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Creative Uses of Second-To-Die Life Insurance
Making families whole
Why do so many family owned businesses fail and create discord among the families when an owner dies? Follow the money. It’s usually distributed unequally, contrary to the owner’s intent.
Objectives of the second-to-die tool
Applications of second-to-die insurance
Side bar
Life Insurance Premiums
As a % of Total Benefits*
Insured age
Single life
Premium as % of benefits
Survivor life
50
1.0%
0.72%
60
1.8%
1.25%
70
3.0%
2.1%
On policies with multi-million dollar benefits, the differences are significant.
*Percentages assume preferred, non-smoking rates.
Uses for second-to-die coverage in businesses
Most privately held companies or partnerships with two or more related owners have debated how to fairly divide the company among the families involved when one of the principals dies. In the case of a rapidly growing company such as McCoy Aerospace with two related owners, when one dies and the company is later sold, the surviving owner’s family gets a huge windfall in which the first deceased’s family doesn’t participate.
Estate planners and insurance professionals alike often attempt solving the problem with individual life insurance policies on all the business owners. Apart from being expensive, that can work if none of life’s variables occur. But what happens if one of the owners is uninsurable for whatever reason? Even many insurance professionals would say there’s nothing that can be done.
Untrue. Second-to-die insurance solves the problem of uninsurability and fulfills the objectives stated earlier.
Mechanics of the transaction
We have two housekeeping objectives associated with this transaction: First, keep the insurance proceeds out of the taxable estate of the second insured to die. Second, avoid the three-year contemplation of death rule. We can accomplish both objectives by creating an irrevocable life insurance trust that we establish before signing any life insurance applications or submitting to any medical examinations.
Alternatively, contemplation of death issues can also be resolved by doubling the insurance benefits during the first three years in order to pay the estate tax if the policy unfortunately remains in the estate. There’s only a minimal charge for this. Doing so allows the insurance company to begin medical underwriting immediately and communicating with the client’s medical team in advance of the trust agreement being executed. However, ideally, the insurance policy remains outside the estate to avoid confiscatory taxation.
Alternatively, use of a substitute application allows the underwriting process to formally begin. However, the insurance is not included in the estate because the owner in the substitute application is the insurance trust. Both approaches accomplish the same thing—keeping the insurance policy out of the estate.
The payout process of second-to-die insurance
The irrevocable life insurance trust purchases the insurance policy, naming itself as owner, applicant and beneficiary. When the second insured dies, the second-to-die policy pays the insurance death benefit, passing the proceeds directly to the insurance trust. These funds provide the liquidity to pay taxes owed.
Additionally, a business owner previously denied life insurance coverage, may be approved for a second-to-die policy with someone—most likely a family member—with whom there is an insurable interest. After all, two lives are insured instead of one, with the benefit not paid until death of the second insured.
Practical application: Simple case with one owner
Suppose that Leon is the sole owner of a retail store chain that grosses $25 million annually. Leon is just 52 years old, but was denied a regular life insurance policy because of poor health. What can he do so his estate avoids paying a substantial portion of the corpus out in taxes? Also, how can he see that his heirs aren’t forced to sell a part of the company at a potentially disadvantageous time? The answer is to insure someone else who can stand in Leon’s uninsurable shoes. This person must be someone in whom Leon has an insurable interest.
Scenario 1: Leon dies first
If Leon were to die first, there is no insurance benefit paid yet since the policy is for the second-to-die of the two insured parties—Leon’s father since Leon himself predeceased Dad. In the interim, Leon’s estate owes tax on the transfer of the company to Leon’s heirs. One option is to take out a loan, pay the tax owed, and then repay the loan with insurance proceeds on the Father’s death. Often such loans are interest only and use the business assets themselves as security.
Alternatively and in conjunction, Leon’s estate may employ Internal Revenue Code Section 6166, Deferral Options, to treat a portion of the tax liability. This Section is intended for use by closely held businesses provided:
If Leon’s company meets these standards, then up to a maximum of $552,000 in estate taxes attributable to transfer of the business interest may be deferred up to four years, paying interest only at the rate of 2 percent. After that, for a maximum of ten years, the estate can pay annual installments of interest and principal.
On death of the Father, the tax-free proceeds from the second-to-die policy may be used to pay off the loans (the $552,000 owed the IRS and the loan taken to pay any additional tax owed over this amount). The estate is made whole without invading its corpus or having to sell a part of the company at a possibly inopportune time.
Scenario 2: Leon outlives his father
Say that Leon’s father is the first to go. As before, there is no insurance benefit paid since the policy is for the second-to-die of the two insured parties—that would be Leon in this scenario. Neither, however, is any estate tax due since there is no transfer of assets. Leon was, and still is, sole owner of his retail store chain. When Leon does succumb, the second-to-die insurance benefits paid on his death are used to pay the estate taxes when ownership of the company transfers. No loan is required as was the case in Scenario 1 above. Neither is the estate’s corpus invaded or is a part of the company sold just to pay estate taxes.
