One of the most pressing problems that business insurance can solve occurs when a business owner dies. Careful planning that includes business continuation insurance can counteract the negative financial consequences that result when no plan exists to address what will occur after an owner dies. Because different forms of business ownership result in different consequences at an owner’s death, sole proprietorships, partnerships and closely held C or S corporations will be primarily discussed in this section.
When a business owner dies, one of three basic consequences results:
The desirability and viability of each option depend on a number of factors, not the least of which are the financial obligations Uncle Sam and the individual states extract.
Money is needed to cover the final expenses associated with death. Include are funeral and burial costs, such as funeral home fees, casket or crematorium expenses, burial plot and others. Final expenses also include any other costs that are directly related to the death. For example, depending on the circumstances of death, the family might be liable for uninsured medical expenses, such as hospital and physician charges.
Furthermore, death often is the catalyst for creditors to seek immediate payment of outstanding debts that would otherwise continue to be paid out of the business owner’s ongoing income from the business.
Death also creates the need for funds to pay expenses associated with administering the estate of the deceased person. An individual’s estate consists of all real estate and personal property, including money and other financial instruments, that the person owned while living and other financial instruments, that the person owned while with administering an estate include legal fees, debt payment, federal estate taxes and any state mandated death taxes. In addition, the person who actually administers the estate—the executor or administrator—usually is entitled to receive a fee for his or her work as well as to have access to funds that allow the estate to be closed.
When an individual who dies has a legally executed will, he or she usually has named a specific person to take charge of finalizing the estate. Such a person, when named in a will, is known as the executor. If the will does not name an executor or if the individual has not executed a will, the appropriate court of law names someone to perform the same duties, in which case he is known as the administrator. The difference between an executor and an administrator is essentially a legal technicality; the duties are the same.
Another term associated with estate administration is probate. Technically, probate refers to actions that occur in a court of law in order to determine whether or not a will is valid. However, in contemporary usage, the term is more often used to refer generally to all activities that occur in administering an estate, not just those that prove or disprove a will's validity. Therefore, when you hear that an estate is "in probate," this usually means the executor is carrying out the process of collecting and liquidating assets, paying debts and taxes, and distributing the remainder of the estate to heirs in accordance with the will and/or state laws.
State laws usually require the estate executor or administrator to finalize the deceased person's affairs quickly. The executor must, by law, use whatever assets are available to pay all debts, including those outstanding at the time of death, those incurred for funeral costs and other expenses associated with the person's death, and taxes owed by the estate itself. Unless the business owner has planned carefully and provided a financial mechanism for dealing with the business after death, the estate administrator may have no choice but to liquidate some or all of the business assets in order to close the estate.
While partial liquidation may be necessary, the result can be a disaster for the heirs. For instance, a small business (especially) may be financially weakened by the death of the owner, making it difficult or impossible for heirs to continue business operations or to have sufficient income for day-to-day living expenses. Or, the same circumstances could result in the business being stripped of significant assets, effectively making it worthless to potential buyers. In either event, two of the original options available to the heirs upon the death of the owner—continuing the business and selling the business—may not be viable, leaving dissolution of the business as the only alternative.
In addition to the cash needs that arise solely because of the business owner's death, additional cash is required to cover the normal and on going income needs of the survivors. For small business owners, chances are high that the business provided regular income to pay for everyday personal living expenses—mortgage and utility payments, groceries, transportation expenses, schooling, clothing, credit card and installment loan payments, etc. While savings accounts and income from investments might provide temporarily for everyday needs, the heirs of many smaller businesses may be unable to survive for long periods without the steady income the business provided by the business.
Cash can be provided quickly by life insurance on the business owner's life providing an immediate source of cash that permits the estate administrator to carry out the legal requirements of closing an estate in an orderly manner without being forced to deplete business assets. With the pool of funds life insurance provides, the administrator is in a better position to take care of all outstanding debts while retaining the value of the business in order to dispose of it in the desired manner. In many states, the executor is permitted to continue operating the business temporarily while performing other duties related to estate administration. If life insurance proceeds are available to allow this action, the business can continue to generate additional income until the estate is closed.
Thus, instead of facing a forced sale or liquidation in order to meet expenses, the heirs still have access to all of the original options and can choose from among them on their own terms, rather than under the pressure of immediate cash needs. Additionally, sufficient life insurance provides immediate cash for the heirs' needs, from paying for funeral and final expenses to covering everyday living expenses.
Regardless of the outcome desired upon the death of the owner—voluntary dissolution of the business, continued operation by heirs, or sale of the business to another party—life insurance is the only guaranteed way to ensure the desired outcome.
Especially in the case of a sole proprietorship, where the deceased owner might be the only family member involved in the business, the heirs may simply wish to dissolve the business and sell off its assets rather than selling the business itself. Assets could include inventory, furnishings, fixtures, equipment and real estate. When the actual business is not sold, the selling price does not include the value of intangibles that would accompany the sale of a business. Intangibles include goodwill generated by the previous owner, name recognition, location, marketing and advertising techniques, customer lists or similar items. In other words, heirs decide to settle for the value of the tangible assets. There's nothing wrong with disposing of a business in this fashion if that is what everyone wants. In this case, liquidation of assets may be chosen rather than occurring because the estate administrator is forced to liquidate to meet estate-closing expenses.
It would be less common for a surviving partner to want to dissolve a business when his or her partner dies, because the survivor may want to continue in business alone or by taking on new partners, although there may be sound reasons for a partnership to choose dissolution as well. The same is true for smaller corporations, especially where the deceased owner was the major driving force behind the corporation. A "one-person corporation" can operate similarly to a proprietorship (aside from the legal requirements); in which case the death of that person has essentially the same results as the death of a proprietor. In any event, to ensure successful dissolution of the business, the business owners and heirs must plan in advance how the dissolution will happen in an orderly and satisfactory way.
It is basic business and common sense that everyone should execute a Will. Part of the duties of a professional agent would be to determine if there is a Will, and if there is not, then strongly recommend they contact a lawyer and prepare a Will immediately.
The more sophisticated your business clients are and the larger the business, the more likely it is they will have a current Will, but it must never be assumed. Also, Wills that are not prepared by an attorney are accepted in many states, it's highly recommended that an attorney be involved, especially when the estate is complex because of the presence of business assets and liabilities that attract the attention of creditors and taxing authorities. The owner's Will, specifically addressing the desired dissolution of the business at his or her death, can specify:
These items, of course, deal only with the owner's business interest. The Will would also include any other provisions appropriate for the particular business plus provisions addressing personal assets aside from those of the business.
By using life insurance policies to back up the wishes expressed in the Will, a business owner can guarantee that cash is available to smooth the way for an orderly transition after death. Made available to the executor, life insurance proceeds provide the cash to administer and close the estate without tapping into and depleting business assets that could be sold.
For the heirs, life insurance provides cash for new and ongoing expenses plus the ability to avoid forced liquidation of business assets and to delay the sale until they are in a position to receive the best price for the assets. This can be especially important because many experts say that a forced liquidation results in a loss of 50% or more of the value that could be obtained through an unpressured sale.
Generally, life insurance policy proceeds written for business purposes and paid in a lump sum when a business owner dies are exempt from regular income taxation. That is, the beneficiary is not required to pay income taxes upon receiving the proceeds. This is the general rule for all life insurance death benefits, but under certain circumstances, some life insurance proceeds may be taxable as income.
