Clear your head of most of your old ideas about life insurance. Your business isn't the same today as it was 10 years ago and your life insurance shouldn't be either.
Big business calls for a whole new look at life insurance. You need to consider if you even need life insurance and who ought to be covered. Other questions are how much coverage is needed, who ought to be the owner, and who should be the beneficiary?
We'll take a look here at who should be the owners and beneficiaries of life insurance with both existing and new policies.
Change Your Thinking Grab one or all of your policies. If you're a married man and the insured, chances are you or your wife are the owner of that life insurance policy.
Chances are also that your wife is the primary beneficiary and your children are the secondary beneficiaries (will receive the proceeds if your wife isn't alive when you die).
Now, remember what the agent said when he sold you the policy: "When your wife receives the proceeds after your death, there won't be any income tax and the proceeds won't be included in your estate because your wife is the owner." That statement is still correct. It just doesn't make sense anymore. Tax law changed that.
The proceeds wouldn't be in your estate if your wife is beneficiary even if you are the owner. Since the proceeds would go to your wife, they would qualify for the 100% marital deduction and aren't in your taxable estate.
But catch this: Your estate isn't the one to worry about when it comes to death taxes if you die before your spouse. In most well-planned estates, there shouldn't be any federal estate tax when the first spouse dies.
"It's almost always at the death of the second spouse that federal estate taxes are a problem," says Darrell Dunteman, an accountant and accredited agricultural consultant at Bushnell, IL. "And, by having your wife as the beneficiary of the life insurance on your life, what have you done?"
You have put the life insurance proceeds right in her estate because she is the beneficiary and receives the proceeds when you die. They end up in the estate of the second spouse that's probably going to be taxed.
When an estate is taxable, the federal tax rate starts at 37%. "By having your spouse named as direct beneficiary of your life insurance, you're telling IRS it's okay for them to take 37% or more of the proceeds of your life insurance at her death," Dunteman says. This leads to one of several important rules of life insurance for successful farm businesses.
Life Insurance Rules Rule 1: In large estates, your spouse usually should not be the beneficiary of your life insurance. Nor should you be the beneficiary of your spouse's life insurance.
Some people may now wonder why not have their spouse as owner of the life insurance on my life and he/she will name the children as beneficiaries. Dunteman gives an example of how that can create problems.
The husband was the insured on a $1,000,000 face value (death benefit) policy that had a cash value of $250,000 and his wife was the owner. The wife died first. The $250,000 of cash value was included in her estate. Plus, the husband became the owner of the policy and the $1,000,000 of death benefit was in his estate.
Rule 2: Having your spouse own life insurance on you, or you owning life insurance on your spouse, can create problems when that owner-spouse dies.
If you shouldn't own the life insurance on your life and your spouse shouldn't, then who should? You might figure you can give the life insurance policies to your children. That can be a good choice. But it's not always real easy, either.
First, the cash value determines the amount of the gift. If the cash value is $110,000, for example, and you have three children, the most you can gift them in a single year, tax free, is $30,000. That's $10,000 each. The other $80,000 might be a taxable gift. Your spouse can, however, join in the gift to make it $60,000 tax free in a single year. But the other $50,000 could be taxable.
You could calculate the tax and use some of your unified tax credit to offset the taxable amount. Or, you might borrow enough cash value out of the policy to keep it tax free and then gift that in another year so the children can pay back the loan. Those are details your attorney or other advisors can help with.
A second disadvantage of having to gift an existing life insurance policy to keep it out of your estate is that you have to live for three years after making the gift for it to be complete. If you don't, it will be treated for estate tax as if you had never made the gift. In other words, it will be included in your estate.
Rule 3: Your children or a life insurance trust (described later) may be the best choice to own your life insurance. But be careful as you gift policies to them. The rules and requirements can be tricky. The best bet is to get good legal help.
However, don't let the drawbacks keep you from gifting existing life insurance policies if it makes sense for other reasons. Just don't put it off. For example, the sooner you get it done the sooner the three years get started.
Who Should Own Insurance? A general rule is that anybody but you or your spouse ought to be the owner of your life insurance.
That often means the person or persons who are to be the beneficiaries are probably one or more of your children. Often, the best choice is an irrevocable trust with your children as the eventual beneficiaries of that trust, Dunteman says.
Farming Child As Beneficiary Consider some of the choices for owner and beneficiary of the insurance on your life.
One choice is your farming child or children. For example, you have a net worth of $2 million almost entirely in land, hogs and facilities, and other farm business assets. Let's assume you have four children and one of them is farming with you. Your choice is to leave your assets equally to your four children - about $500,000 net each if you died now.
For the farming child to keep the business intact, equal distribution means he would have to buy $1.5 million of equity from the other three children. He would, of course, own the other $500,000 from his share of inheritance.
In an expanding business, there could easily be a hefty amount of debt.
Your business might, for example, have $3 million of assets with $1 million of debt to result in that $2 million of net worth.
One way for the child (say it's your son) involved in the business to be able to handle buying out the other heirs (his brothers and sisters) would be for him to own life insurance on you or your spouse or both.
If the son owned $1,000,000 of life insurance on you, he uses that to buy assets from the other children or your estate at your death. That, plus his $500,000 of inheritance, gives him $1.5 million of equity in the $3 million operation. As a good manager, he can probably handle it. But if he only had $500,000 of inherited equity, the debt to asset ratio as a percent debt would be 83%.
Since the son in this example would be the owner and beneficiary of the life insurance, none of it would ever end up being included in either parent's estate. The farming child would receive the proceeds free of both income taxes and federal estate tax. He should, of course, look at his estate planning because, through inheritance and the life insurance in this example, he would someday quickly add $1.5 million to his net worth.
