‘Split Dollar Life’ Can Help Next Generation Inherit Family Firm

The entrepreneur faces tough odds in creating a successful family business--and even tougher odds in making sure that the business outlives its creator.

For one thing, the estate tax makes it difficult for the business to survive into a second, not to mention a third, generation.

But you can guarantee that your business survives if you make proper use of life insurance as an estate planning tool. If you buy what insurers call “split dollar life” insurance, your business foots most of the bill--without saddling you or your heirs with unpleasant tax surprises.

Split dollar life insurance gets its name from the fact that it splits the premium, the cash value and the death benefit between the business owner and the business. You understand how it works if you see where the premium for the coverage comes from, where it goes, and what it buys.

Part of the premium for split dollar life insurance--the lesser part--comes from the pocket of the business owner, part from the business itself. Similarly, over time, part of the premium--the lesser part at first, the greater part later on--goes into building up cash value in the policy.

What the premium buys is simple: a death benefit split between the business owner’s family and the business. In practical terms, the second generation gets a supply of cash, enabling it to take over the family business without triggering estate taxes. The business, meanwhile, recovers what it spends on premiums.

How?

Assume that a husband and wife, ages 55 and 53, respectively, run a business worth $5 million. They have two children active in the business, and should her husband die, the wife would prefer to turn over the business to the children, buy a condo in Hawaii, and play golf for the rest of her life.

The husband and wife set up an irrevocable trust that buys a $1.25-million split dollar life insurance policy on the husband and similar coverage on the wife.

The husband and wife contribute funds to the trust, as does the business. The trust pays the premiums on the insurance--in all, $2.5 million in coverage on the founders of the business, or about what the government would take in estate taxes should both die simultaneously.

The policies build up cash value over time, and under the terms of the trust, the business has a claim on the cash value equal to its contributions to the premiums. The trust owns the rest of the cash value.

The husband dies and his stock goes to his wife as his beneficiary. She becomes the owner of all the stock in the company.

The proceeds of the insurance policy flow from the insurer to the trust--and then, in part, to the wife in exchange for the husband’s stock, and in part to the business. Thus the wife gets cash in exchange for the husband’s stock, and the business recovers what it spent on premiums.

At this point, the trust becomes owner of half the stock in the company, and the wife has $1.25 million. She invests it, preserving the capital and living off the income.

Things don’t stop here, however. The children are the beneficiaries of the trust, and under its provisions, the trust immediately transfers the father’s stock to them, making them owners of half of the company.

Similarly, when the mother dies, her stock flows first to the trust in exchange for the $1.25 million in insurance on her life and then to the children, making them owners of their mother’s half of the company.

All this happens without triggering income taxes.

How?

Under federal tax law, if you buy stock at $1 and sell it at $100, your basis is $1 and you pay taxes on the gain--$99. But if you sell inherited stock, your basis is the value of the stock at the time you inherited it. If its value is $100 when you inherit it and you sell it for the same price, you have no gain and no tax.

In the scenario above, the wife gets a stepped-up basis--as tax law calls it--in her husband’s stock when he dies. Since she immediately sells the stock to the trust at the same value, she has no gain and pays no tax.

Similarly, since the stock goes immediately from the trust to the children, they have no gain either. Meanwhile, the trust has kept the life insurance proceeds out of the estates of both parents, once again avoiding taxes.

“What you accomplish with this strategy is that you buy life insurance with the help of your business--and you transfer your company to the next generation without saddling them with estate taxes,” said Steven R. Craig, general agent for Berkshire Life Insurance Co., with offices in Sherman Oaks.

“The proceeds of the policies never increase the estates of the parents,” said Craig. “Instead, the proceeds come into the estates only in exchange for stock with a stepped-up basis and no immediate tax bill.”

Split dollar life insurance can take many forms to solve many problems, Craig said, as can an irrevocable trust. The business owner needs help from an attorney with expertise in estate and business succession planning, and perhaps from an accountant as well.

“Many first-generation business owners want to leave the company to their children, only to learn that the estate taxes may force the children to sell it anyway,” said Craig. “But with some careful planning, they can accomplish that aim with the help of the business itself.”

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Columnist Juan Hovey may be reached at (805) 492-7909 or at jhovey@gte.net.