The first hurdle all life insurance policies must overcome is whether the death benefits qualify by law as "life insurance proceeds." In establishing whether such proceeds qualify, the Deficit Reduction Act of 1984 tightened up the definition of life insurance in response to the introduction of universal and variable life insurance, both of which have investment features. The purpose was to restrict favorable tax treatment to the pure life insurance benefits in such policies and not to extend favorable treatment to investment vehicles. In order to qualify as life insurance proceeds, policies must meet one of two "tests" described in the Internal Revenue Code (IRC). Such tests are basically of an actuarial determination and outside the scope of this text, but, in general terms the essence of each requirement is that life insurance policies must be written in such a way that the purchaser pays relatively modest premiums for modest returns and that the death benefit portion is always greater than any cash surrender value or investment portion. Policies that meet one of the two IRC tests qualify as life insurance proceeds and, therefore, avoid income taxation under most circumstances.
Another factor that can affect whether a beneficiary must pay taxes on life insurance proceeds is application of the so-called transfer for value rule. This part of the Internal Revenue Code requires that, when ownership of an existing life insurance policy is transferred to another person in return for a "valuable consideration," a portion of any death benefits are subject to income taxation. Exempt from income taxes are the valuable consideration paid for the transfer of the policy plus any premiums the individual paid after gaining ownership of the policy.
As an example, suppose Lisa, a sole proprietor, owned a $200,000 policy on her own life. She decided to transfer the policy to her adult son, Patrick, in return for $3,000. Patrick, as the beneficiary, pays premiums totaling $5,000 before Lisa dies in a traffic accident. Because of the transfer for value rule, when Patrick receives the $200,000 proceeds, he must pay Income taxes on all but $8,000. According to the law, a transfer for value does not necessarily have to involve cash, such as the $3,000 Patrick paid his mother. If he had acquired the policy in return for some other valuable consideration, the rule still applies. For example, Patrick might have received the policy in return for providing Lisa with free consulting services for her business which would also qualify as a transfer for value. On the other hand, if Lisa had given the policy to Patrick as a gift, the proceeds would be tax exempt. While the transfer for value rule would apply to nearly anyone to whom Lisa might transfer the policy for value to a brother, a sister, an employee, a good friend-it does not generally apply to a spouse. Any death proceeds would still be tax exempt for Lisa's husband, for example, even if Lisa had received some value from him in return for transferring ownership of the policy.
Finally, the tax code identifies a number of other situations that could result in income taxation of life insurance proceeds, including:
Depending on the type of business and the arrangement made to pay life insurance benefits covering a business interest, the beneficiary(s) might be individual family members, the business itself, or the estate. Different tax effects can occur depending on who owns and who is the beneficiary of the policy. In most cases, arrangements can be made so the proceeds will be received income tax free. However, a number of different factors can cause the proceeds of life insurance policies to be subject to another form of taxation the federal estate tax.
The federal estate tax laws have changed dramatically, as have most tax rates, including Gift Tax, Generation-Skipping Tax and Unified Credit. Be warned, however, that this tax is repealed in 2010, and unless Congress acts in the interim to permanently repeal the estate tax, the estate tax will be reinstated starting in 2011 and revert back to the law as it was before the 2001 Tax Act was passed. This discussion considers the estate tax as it exists in early 2008.
Current law provides for two major exemptions from federal estate tax:
1. There is no federal income tax on the first $2 million of assets for years 2007 and 2008; in 2009 the exempt amount increases to $3.5 million.
2. There is an unlimited marital deduction for assets passing to a spouse who is a US citizen. Any amount that is left at death or given to a surviving spouse, regardless if it is given outright or in certain types of trusts, is exempt from federal estate tax.
Under the current tax law, the top federal estate tax rated is 45% in 2007 through 2009, while the amount exempt from tax is $2 million in 2007 and 2008, rising to $3.5 million in 2009 (see below). The tax is repealed for the year 2010 only. At the present time, prior to the presidential election, the repeal of this law is a plank in the Democratic party, which is described as a "tax plan that helps only the very rich" even though it helps the small businesses to keep family-owned businesses alive after the death of the owner, and even though the largest group of employers in the United States are the small businesses…
The present two major exemptions would appear to make tax planning easier for most Americans, and in particular, the owners of small businesses who want to see the "fruits of their labor" passed on to their heirs. With the high exemption amount presently, many insurance agents have ignored estate planning uses of life insurance to keep assets for the heirs by using life insurance to pay off any estate tax. At this time, with the uncertainty about which party will control Congress and the White House, and questions regarding future budgetary constraints, there is a good chance that the estate tax will not be permanently repealed.
Many middle-income families now own homes that are worth several times what they cost, and even with the recent "bust" in the real estate market, the values of homes still remain higher than when the home was purchased. Even if present assets do not exceed the $2 million—or whatever future exemption amount—they might exceed this amount at the time of death. Also, in some cases, the proceeds of life insurance re also included in your taxable estate regardless of the beneficiary. Therefore, is it only good planning to focus on strategies that may help to freeze the assets in the estate of the client/business owner?
Basically, for calendar years 2007 and 2008, the estate and Generation Skipping Tax (GST) tax at time of death transfer exemption is $2 million. The highest estate and Gift Tax rate is 45%
For calendar year 2009, the estate/GST exemption goes to $3.5 million, with highest estate and GST tax rate at 45%.
For Calendar year 2010, all estate and GST taxes are repealed, and there will only be gift tax of 35%.
For calendar year 2011, the exemption for estate tax will be $1 million. For GST tax it will be indexed from 2002 and will be $$1.1 million. The highest estate and gift tax rates will be 55%, plus 5% surtax on certain estates over $10 million.
Note: The gift tax exemption remains at $1 million throughout this period.
Estate tax, which is often called "death tax," is a tax on the property that is transferred at death, and the gross estate will include the value of all property to the extent of the individual's interest in the property at death. The types of property that would be included in the gross estate fall into basically three categories.
This category includes all property that is transferred at death by Will and or state intestacy laws, and is usually called the "probate estate." Examples of this property would be real estate, stock, bonds, certificates of deposit, furniture and personal effects, jewelry and works of art and Momma's mink coat, and for business purposes, an interest in a partnership, and an interest in a sole proprietorship. It also includes bank accounts and promissory note or other forms of evidence of indebtedness that is owned.
As a general rule, half of the value of property owned by a husband and wife jointly will be included in the estate of the first spouse to die. The unlimited marital deduction allows the transfer of the property from the deceased spouse to the surviving spouse without being subject to federal estate tax. Upon the death of the survivor, the entire property still being held at death will be subject to taxation.
If two people who are not married own property jointly, then the entire value of the property is included in the gross estate of the first to die—unless the estate can prove that all of part of the payment for the purchase of the property was actually furnished by one or the other joint owner. If, on the other hand, you and another joint owner acquired property by gift or inheritance, only the fraction of the property owned by you is included.
Property that is jointly held will pass to another owner automatically on death, regardless if there is a Will or the owner passed intestate. In some states, Transfer on Death (or Totten Trust accounts) allows securities and bank accounts to pass directly to a beneficiary even if the property is not held in joint name.
The client's gross estate will include life insurance proceeds that are received either (a) by or for the benefit of the estate, or (b) by other beneficiaries if the client owns all or part of the policies at time of his death. In tax law, "ownership" includes the power to change the beneficiary of the policy, the right to cancel the policy and receive the cash value, the right to borrow against the policy and the right to assign the policies.
