interest, inclusion of the life insurance proceeds in the estate can be effectively avoided.  Given the current estate tax rate of 45% and the fact it is set to revert to a maximum of 55% in the coming few years, getting a substantial asset out of the estate can greatly reduce the tax burden and ensure that more gets to the co-owners heirs. 

The ILIT also has value in the family business context, or anytime a business is being passed to a younger generation.  Take for instance a business owed by Father, who intends for Son to inherit the business.  Mother is not involved in the business, but Father wants her to be well taken care of in the event he passes away.  Son works for Father currently, but is not sure he wants to take over the family business right now. 

An ILIT serves a number of purposes in the preceding scenario.   Upon Father’s passing, the ILIT will use the life insurance proceeds to purchase Father’s interest in the business.  The cash will go into his estate and pass to Mother directly, or through a credit shelter trust.  The ILIT may also provide that income from the business is to be paid to Mother for a set period of time ensuring that Mother is provided for.  Son, still unsure if he ultimately wants the business, need not decide immediately whether to take control.  This is also an effective way to keep a business in the family if Father feels that Son is not yet ready to exercise full ownership and control.  If Son decides he wants to stay in the business, he may elect to do so at a later date.  If Son decides to leave the business, the trustee can sell the business without rushing to accept any offer.  The proceeds of the sale will go into the ILIT, ultimately to the benefit of Son. 

The above example is equally applicable to any business with an owner that is preparing another generation to take over the business, though that person may not yet be ready to do so. 

Owners take pride in the business they build, doing so not only to build a legacy, but also to provide for their family and heirs.  Proper planning for succession can result in continuation of the business, as well as more value being passed to the owner’s heirs.  The ILIT is an often overlooked, but extremely valuable succession planning tool that can achieve owner’s goals and save the owner’s estate from the crippling federal estate tax.  If you would like more information about the using an ILIT for business succession planning, please contact Benjamin Qualley at Gerbers Law, S.C. at 920-499-5700 or e-mail him at bqualley@gerberslaw.com.