Practical application: More complicated case with two owners
Going back to John and Robert McCoy whom we met earlier and who have positioned their McCoy Aerospace to enter a period of explosive growth. Assume both brothers are just 56 years old and in excellent health. The two purchased single life policies on each of them with a $5 million death benefit and a second-to-die policy on them both with a benefit of $35 million—an amount they estimate the company will be worth at the end of McCoy Aerospace’s anticipated growth period.
The purpose of the single life policies is to allow one brother to buy out the other’s interest in the company on his demise. The second-to-die policy provides an instrument to equalize the cash flow to both estates and the two brother’s families after final sale of the company. Here’s how it works:
Harsh family discord follows—to put it mildly. The disharmony is proportional to the $40 million difference in the value either side has received so far. John’s side feels they were robbed of something that was rightfully theirs since their father was co-architect of the growth plan and Uncle Robert was merely the caretaker who happened to be around while it happened. Robert’s side believes their dad was really the brains behind the company who worked the growth plan, turning mere thoughts and ideas into economic reality. This family enmity is clearly not what both brothers planned when they undertook their insurance policy strategy. The solution follows.
6. Before their deaths, John and Robert instructed their respective estate trustees to distribute whatever monies were necessary to maintain fairness and harmony between both families. However, John’s heirs have now received a total of $45 million ($5MM from buy-out by Robert on John’s death plus $5MM single life benefit from Robert’s death and the $35MM benefit from the second-to-die policy). Robert’s estate receives all of the $45 million proceeds from sale of McCoy Aerospace. Family proceeds are now balanced as the two brothers had planned before either died. The second-to-die insurance strategy worked at restoring family harmony.
Certainly, the trustees of both estates could have adjusted the monies paid to both estates since the company did indeed prosper during Robert’s tenure. The point is, because the second-to-die insurance worked, the trustees had the funds to distribute equitably between the families to maintain harmony and fairness of distribution in accordance with both brothers’ wishes.
John
Robert
Total
Ownership of McCoy Aerospace
$5MM
$10MM
Single life payout to Robert on John’s death. Used to buy John’s interest in the company.
$0
Robert dies: Single life distribution
$5
0
Second-to-die distribution
$35MM
Trustee sells McCoy Aerospace
$45MM
($45MM)
Total funds received
What if the company declines?
Just as company fortunes may improve after the death of one owner, they may also decline. For such companies, buy-out of the interest owned by the deceased owner’s estate is worth more than the surviving partner’s at a later time. What to do to make things fair?
Following the same fact set as used above for McCoy Aerospace, Robert McCoy uses the $5 million single-life policy to buy out Brother John’s interest in the company on his death. At that point the company is worth $10 million. However, say their plans to position the companies for explosive growth don’t work out. Now it seems that John’s estate enjoys the windfall by receiving the $5 million buy-out for a company whose value has dropped from $10 million to $4 million in just two years. When Robert dies and the estate’s trustee sells the company for that amount, Robert’s family comes up way short. Certainly this does nothing to ease tensions between the two brother’s families. Of course, John’s side may claim that Robert was incompetent. Therefore, his heirs don’t deserve an equal share of what the company was once worth with benefit of John’s watchful guidance.
However, if both partners—while living—intended to give their respective families an equal share after their deaths and to eliminate family discord due to unequal distribution, then second-to-die insurance could also save the day if the company’s fortunes decline. The estate planning attorneys must take great care in drafting the trust to provide the trustees with sufficient discretion to achieve the owners’ goals on their demise. Here’s how it’s done:
Summary of Funds distribution: Declining Fortunes
Single life payout on John’s death to Robert, used to buy out John’s estate’s interest in the company.
$0MM
$4MM
($4MM)
Trustees balance distribution to both estates
($20.5MM)
$20.5MM
($41MM)
$24.5MM
Of course, with this much money at stake, no matter what both trustees agree to, someone will complain. John’s trustee could have discounted or eliminated entirely the monies paid to Robert’s estate since the company did indeed remain stable during John’s tenure. The point is, again the second-to-die insurance provided the funds to distribute equitably between the families to maintain harmony and fairness of distribution.
Certainly, both families would have been better off had the company prospered according to plan. However, it’s difficult to feel too sorry for a family receiving over $24 million.
Most insurance companies are used to viewing second-to-die insurance as used between two spouses. The intent is that any estate taxes payable by the next generation comes out of insurance proceeds rather than the estate’s corpus. The departure from this custom comes when using second-to-die insurance to balance distributions between company owners as with the McCoy brothers or to provide insurance benefits for someone who is uninsurable. Often applications for second-to-die policies have different results than applications for single life policies.
The explanation of the intent to the insurance company turns on insurable interest. The insurance agent must persuade the insurance company the beneficiary has a greater interest in the insured being alive than deceased. For family members, this presumption is usually automatic and presents no real issue. As in the case of the McCoys, there is also an underlying business reason for using second-to-die insurance for both owners. Once the underwriters understand the two insureds are business partners as well as brothers and the insurance is for estate balancing purposes, any questions are usually resolved.