There can be substantial tax advantages by transferring ownership of a life insurance policy to children or to a trust for the family's benefit. The first requirement would be to making a gift of the policy at least three years prior to death. This three-year waiting period can be avoided for a policy that has been newly purchased if another party, such as a trustee of an irrevocable trust, applies for the policy and owns the policy from its effective date. These irrevocable trusts can be structured so that the insured transfers money each year for premium payments. Often, therefore, these payments can qualify for the annual gift tax exclusion. This is a very effective way of making sure that insurance proceeds go to the heirs without incurring gift or estate tax.
The value of the payments from qualified pension plans, IRAs and other retirement plans that are payable to surviving beneficiaries or the estate of an employee—or the owner in case of a Keogh/HR10 plan —usually is included in the gross estate.
Gifts of property that are made during a lifetime are usually not included in the decedent's gross estate, but must be included in the calculation of the estate tax if they exceed the $12,000 annual gift tax exclusion. However, life insurance proceeds are included in the estate if the policies—or ownership of the policies—were given away within three years of the death of the decedent. Also, any gift tax paid within 3 years of death is included. Lifetime gifts that a decedent in which the decedent retains some interest in or control over (such as voting rights in closely-held stock) will be included in the gross estate.
Allowable deductions include funeral and administration expenses of the estat5e, debts, unpaid mortgages and other indebtedness on property included in the gross estate. Also, a marital deduction and charitable deductions are allowed.
To be deductible, debts must be enforceable personal obligations of the decedent, such as outstanding mortgages, personal bank loans, auto loans, credit card balances, utilities bills, etc. Deductible taxes also include accrued property taxes, gift taxes unpaid at death, and income taxes.
The "Fair Market Value" which is the price at which property would change hands between a willing buyer and a willing seller. Property that is traded on an established market, such as publicly traded stocks, is easily valued. Stocks and bonds that are traded publicly are valued at the high and low selling price on the date of death, or there is an option of using a date six months after death (see below).
However, interests in closely held businesses or partnerships must be appraised, taking into account the assets of the business, the earning capacity, and other pertinent factors. This is obviously, the area in which an accountant is necessary.
The gross estate is valued as of the date of death or six months later (alternative valuation date), whichever is elected by the personal representative. An election to value the estate six months after the date of death generally will apply to all of the assets in the estate, but is available only if the election results in a decrease in the gross estate and estate tax liability.
The amount that remains after subtracting any allowable deductions is the taxable estate and the federal estate tax is computed on this amount. Gifts that are made after 1976 are also factored in and can increase the marginal tax bracket of the estate.
As a general rule, any property acquired from a decedent gets a new basis.
Basis is generally the cost of an asset or the amount used to calculate the tax.
Since the old new basis is almost always larger than the old basis, this is known as the "stepped-up" basis. In most cases, the new basis is the fair market value at the date of death or alternative valuation date, whichever is used for estate tax purposes.
NOTE: Under the new tax law, any property that is acquired from a decedent who dies in 2010 will not get a "stepped-up" basis. Therefore, if a beneficiary inherits property from a decedent, he will usually receive a basis that is equal to lesser of the fair market value of the property on the date of the decedent's death or the decedent's adjusted basis in the property—this is called the "carryover basis." IF this new rule goes into effect, it becomes extremely important to keep accurate basis records so that they will be available for the heir. Also, if this new rule goes into effect, there appears to be ways to make sure that certain types of assets are not eligible for the basis increase, but a tax accountant must be involved.
While the estate tax remains in effect until it is repealed (if it is) in 2010, most married individuals will want to take advantage of both the estate tax exemption and the unlimited marital deduction , which has the effect of reducing federal estate tax to zero for the estate of the first to die.
One way to do this is by placing property in a special marital trust, thereby arranging for the spouse to receive a lifetime income interest in certain property. After the surviving spouse dies, then the property will be passed on to whoever is specified in the trust document.
Property transferred to a surviving spouse who is a non-US citizen by gift or death is not allowed, however the law provides that tax-free gifts to a non-citizen spouse can total only $125,000 (for 2007) per year—which is adjusted for inflation. However, there is no lifetime limit to the total value of gifts that can be given tax-free to a spouse who is not a citizen of the US. In addition, a Will can be drafted so that property placed in a Qualified Domestic Trust will have the estate tax postponed until the property in the trust has been distributed or the surviving spouse dies. This, of course, requires legal help in setting up such a trust.
For year 2007, computing the estate tax is rather simple, although it must always be performed by a tax attorney or accountant.
From the gross estate of the individual, deductions are subtracted—such deductions are assets such as cash, marketable securities, business equity, residence, vacation residence, personal property, deferred compensation, ordinary life insurance and group-term life insurance. The amount of deductions depends upon the gross estate. In 2007, if the gross estate is $1,500,000, then deductions from gross would be $1,500,000, so there would be no estate tax.
If, for instance, the individual has a gross estate of $2,500,000, deductions of $1,00,000, leaving a taxable estate of $1,500,000. The estate exemption for this year is $1,500,000, leaving zero federal estate tax.
However, if the gross estate is $10,000,000, deductions (for example) of $6,500,000, this would leave a taxable estate value of $3,500,000. The estate exemption is $2 million for 2007, leaving a taxable estate after exemption of $1,500,000, leaving a tentative estate tax of $690,000.
As they say in the television commercials, "Don't try this at home!" Obviously, the large estates must be handled by professionals. These examples are provided to prove a point: When an estate is worth 7 or more figures, don't even try to guess what the tax consequences are. The next logical question is, for the professional insurance agents, then where do I start to determine how much life insurance the individual needs so that there will be something left for the heirs?
This is very nebulous at this time because of the fluidity of possible estate-tax law changes. Therefore, a professional agent must keep abreast of changing laws in order to provide the kind of service that such clients require. Unless the agent has an IQ and retentive memory "off-the-charts," it would not be possible to provide specific advice. Therefore, the lesson here is
Become acquainted with accountants and attorneys who specialize in tax issues. Further, continue your own education so that you can converse intelligently with them on matters that affect your mutual interests.
Take time to take advanced insurance courses from the American College of Life Underwriters or comparable institutions. If at possible, become a CLU or obtain another professional designation. If nothing else, this training will build confidence so that the professional agent can be of service to those who need professional assistance.
Gifts of property made by the decedent during his lifetime, as a general rule, are not included in the gross estate, but must be calculated in the estate tax calculation if they exceed the $12,000 annual gift tax exclusion. (Note, however, that life insurance proceeds are included in the estate if the policies or ownership of the policies were given away within three years of the death of the decedent. Lifetime gifts that a decedent retains some interest, such as a life income interest—or control over (such as voting rights in a closely held corporation) will be included in the decedent's gross estate.
A (one) person can give up to $12,000 annually ($24,000 if the spouse consents) to as many individuals as the persons wants, without paying any gift tax. But, above that amount, gifts consume the lifetime gift tax exemption amount of $1 million (this amount does not increase) and then can result in gift taxes. The reason for the gift tax is that people could simply give away their estate and not ever have to pay estate taxes. CAUTION: One should think long and hard about making significant gifts that would result in a gift tax payable in light of the possible permanent repeal of the estate tax.
Under the current tax law, the highest gift tax rate for 2007 through 2009 has been reduced to 45%; however, unlike the estate tax, the gift tax is NOT repealed. Beginning in 2010, the highest gift tax rate will be equal to 6the highest individual income tax rate, which, by then, is scheduled to be 35%.