Off-Farm Children You might just reverse that and have your off-farm children be the owners and beneficiaries of the life insurance on your life. Using the same example as before, those children might each receive one-third of the $1 million of life insurance proceeds or $333,333 each. If equal distribution is your plan, then they would each receive about $166,667 ($500,000 total to the three of them) of farm assets. The farming child would buy those farm assets from the off-farm children, probably with borrowed money.
All the rest of the farming assets would then be willed to the farming child and his debt situation would be just like described before. Or, the off-farm children might get only the life insurance proceeds and the farming child might be willed all the farm assets.
Like before, there would be no income tax on the life insurance proceeds and none of the proceeds would be in your estate.
There can be some problems with your children being the owners of your life insurance, Dunteman adds. They can cash in the policy or let it lapse. Your spouse won't get the proceeds if needed because the children will be the beneficiaries. If that bothers you, another good choice is an irrevocable trust.
Irrevocable Trust In many situations, the best choice to own your life insurance is an irrevocable trust. You get to set some rules that govern the trust. But, because the trust is the owner of the life insurance policy or policies, the proceeds are never part of your estate.
The trust solves the problems. Your children can't cash in the policy and you have safeguards that won't let it lapse. Plus, if your spouse might need the income from the life insurance proceeds, you can provide for that in the trust document you draft. There's flexibility to allow some choices.
The easiest way to use the trust is to set it up before you buy the life insurance. You gift cash to the trust and the trust uses that money to buy the life insurance. But it can also work for existing life insurance policies.
Again, say you have three children who are going to be beneficiaries.
You can gift up to $10,000 for each of those children to the trust each year using your $10,000 tax-free, gift exemption for a total of $30,000. Your spouse can join you to double the amount even if all the life insurance is going to be on your life.
There's one catch, but it's not a problem. To keep that gift to each child tax free, it has to be a "present" interest. With the irrevocable trust, the child or children have a "future" interest since they won't receive the benefits until your death when the life insurance company pays out the proceeds.
To transform that future interest into a present interest, a letter has to be sent to each beneficiary when the cash gift is made that says they have a certain amount of time (usually 30 days) to withdraw their share of the gifted amount. This is called the Crummey provision, named after a landmark case, Crummey versus IRS.
After that time passes, the money is used to buy the life insurance. Since the children involved are all informed in advance that the purpose of the gift is to buy life insurance that they will someday receive, it's not likely they will choose to withdraw their share of the gifted cash. The unspoken leverage is that a child who withdraws his/her share of the amount gifted to the trust may find his/her inheritance reduced or eliminated.
Never put that in writing. Each year, you would continue to gift to the trust within the $10,000 tax free amount to pay premiums. The actual amount of money gifted would be the premium amount for the life insurance being purchased by the trust. Each year, the children would be notified that they have the right of withdrawal of their share to assure that the gift is a present interest.
It is very important that you work with an attorney experienced in estate planning and irrevocable trusts for life insurance when doing this. You want the trust document to be drafted to fit both your needs and all legal requirements, Dunteman says.
Life insurance is not just for relatives. In the case of a business, life insurance on partners or corporation owners may help survival of the business after the death of a partner/owner.
Take an example of 10 producers who form a farrowing corporation. Maybe each puts up $100,000 and they start producing pigs.
If one of those shareholders dies, he/she will probably leave the shares to the spouse and/or children. Most corporations have restrictions on who can be shareholders. So the new owners of the shares must sell them back to the corporation or other shareholders according to the terms of a buy-sell agreement signed by the original shareholder.
If the corporation buys back the shares, a life insurance policy on the original shareholder will insure enough cash to do so. The corporation is the owner and beneficiary of the life insurance. They should have life insurance on all the shareholders, in this example. The cash proceeds would buy the shares from the deceased shareholder's family.
Life insurance can also work for a smaller partnership, involving related or unrelated partners.
Most financial and business advisors first suggest a buy-sell agreement that sets the price and terms for buying shares of the business in case a partner dies while you are in business together. Or, the agreement will state how to determine the price at the time of a partner's death.
Then, the partners should look at ways to finance that buy-sell agreement. Part or all of that may be with life insurance. You own a policy on a partner, and he/she owns a policy on you. If one of you dies, the other receives the life insurance proceeds and uses that cash to fund the buy-sell agreement. The idea is that the surviving partner ends up with the business without unwanted new partners. The surviving spouse and/or children end up with a buyer for their share of the business - and cash for it.
Term Or Whole Life When partners or shareholders are likely to want out of the business at retirement age, term life insurance rather than whole life insurance is often used to fund those buy-sell agreements. The need for life insurance is more likely to end when the partners retire. They may dissolve the business and divide it up. Or they may sell out.
Term insurance ends when the need for it ends. Since it often is kept in force only until a person is about age 65, it is much cheaper.
A farming child would more likely buy permanent, whole life insurance on his parents because the brothers and sisters are always going to be there, wanting their shares - probably in cash, when Dad and Mom die.
For more information, send a stamped, self-addressed envelope for a copy of a two-page report, "The Irrevocable Life Insurance Trust," by Bob Dunaway to National Hog Farmer, 7900 International Drive, Suite 300, Minneapolis, MN, 55425.
Darrell Dunteman has just published a book, "The Agriculture and Small Business Owner's Guide to Life Insurance." To order, send $16.95 plus $3.50 for shipping and handling (Illinois residents, add $1.06 sales tax) to Ag Executive, P.O. Box 180, Bushnell, IL, 61422-1080.