Indications that second-to-die coverage is applicable
Situations and facts vary widely when strategizing the components that go into thoughtful estate plans. It’s like putting the pieces of a jigsaw puzzle together. Each has its place in the whole, but each must fit with the others. Here are the indicators we think flag how second-to-die insurance could be applicable to particular situations:
Business ownership structure
The most common business applications for second-to-die insurance are with family owned companies where the owners are somehow related. Ownership could be among siblings, parents and children, uncles and other second-tier relatives. Family ownership puts to rest any issues of insurable interest. It further provides trustees with the funds necessary to settle family acrimony caused by an unbalanced distribution of funds.
However, ownership doesn’t necessarily have to be limited to just two owners. Though more complicated, the strategy of having multiple insureds for estate balancing purposes where a company is concerned may be appropriate in certain instances. The driving criteria are:
The risk of illiquidity and forcing a disadvantageous asset sale to raise money for expenses
Owner’s insurability
Estate and company size
The minimum estate value must be at least $2 million to make tax liability a consideration. Estates with values lower than that generally don’t pay estate taxes. Companies that are (or will be) part of the estate can be any size. However, if the company is illiquid (as most are) or if its assets consist largely of real property whose forced sale could be economically disastrous, then second-to-die insurance may provide a solution regardless of size.
Multiple marriages
Analyzing proposed policies
After incorporating a second-to-die insurance strategy into the estate plan, how can we make sure the policy does what it’s supposed to? Many just trust that to the insurance agent trying to sell the policy. However, there are some simple things non-insurance professionals can do to determine if a proposed second-to-die policy accomplishes what the estate plan intends.
Look at the illustration for the proposed second-to-die policy. Illustrations work with three variables: The premium, cash surrender value and death benefits. They compute one variable based on assumptions for the other two. The result is usually both a guaranteed and a nonguaranteed rate. The guaranteed rate is the worst case scenario with the lowest interest rates and credits to the policy and the highest mortality payout expenses. This is the performance the carrier has promised. From this, you can readily see the premiums, cash surrender value and death benefits of the policy. Ask, even under the worst case scenario, does this policy provide the funds to accomplish our intent?
Next, review the assumptions the carrier used to compute the illustration. These should match the age, sex and underwriting health status of the prospective insureds. If they don’t, there is an error somewhere and the illustration is invalid for your purposes.
Few trusted advisors would recommend an insurance carrier with questionable financial stability. Depending on how often you need it, the Vital Signs report (www.lifelinkpro.com by fee subscription) provides ratings of all insurance carriers by the major rating services (A.M. Best, Standard & Poor's, Moody's, Fitch, and Weiss). Determine if a carrier is losing money in either operating results or its investment portfolio (or both areas). Such losses are a possible warning sign of problems in future policy performance. Since the objective of the second-to-die strategy is to insure two lives, the insurance carrier must be stable for a longer time horizon.
Some illustrations provide two nonguaranteed columns in their illustration instead of just one. This usually pegs interest credits halfway between the guaranteed and the current/nonguaranteed assumptions. This second nonguaranteed projection doesn’t identify the most likely case. It’s just a halfway point in the interest rate projections, nothing more. The mortality charge assumptions do not usually change for either of these nonguaranteed illustrations.
Capability of the insurance professional
Competence of the insurance representative providing expert advice is critical when considering a second-to-die strategy. Be sure the representative has these minimum qualifications:
Request an inforce reprojection
Once the second-to-die policy is purchased and in place, the job is not finished. As time goes on, it’s always a good idea to ask the insurer for an inforce reprojection. This shows any changes in credits or charges the carrier has declared for the next policy year. Carriers don’t normally issue inforce reprojections unless requested. Watch for:
Vanishing premiums
Some clients balk at paying premiums. The insurance industry counters with illustrations showing “vanishing” premiums. This doesn’t mean the second-to-die policy is paid. It simply means the policy cash value and earnings cover the premium so it appears to vanish in later years. However, during periods of declining investment portfolio performance and of rising mortality expense, premiums that once vanished have a nasty habit of returning. Be aware of this and communicate the potential of having to write a check to pay the premiums to the client.
Understanding the words
Conclusions
Second-to-die insurance is one of the creative products the estate planning industry can use to achieve its clients’ financial goals. Future creative uses of insurance to accomplish very specific financial goals where one or more unknowns can affect the outcome will likely separate the industry leaders from the rest.
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About the authors
Joel Kabaker, MBA, CLU, ChFC has over 25 years of insurance, finance and estate planning experience. He has successfully employed the risk management program described in this article in his practice many times over. Joel is a principal at Simon, Altman & Kabaker, one of California’s premiere insurance brokers. The professional resources of his firm span insurance, estate planning, succession planning and consulting. Contact Joel at jkabaker@sakinsur.com.
Michael Altman is also a principal at Simon, Altman & Kabaker. His business focuses on estate analysis for high net worth individuals and families. Michael has a national reputation in planned giving and charitable endowment. He is a frequent lecturer and fundraising trainer for numerous charitable organizations. Contact Mike at maltman@sakinsur.com.