The gift tax was retained largely to limit the amount of income tax that taxpayers can avoid by giving income-producing and appreciated assets to family members in lower income tax brackets. The $1 million gift tax exemption will remain constant and will not be indexed to the inflation rate.
Any gift given above the annual exempt amount is included in the estate upon death. The value is not the amount of the gift at the time of death of the giver/decedent, but the value at the time the gift was given. In addition, there are some special rules.
A gift of life insurance made within three years of the death of the giver will be included in the decedent's gross estate at its full face value.
Since there is considerable uncertainty currently existing as to whether the federal estate tax will be repealed, it would seem prudent to consider gift-giving strategies that minimize the size of the taxable gift and that avoid gift tax to the extent possible.
The subject of gift taxes is extremely important in estate planning and can be extremely involved when children are involved. A professional estate planner must be aware of such gift-tax saving vehicles as the Crummey Trust (where property can be transferred and the gift can qualify for the annual gift tax exclusion), a Totten Trust (which is created when a donor deposits his own money into a bank account for the benefit of a minor and names himself as trustee, thereby allowing the funds to avoid probate), and Section 529 (Qualified Tuition Programs).
An additional tax may apply to gifts or bequest that skip a generation, such as a gift of property directly from a grandparent to a grandchild—the Generation-Skipping tax. The reason for the tax is so there could be the imposition of the gift or estate tax that would have been paid if the intervening generation had received the gift or bequest.
This tax is rather stiff—in 2007 the tax is imposed at the maximum estate and gift tax of 45%, which is payable in addition to any estate or gift tax otherwise payable as a result of the transfer. However, most will escape this tax as the first $12,000 ($24,000 if made with consent of the spouse) outright gifts of the grandparents are included in the annual exclusion. Plus, each individual is entitled to an aggregate $2 million exemption form the tax for lifetime gifts and transfers at death. Since a married couple can "split the gift," they cam make up to $4 million in generation-skipping transfers without incurring the tax.
Plus, any subsequent increase in value on the transferred property after it is given, will escape the generation-skipping tax.
Only individuals are required to file a gift tax return, and it is not necessary to file a gift tax return if the person
Life insurance policy proceeds must be included in the value of an estate when the proceeds are payable to the insured's estate. Therefore, if the beneficiary of the policy is the estate, the proceeds are considered in determining the value of the estate. If the business owner wants to be certain life insurance funds are available to close the estate, a separate life insurance policy can be written for that purpose and identified in the Will, indicating the life insurance proceeds are to be payable to the estate. While this causes the funds to become part of the estate, such an arrangement can provide the much-needed funds an executor might need to close the estate without depleting the assets of the business to pay bills. This can be especially critical for a proprietorship, where the owner's death effectively causes the business to cease to exist.
Life Insurance must also be included in the estate when the proceeds are receivable for the benefit of the estate. A policy beneficiary might be legally obligated to pay off the deceased owner's existing debts, taxes and any taxes that arise because of the death. For example, consider the case of a proprietor whose beneficiary is his wife. Since the spouse, like the proprietor, is considered one and the same with the proprietorship, the business debts and taxes are the legal responsibility of the surviving wife. The life insurance proceeds payable to the wife in this case must be included in the husband's estate to the extent she is legally obligated to pay estate expenses
A different standard applies for including proceeds in the insured's estate in community property states. In these states, the law requires that all property acquired either individually by a husband or wife or by both jointly during their marriage must be considered the common property of both, regardless of whose assets actually paid for the property. A life insurance policy purchased during the marriage is therefore considered community property.
Life Insurance policy proceeds must also be included in the estate when the insured had incidents of ownership in the policy when he or she died. This is true even if the beneficiary is not the insured's estate. The Internal Revenue Code recognizes at least the following contractual rights under a life insurance policy as incidents of ownership:
Individual court cases have identified other incidents of ownership in certain jurisdictions-rulings that might not be upheld everywhere. For example, one court ruled that the right to change a policy's settlement option was an incident of ownership, while a court in another jurisdiction ruled the same right was not an incident of ownership.
Where the insured specifically wants to avoid having the policy proceeds included in the estate, Incidents of ownership can generally be avoided by allowing someone else to own the policy. An existing policy can be assigned or given as a gift to someone else. New policies can name someone other than the insured as the owner. For example, the spouse of a proprietor, partner or corporate stockholder may own the policy. Alternately, partnerships and corporations as entitles may own and be the beneficiaries of policies on the partners and stockholder-owners. The insured business owner may personally provide the funds to pay the life insurance policy premiums even though someone else owns the policy. Merely paying the premiums is not considered an incident of ownership according to the IRS.
Life Insurance proceeds are included in the insured's estate if the insured transfers the policy to someone else for inadequate consideration and the transfer would otherwise be includable under other sections of the Code. "Inadequate consideration" means that a genuine transfer of the policy did not occur and the insured retained certain rights under the policy that make the proceeds includable in the estate. For example, suppose an insured "sold" a $100,000 policy on his life to his son and policy beneficiary for $1,000, but the insured retained certain rights in the policy. Also suppose the policy had significantly more cash value than the $1,000 the son paid for the policy. The IRS would likely consider this a transfer for inadequate consideration. In this case, the difference between the amount the son paid and the fair market value of the policy would be includable in the insured's estate.
When the deceased person is married, an unlimited marital deduction is available to reduce the estate size.
The marital deduction allows an individual to pass all of his or her property, including life insurance policy proceeds, to the surviving spouse with no estate taxation at all. While this deduction solves the problem of paying estate taxes when the first spouse dies, the value of the surviving spouse's estate when he or she eventually dies is then subject to estate taxation and the value might be greater at that time than when the first spouse died. Furthermore, the deceased might not leave all property to the spouse; some property might pass to other heirs, in which case no marital deduction is available for that portion of the property. As a result, property left to any other heirs will be included in the value of the estate.
For jointly owned property, one-half of the value of property owned by a husband and wife jointly will be included in the estate of the first spouse to die. The unlimited marital deduction allows the transfer of the property from the deceased to the surviving spouse without being subject to federal estate taxes.
Whether a life insurance policy is written for business or personal purposes, the general recommendation is that someone other than the insured should own the policy. In most cases, the policy proceeds then can be partially or completely exempt from federal estate taxation, except for the circumstances noted here.
Of course, the insured may intend for the proceeds to be payable to the estate to make the funds accessible to the executor or administrator. In this case, the proceeds are subject to federal estate tax, but that may be preferable to selling off assets in order to close the estate. It is important for the insured to have competent legal and tax advice in determining the most appropriate solution for his or her particular situation.
A properly written Will and sufficient life insurance are the keys to:
The Will can be especially important when the business is to be continued because it clarifies the arrangements that have been made to see that the transition occurs. Legally formalizing these arrangements helps avoid many of the problems that could otherwise arise. Therefore, having a Will that indicates the business will continue and sufficient life insurance to fund expenses during the transition period are necessary for all of the same reasons that exist when the business will be dissolved.
In addition, when the business will be continued instead of dissolved, cash from life insurance might be even more critically needed to maintain the business's reputation. Unfortunately, the death of a business owner can cause both customers and creditors to question the solvency of the business. Customers may take their business elsewhere and creditors may call in debts. Life insurance can alleviate these concerns by providing cash to maintain business operations at the same level as before the owner died.
Instead of dissolving the business or having the heirs become owners, the deceased person's heirs might sell the business interest. Surviving partners or corporate owners might not want to accept a new business associate who has been essentially selected by the heirs by virtue of selling to an outsider, therefore the best solution may be for the surviving partners or stockholders to purchase the deceased person's interest from the heirs. The survivors maintain control of the business and can decide for themselves whether or not to offer a share of the business to someone else.
Planning for sale of the business when the owner dies begins with but does not end with a Will. Additional legal documents, which we'll discuss, are needed to ensure the sale will occur as planned, but the Will can also be used to document the business owner's wishes. Citing the sales agreement in the Will along with the owner's personal bequests can also clarify that all legal statutes are met. For example, in most states, a spouse is entitled to receive a specified minimum portion (often one-half) of the estate of the deceased spouse, regardless of what the Will specifies and regardless of any separate agreements the deceased might have made prior to death. Therefore, mentioning the sales agreement in the Will can confirm in one document that the spouse has been provided for legally elsewhere and that the business may be sold as planned.
To ensure the business will be sold as intended, the owners must execute a buy-sell agreement. This legal document, which requires the advice and assistance of an attorney, ensures that the purchaser will buy and the deceased person’s estate will sell the business as stipulated in the agreement.
Properly written and funded (preferably by life insurance), a buy-sell agreement has benefits for all parties. The purchasers have the confidence of knowing they will have the right and the money to purchase the business interest if the owner dies. They are relieved of concern about how the business interest would be disposed of in the absence of a funded agreement.
For the sellers-the heirs or estate of the deceased-the guarantee that the buyer will purchase the business provides peace of mind, both that the business will be sold promptly and for a fair price and that the proceeds of the business sale will be forthcoming with a minimum of delay. The estate can be closed more quickly without fear that the administrator will be forced to liquidate the assets that make the business valuable.
Even before a business owner dies, a funded buy-sell agreement can be used to demonstrate the strength and soundness of the business to clients, business associates and creditors.
The buy-sell agreement is a legal document that binds all parties to its terms. For this reason, the agreement must be prepared by an attorney who understands the purpose of the agreement and the desires of both the seller and the buyer. The key provisions of buy-sell agreements are as follows:
A buy-sell agreement that is funded with life insurance guarantees that the dollars to execute the agreement will be available when the business owner dies. Some basic questions about the life insurance need to be addressed at this point.
For funding a buy-sell agreement, permanent insurance is nearly always preferable to term insurance. First of all, chances are the business owner will live, rather than die, so the odds are smaller that the policies will be used for their original purpose. Permanent insurance builds cash values that can be used for retirement or other purposes if desired.
Second, although term insurance might initially cost less than permanent insurance, rates will rise as the policy is renewed and the insured person ages. In addition, term insurance will not build cash values that could be used for other purposes.
Agents involved in the sale of business life insurance often are asked whether or not existing life insurance policies can be used to fund a buy-sell agreement. While there is no legal reason why this can't happen, it is not a good idea for at least two reasons. First, the reasons the policies were purchased probably still exist, such as protection for a spouse and children or accumulation of cash values for specific purposes, etc. If the policies are used, instead, to fund a buy-sell agreement, the original needs will no longer be met.
Second, transferring policies can have undesirable tax consequences. For example, there is the transfer for value rule that requires a part of the death proceeds to be taxed as income—which could occur if the potential purchaser pays the insured a lump sum for the existing policy, then takes over the premium payments. The total of the lump sum and the subsequent premiums are not subject to income taxation, but the buyer would pay income taxes on the amount of death proceeds in excess of that total when the owner dies.
Furthermore, the transfer for value rule would apply even if the potential buyer were simply named policy beneficiary or named in the buy-sell agreement to receive the policy proceeds-if the buyer gives any kind of valuable consideration in return. Remember from our earlier discussion that "valuable consideration" does not necessarily mean money.
For example, suppose the potential buyer is an employee of a sole proprietor. The insured proprietor agrees to name the employee as the beneficiary of the existing policy (in order to have the money available to meet the terms of the buy-sell agreement) in return for the employee's agreement to perform certain services without pay. The proprietor has received valuable consideration, from the Internal Revenue Service's viewpoint, subjecting the employee to income taxation under the transfer for value rule. Obviously, an attorney and/or tax accountant must be involved in order to ensure the desired tax outcomes and to prevent undesired consequences.
While these rules apply to other situations as well, you can see that transferring existing policies to fund a buy-sell agreement can have far-reaching effects. Therefore, new life insurance written specifically to fund the buy-sell agreement is preferable.
Since the purpose of the life insurance is to purchase the business, the amount of insurance should be at least as much as the agreed-upon purchase price. That sounds simple enough if an exact amount is specified in the buy-sell agreement. However, some agreements do not stipulate a specific dollar amount, instead describing a formula or some other method for determining the business value in the future. The reason for using this type of valuation rather than a dollar amount is to allow adjustments for future increases or decreases in the value of the business that could occur before the proprietor dies. For example, the agreement could specify a purchase price of $200,000 based on the value of the business in 1994. However, suppose that by the time the owner dies in 2004, his or her share of the business is worth $800,000. While the purchaser would be getting quite a bargain for $200,000, the heirs are likely to be unhappy if they must sell for one-fourth of the actual value.
The question of policy ownership takes into consideration who the buyer is. Remember that the insured should not own the policy to avoid the "incidents of ownership" tax complications. So, whether the buyer is a proprietor's employee or a family member, a partnership or corporate entity, an individual partner or stockholder, or someone else, that person or entity may own and pay premiums for the policy on the person's life and also be the beneficiary of the policy.
Alternatively, a trust maybe established as the policy owner, with the potential buyer making the premium payments. Under a trust arrangement, either the trust or the buyer may be named as beneficiary. If a trust is beneficiary of the policy, the trust is, of course, bound by the buy-sell agreement, so there is no question about whether the benefits will actually go to the buyer to purchase the business. When the buy-sell agreement is written, a provision specifically directs the trustee to collect the life insurance policy proceeds and use them to arrange for transfer of the business to the buyer. All details about how this happens are included in the buy-sell agreement itself.
Depending on the details of the particular situation, a variety of tax consequences may come into play-for both federal estate tax and federal income tax purposes. The tax benefits available to a life insurance beneficiary when ownership is properly arranged apply in the same way when life insurance funds a buy-sell agreement. The beneficiary/buyer is able to purchase the business with the life insurance proceeds, which are income tax free.
Regardless of how the business interest is disposed of, the value of the business must be included in the deceased owner's estate for estate tax purposes. That is, whether the heirs receive the business without a buy-sell agreement or someone purchases the business-with or without a buy-sell agreement-the value of the business is considered part of the deceased person's estate. Determining the exact value for estate tax purposes is sometimes assisted by the existence of a buy-sell agreement.
For federal estate tax purposes, the value of any property included in the estate is its fair market value defined in the estate tax regulations as:
"The price at which the property would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or sell and both having reasonable knowledge of the relevant facts."
Furthermore, the value to be included in the estate is generally the fair market value on the date the individual died. Alternatively, the regulations allow the property to be valued as of six months from the date of death if the estate administrator believes valuation at the later time will result in a smaller estate value and, therefore, lower estate taxes. Once the later valuation date is chosen, this date is locked in so the administrator cannot later decide to choose valuation on the date of death.
The major rule on taxation of life insurance proceeds simply says that life insurance proceeds paid to you because the insured person dies, are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident and health policy or an endowment contract.
If death benefits are paid to you in a lump sum (or any method other than at regular intervals), the recipient must include in his income only the benefits that are more that the amount payable to the recipient at the time of the insured person's death. If the benefit payable at death is not specified, the recipient must include in his income the benefit payments that are more than the present value of the payments at the time of death.
If life insurance proceeds are received by the recipient in installments, the recipient can exclude part of each installment from his income.
In order to determine the excluded part, divide the amount held by the insurance company—usually the total lump sum payable at the death of the insured—by the number of installments to be paid. Anything over this excluded part must be shown on the individual's tax form at interest income.
If, for instance, you receive death benefit from a life insurance policy with the death benefit of $100,000 and you elect to receive it over 10 annual installments. Therefore, any amount that you receive in excess of $10,000 each year will be considered as taxable interest income to you.
If the insurance company pays you only interest on proceeds from the life insurance left on deposit with them, the interest that is paid is taxable as interest income. If the interest payment is the only payment that is received under the policy, then the entire amount is taxable as interest income. The individual or successor beneficiary, who would receive the principal of the benefit, would receive that tax-free. For those receiving annuity death benefits, there are special exclusion ration rules that are applied.
If a life insurance policy is surrendered for cash, the rule is quite basic: Any proceeds that are more than the cost of the policy is taxable. The cost is total of premiums that you paid for the policy, less any refunded premiums, rebated, dividends, or unrepaid loans that were not included in your income.
However, if, for instance, you terminated a policy that had a cash value of $100,000 and of that amount you only paid $80,000 in net premiums. Therefore, $20,000 would be considered as taxable income to you at that point. But if you exchanged one life insurance policy for another policy, it is possible that you may not have a taxable transaction. The rules are rather technical on this matter, so it is imperative that a tax advisor or consultant become involved.
Endowment contracts are not as popular as they once were, and the tax rules are rather confusing as to what amount is taxable and how to calculate the cost. There are a number of ways in which insurance proceeds can be paid, so if an endowment contract is involved, a tax expert should become involved.
Certain amounts that are paid as accelerated death benefits under a life insurance policy or viatical settlement before the insured's death are excluded from income if the insured is terminally or chronically ill.
A viatical settlement is the sale or assignment of any part of the death benefit under a life insurance contract to a viatical settlement provider—defined as a person who regularly engages in the business of buying or taking assignment of life insurance contracts on the lives of insured individuals who are terminally or chronically ill and who meets to requirements of section 101(g)(2)(B) of the Internal Revenue Code.
Accelerated death benefits that meet the IRC requirements for terminal illness or for chronic illness, are excluded from income for tax purposes. However, note that this exclusion does NOT apply to any amount paid to a person (other than the insured) who has an insurable interest in the life of the insured because the insured is a director, officer, or employee of the person, or, has a financial interest in the person's business.
If you inherit property, your basis is considered to be one of the following:
If a federal estate tax return does not have to be filed, the basis in the inherited property is its appraised value at the date of death for state inheritance or transmission taxes.
The 2001 Tax Act provides that the step-up basis rules are to be replaced with a carryover basis system in 2010. As of this date, the carryover basis rules have not been determined by Congress.
In community property states, the basis of the surviving spouse's one-half share of the community property will also receive a step-up in basis, normally to its fair market value, at the date of the decedent spouse's death.
TIP: If you receive property by inheritance, you should request a copy of the estate tax return from the executor to determine your basis in the inherited property.
In community property states (does not include Florida) husband and wife are each usually considered to own half of the community property. When either spouse dies, the total value of the community property (including the part belonging to the surviving spouse) becomes the basis of the entire property. At least half the value of the community property interest must be included in the decedent's gross estate, regardless if the estate files a tax return or not.
If property is held for personal use and then it is changed to business use, or used to produce rent, the owner can then begin to depreciate the property at the time of change—starting with the value of the property value at the time the usage was changed. An example could be something as simple as changing residential property to business property, or renting the property.
The basis for depreciation is the lesser of the fair market value of the property on the date of the change of usage, or the owner's adjusted basis on the date of the change.
If property that has been changed to business or rental use, is later sold or disposed of, the basis to be used will depend upon whether there is a gain or loss.
The basis for determining a gain in property value is the adjusted basis in the property when the property is sold.
The loss is calculated starting with the smaller of your adjusted basis or the fair market value of the property at the time of the change to business or rental use. At that point increases or decreases for the period after the change in the property's use.
EXAMPLE: About ten years ago, you paid $150,000 to have a new house built on a $25,000 lot. You paid $25,000 for permanent improvements for the house, but a storm took off part of the roof that cost $2,000 to repair before renting the property. Land is not depreciable, therefore only the cost of the house is used for calculating depreciation.
The adjusted basis in the house when it became rental property was $173,000 ($150,000 plus $25,000 for permanent improvements, less the casualty loss of $2,000). On the date that the house was declared rental property, the fair market value of the property was $160,000 for the house and $20,000 for the land, so the basis for figuring depreciation on the house is its fair market value on the date of the change ($160,000) because it is less than the adjusted value of the house ($150,000 + $25,000 - $2,000 = $173,000).
Profit-sharing plans with permitted discretionary annual contributions have been used by businesses for many years, particularly smaller businesses which often fall victim to unstable cash flow and who have been attracted to profit-sharing provisions that enable them to forgo making a contribution in any year as long as contributions are substantial and recurring. One of the ways that business owners have used their profit-sharing accounts is to purchase life insurance that is designed to fund their obligations under a cross purchase buy-sell agreement.
The primary method of ensuring the continuation of a business after the death of an owner is to use the buy-sell document. Sole proprietors are particularly sensitive to the problem of continuation after death of the principal, as without proper documentation, the company and the owner die simultaneously.
Corporations have "eternal life," but even so, they can be (and often are) dangerously on the precipice of financial failure upon the death of a stockholder-officer. Regardless of the type of business, ensuring the continuation of the business under the direction of surviving owners is an important business priority.
Except for sole proprietorship, buy-sell agreements may call for the business to purchase the owner's interest at death—an entity-purchase agreement—or may provide for surviving owners to purchase the deceased's interest in a cross-purchase agreement.
When an entity-purchase agreement is used, the business and each owner enter in an agreement whereby the business agrees to purchase the owner's interest at death. When the purchase has been accomplished at the death of the owner, the surviving owners' interest in the business will have increased in value because the deceased owner's interest has been absorbed by the business.
The existence of a buy-sell agreement sometimes helps in valuing property for estate tax purposes when the business is closely held. This can be any small business; don't confuse this terminology with closely held corporations. In this case, the law applies to any type of business controlled by one or only a few people, including proprietorships, partnerships and corporations.
If properly handled, the buy-sell agreement for a closely held business can establish a purchase price that legally binds the Internal Revenue Service to accept that amount as the fair market value for estate taxation. The pertinent section of the Internal Revenue Code states that the value established in a purchase agreement (such as the insurance-funded buy-sell agreement) may be used for estate tax purposes-even if the value is less than the fair market value on the date of death-provided all of these requirements are met:
1. The agreement is a bona fide business arrangement.
2. The agreement is not a device to transfer property to the deceased person's family for less than full or adequate consideration.
3 The terms of the agreement are comparable to agreements entered into in an "arm's length transaction" (defined below).
4. The heirs or the estate must be obligated to sell the business when the person dies.
5. The business owner must be obligated, if he or she chooses to sell the business while alive, to first offer to sell to the purchaser at the price established in the agreement.
6. The purchase price must be fair and adequate at the time the agreement is executed.
7. The purchase price must be established in the agreement or the agreement must include a formula or other method for determining the price.
The term "arm's length" in this case is used primarily to demonstrate the lack of a close relationship between the parties involved. An arm's length transaction is one that is negotiated between unrelated parties, acting independently to serve their own best interests. The assumption is that, because of the independent interests, the arrangement negotiated is based on the fair market value of the property or services involved in the transaction.
A transaction between two related or affiliated parties that is conducted as if they were unrelated, so that there is no question of a conflict of interest. Or sometimes, a transaction between two otherwise unrelated or affiliated parties.
In determining whether or not a transaction occurred at arm's length, tax regulations cite certain factors to consider:
The IRS especially scrutinizes smaller and/or family-owned and managed businesses for abuse of the arm's length transaction requirements since families are more likely to make financial concessions for each other that result in loss of tax revenues for Uncle Sam. Thus, the IRS expects family members to perform business transactions with each other in the same manner they would with total strangers if the purchase agreement is to represent true value for estate tax purposes.
A term used in regard to valuing property for estate tax purposes is an "estate freeze" or a “valuation freeze." The "freeze" refers to establishing a value that will be used for inclusion in the gross estate regardless of the actual or fair market value at the time of death, which may establish a lower value than might otherwise apply if property has increased in value during the time between the agreement's execution and the time of death. Please note, however, this is a highly technical action and will require the services of a tax attorney or accountant.
Tax problems can arise in attempting to establish the business value for estate tax purposes when a buy-sell agreement for less than fair market value exists between family members. For example, a proprietor and a relative might enter into a buy-sell agreement, or an individual's sibling might be one of the partners in a partnership.
Using a buy-sell agreement as a means to establish value for estate tax purposes where the purchase price is less than fair market value when the business owner dies, as stated earlier, the IRS will require that (1) The agreement is a bona fide business arrangement; (2) The agreement is not a device to transfer property to the deceased person's family for less than full or adequate consideration; and, (3) The terms of the agreement are comparable to agreements entered into in an "arm's length transaction."
All three conditions are considered to be fulfilled if more than 50% of the property's value (the business value in this case) is owned by people who are not members of the family and not the "natural objects of the decedent's bounty." Liberally interpreted, the "natural objects" might be not just a spouse and children, but also parents, siblings, grandparents, uncles, aunts, nephews, nieces and cousins of both the deceased and spouse. This requirement obviously excludes a 100% family-owned business no matter how distantly related the family members are. In actual court cases involving family businesses and buy-sell agreements, these requirements have resulted in some unexpected and unfavorable estate tax consequences.
This relatively recent section of the Code can cause tax problems for family members entering into buy-sell agreements. In any discussion of providing life insurance funding in such a situation, the client must have consulted with a tax attorney or accountant.
There are a plethora of methods for valuing a business and there are often disagreements between professionals involved in business valuations. For the purposes of this text, the most common methods will be discussed, starting with the IRS input in business valuation.
In valuing a privately owned business-the type you will most often be involved with-companies must comply with general IRS rulings. The IRS advises that valuation requires careful analysis of all financial data available and all other relevant factors that might affect the fair market value. These "other relevant factors" are then listed—but not intended to be all-inclusive—as follows:
In any given situation, some of these factors weigh more heavily than others. Even in the case of corporations, for example, smaller closely held corporations are not likely to pay dividends at all, so the dividend-paying capacity is a negligible or nonexistent consideration. While these are just general guidelines, each guideline that is appropriate should be applied in order to support an honest and fair business valuation
The alternate valuation date is the earlier of the date 6 months after death and the date on which the estate's assets are distributed, sold, exchanged or otherwise disposed of. Alternate valuation may be elected only if it is necessary to file an estate tax return. Furthermore, use of the alternate valuation date must result in a decrease in the estate tax. The election must be made for all property included in the estate and includes only property that is not sold, distributed or otherwise disposed of within six months after the decedent's death.
Tax experts, such as Ernst and Ernst, believe that choosing an alternate valuation date may be helpful in reducing estate tax if the market value of the assets in the estate is declining. However, in that situation, the tax basis of those assets must also be reduced which means there will be increased income taxes in the future if the market value of the assets rises and they are then sold. Therefore, the decision to elect the alternative valuation date to reduce estate tax should be balanced against a possible increase in future income taxes.
If the decedent used property that he owned for forming, trade or business purposes at the date of death, the executor of the decedent's estate may, under most situations, choose the special-use valuation method for that property. Therefore, the property is included in the decedent's estate at the value based on its current use and not at the value based on what its most lucrative uses might be—if the property is used for farming, the value of the property is based upon its worth as farmland, and not what it might be worth for industrial or residential purposes.
There are special conditions that must be met before the special-use valuation method can be used, and they are sufficient complex to require the advice of a tax advisor.
The maximum amount that the special-use method can decrease the value of the estate is $940,000 (in 2007), increased each year for cost-of-living adjustments.
One of the most popular approaches to business valuation for purposes of a buy-sell agreement is negotiation—the parties to the agreement simply negotiate and agree upon a price that all parties believe is fair. This is sometimes referred to as the agreed value method-though it is less a method than simply a means of assigning a price. Both the owner and the potential purchaser are in good positions to know how much the business is worth and to trust each other's judgments-especially if they are already co-owners of the business. However, it is often a good idea to have a professional appraisal because business owners have been known to both overprice and under-price the value of a business inadvertently. An appraisal will indicate whether the perceived value is at least close to the appraised value.
When a business is valued by negotiation, subsequent annual evaluations are absolutely necessary and provisions for these annual reviews must appear in the buy-sell agreement. Since the value of a business is subject to both increases and decreases, this step is vital to providing a fair business deal for both parties. For example, Partner X and Partner Y might agree upon a purchase price of $150,000 for each partner's business interest. Ten years later, Partner X dies after the two partners have built a million dollar business. It is easy to see how unhappy the deceased person's heirs will be to accept $150,000 for a business interest now worth half a million dollars.
Surprisingly, though annual reevaluation is so important, it is often overlooked. As a result, many buy-sell agreements also include a provision that if a new price is not agreed upon annually, one of two things will occur: either another valuation method (usually a formula approach as discussed below) automatically takes precedence; or an independent professional appraisal will determine the purchase price if the buyout is triggered by the individual's death and no recent review (timing of "recent" must be specific) has occurred, e.g., the agreement could stipulate the appraisal must occur if no new price has been agreed upon within two years after the date of the last valuation.
The agent can play a special role in the annual evaluation as an increase in the business value calls for additional life insurance to fund the buy-sell agreement. A calendar should be maintained by the agent of the annual valuation dates and then notifying clients when it is time to arrange the review. This would be mandatory for the agent that had arranged the funding policies for the original buy-sell agreement—by neglecting to inform the client, the agent is leaving additional insurance "on the table."
Book value is the value any given asset is assigned for purposes of the business's balance sheet, based on the cost of the asset minus accumulated depreciation. Considering the entire business as an asset, book value is the company's net worth—the sum of its assets minus its liabilities. The major problem with book value is that, because it is based on the original cost of the asset without regard for intangibles or for conditions in the marketplace, the book value of a business can be significantly different from its fair market value. Very often, the book value is less because a significant part of a business's success can be attributed to intangibles the owner has built up over the years, such as goodwill, trade secrets, exclusive contracts, advertising techniques and even increase in property value of the business location.
Adjusted book value is book value that has been modified. For example, the value of certain assets could be adjusted to their current market value and book value could be adjusted to reflect accounts receivable and payable. Although book value is unacceptable for many types of businesses, it can be useful when certain conditions exist. For example, in some businesses, most assets are current assets, such as inventories or accounts receivable. Assets such as these frequently can be liquidated quickly at a price close to their actual value. However, for businesses that do not have this profile, book value is less realistic.
Some formulas involve capitalization of earnings, which refer to the firm's average net earnings over a specified period of several years, multiplied by a certain factor. The multiplier or capitalization rate used for this purpose is usually one that has been established for a particular industry and can be obtained from a trade association. For example, if average net earnings over the period are $100,000 per year and the multiplier is three, value is set at $300,000. Like book valuation, however, this formula method ignores intangibles. Furthermore, capitalization of earnings also ignores the value of any other tangible assets such as inventory, equipment and accounts receivable, all of which can be significantly valuable in certain businesses. On the other hand, capitalization of earnings formulas can work well when the value of the business is based almost exclusively on professional services such as those provided by accountants or lawyers. Exceptions include professional operations that want to include the value of real estate or, in the case of a professional business with important name recognition, the value of the name, which could be a significant intangible asset.
The "value of the name" of the business, or its reputation, brings up another important consideration in using a capitalization of earnings formula. The death of the owner who built the reputation that goes with the name could conceivably result in a sudden drop in earnings. For example, suppose a law firm's reputation is closely tied to founder J. J. Barlow, even though Barlow employs dozens of competent attorneys who perform 95% of the legal work. If the association with Barlow is the factor that makes the firm successful, Barlow's death can result in business being moved elsewhere even if a new owner has the right to retain the Barlow name. Therefore, potential loss of earnings should be considered in valuing a business based on capitalization of earnings.
A common criticism of formula approaches is that, while they may appear accurate and fair for any one year of business, formulas might produce unfair results for another year when changes occur in economic conditions or in the business itself. To counteract the problems with formulaic approaches, some buy-sell agreements include provisions that tie the capitalization multiplier—for example—with a known economic indicator. Other provisions might specify that, if profits exceed or do not meet certain margins in certain years, those years will be excluded in determining average earnings or that instead of net earnings, gross revenues will be used.
Particularly, for a large business or rapidly growing business, an independent outside appraisal performed by a professional appraiser is often used. Later, reevaluations are required to keep the value up to date. While annual appraisals are not necessary, changing economic conditions should trigger periodic reviews. Professional appraisals can be costly and are not always perfect as often with large businesses or those with exceptional growth, there are no other similar businesses with which to compare. However, a competent appraiser is likely to ask the questions that generate information about what makes a particular business unique and as a result, might actually add intangible value.
One of the benefits in using professional appraisers, when appraisals are questioned, particularly involving third parties and/or the IRS, courts have usually relied upon independent appraisals in business valuation questions. All parties are likely to be more satisfied with the opinion of an unbiased outsider, especially if the buyer and the seller have wide differences of opinion regarding the value of the business. Also, this gives the owners more than just a "feel" for the value of their business and often the independent evaluation can use the appraisal in various business transactions, such as opening a line of credit with suppliers, borrowing from financial Institutions and even dealing with a corporate board of directors.
The need to appropriately value a business for purposes of funding a buy-sell agreement with life insurance is readily apparent. The amount of life insurance purchased to fund the buyout should equal, as nearly as possible, the purchase price. If full life insurance funding is economically unfeasible, buy-sell agreements may be written to provide for a down payment from the buyers, who will then make a series of smaller periodic payments. In this case, the initial amount of life insurance should equal at least the agreed-upon down payment. However, clients should be encouraged to purchase as much insurance as they can afford in addition to the down payment to provide for cash needs through the transition period after an owner's death. And, at each annual or other periodic review of the buy-sell agreement, be prepared to offer additional life insurance to meet increased cash needs, whether for funding the buyout or for other expenses that arises at death.
As stated earlier, an accurate business valuation for a buy-sell agreement can freeze the value for estate tax purposes. One of the most important issues is that the price must be acceptable to the IRS, which ultimately decides how much estate tax is due. Whether the agreement is between a business owner and an outsider, an employee, or a family member, fulfilling the arm's length transaction requirement is a key factor. Many IRS rulings and court cases have held the buy-sell agreement valuation to be binding for estate tax purposes provided the value was reasonable when the agreement was executed, even if the price appears to be less than fair market value when the owner died, and the valuation could be justified on its own merits. In other words, an arm's length transaction, while key, is not sufficient per se if it appears an inadequate price was arbitrarily set.
In establishing the buyout price, the parties to the agreement must also be careful because if the IRS does not accept the price for estate tax purposes, the heirs can suffer a double loss. First, the price is likely to be binding for the sale; that is, the heirs must sell the business at the price in the agreement. However, the IRS may assign a greater value that must be included in the estate for taxation. The result is that the estate must pay more taxes on a value greater than the estate actually received from the sale of the business. In summary, then, valuation for a buy-sell agreement can be binding for estate tax purposes if the parties involved are careful to use a reasonable approach in establishing a value and are able to substantiate for the IRS that the value is appropriate and meets IRS guidelines.
1. A term that technically refers to proving the validity of a Will, but which is commonly used to describe the entire process of administering an estate is
A. for value.
B. estate freeze.
C. Will verification.
D. transfer probate.
2. Life Insurance proceeds are generally
A. exempt from income taxation.
B. taxable.
C. taxable for the portion that exceeds the premiums paid.
D. taxable, unless the beneficiary is the deceased person’s spouse.
3. The federal estate tax applies to
A. an individual’s right to transfer property to others upon the individual’s death.
B. all income earned by a deceased person in the 3 years prior to his/her death.
C. property left to a deceased person’s spouse.
D. all property owned by an individual at the time of his/her death.
Federal gift tax is not imposed on gifts of _____________ or less per year per beneficiary.
5. Life insurance policy proceeds must be included in the value of an estate when the
A. estate pays the premiums.
B. proceeds are payable to the insured’s estate.
C. proceeds are payable to the insured’s heirs.
D. policy was term insurance.
6. The ________ provision of the tax code allows an individual to leave all property to a spouse at death free of estate taxes.
A. unified credit
B. gift tax
C. unlimited marital deduction
D. income tax
7. A properly written buy-sell agreement
A. binds the seller and buyer to the purchase price stipulated in the agreement.
B. gives the seller’s spouse the ability to void the agreement.
C. leaves the purchase price to be determined by the seller’s heirs in the future.
D. does NOT bind the seller’s heirs or estate.
8. The minimum amount of life insurance that should be purchased to fund a buy-sell agreement is:
A. $500,000.
B. an amount at least equal to the purchase price.
C. an amount equal to the stipulated purchase price plus 10% to account for future increases in the value of the business.
D. an amount determined by the agent.
9. When a business owner dies the value of his/her business interest
A. is not included in his/her estate.
B. must be included in his/her estate.
C. is not included in his/her estate if there is a buy-sell agreement.
D. passes directly to the heirs’ estate tax free.
10. The IRS requires that the value of property to be included in the deceased person's estate is the fair market value on (at)
A. the date the deceased originally acquired the property.
B. six months from the date the individual died.
C. the date the individual died.
D. the date the individual died or six months later, at the executor's option.
ANSWERS
1D 2A 3A 4D 5B 6C 7A 8B 9B 10