Family Business Interests, Charitable Remainder Trusts and Life Insurance: Q & A with Capital Strategies GroupBradley’s Family Owned Business team asked our friends at Capital Strategies Group, Inc. to share a case illustrating how high-net-worth families involved in family businesses are using life insurance in creative ways that go beyond the standard uses for term or whole life policies. Here’s a Q & A with Preston Sartelle, Director of Business Development at Capital Strategies Group, Inc., that shows how a large block of life insurance can enhance the results and yields of business succession and estate plans for families.

Capital Strategies: We recently had the pleasure of working with a family of first-generation wealth looking to exit their business in a way that met several goals. First, they wanted to pay as little income tax as possible, which was problematic due to the extremely low basis in their company stock. Second, they wanted to provide a significant benefit to charity, and third, they wanted to maximize wealth to the second generation. After considering various options, the family settled on a Charitable Remainder Trust (CRT) combined with a life insurance policy insuring a family member from the first generation.

Bradley: It is likely helpful to offer a basic explanation of the workings of a CRT in this situation. There are, of course, several types of CRTs, each with complicating nuances, but the basic steps are relatively simple:

  1. The owner (donor) transfers the business interest to a CRT that is structured to pay the donor a specified amount during life, or for a certain term of years, with the remainder going to one or more designated charities or to a private foundation.
  2. The donor will be entitled to an immediate income tax deduction for the present value of the remainder interest given to charity, subject to the standard limitations on charitable deductions.
  3. The CRT is a tax-exempt entity and can sell the business interest without incurring capital gains tax at the trust level, thereby allowing the sales proceeds to be reinvested by the trust undiminished by taxes.
  4. During the donor’s life (or for the term of years), the CRT will distribute to the donor either a set dollar amount or a set percentage of the trust’s value determined annually—an income stream that the donor would not otherwise have if the interest was held until death. Each distribution is reportable by the donor as taxable income to the extent of any income that would have otherwise been recognized by the trust. In other words, any capital gains triggered by the sale are deferred over the course of the distributions to the donor, providing a tremendous advantage to selling the interest outright with all gain reported in the year of the sale.
  5. At the donor’s death (or at the end of the term of years), the charity or private foundation receives all remaining assets held by the CRT.

Bradley: What are some of the non-tax benefits of combining the CRT with an insurance policy?

Capital Strategies: The CRT can provide a boon to the next generation where the donor allocates the CRT distributions to a life insurance contract on the life of the donor. Often the amount of death benefit purchased with the CRT distributions far exceeds what the donor’s heirs stand to inherit from the business net of estate taxes.

As a quick example, consider a 70-year-old donor who owns $5 million worth of zero basis stock in the family business—a roughly $1.2 million capital gains tax liability if sold today. If the stock is retained by the donor and transferred to children at death after growing at 5 percent for 15 years, the children would inherit roughly $6 million net of estate taxes assuming the donor’s estate tax exemption had been otherwise used.

Instead, the donor could transfer the stock to a CRT, providing an income tax deduction for the present value of the remainder interest. The CRT could then sell the stock and pay the donor a 5 percent annuity for life, all or a portion of which the donor could use to purchase a life insurance contract. So, let’s assume a roughly $190,000 annual distribution to the donor, net of capital gains and income taxes – the actual amount will of course depend on actual CRT earnings.

Bradley: What are some other factors to consider?

Capital Strategies: The amount of insurance that could be purchased with the CRT distributions will depend on several factors, not the least of which is the donor’s health. If the donor is a standard, non-smoker underwriting risk, a universal life policy to the age of 100 with a lifetime premium schedule of $190,000 would result in approximately $6.85 million of death benefit proceeds to the next generation net of income and estate taxes—the amount the heirs stood to receive previously plus a 14 percent bonus. And, of course, the charity receives the residue of the trust, the amount of which will depend on the trustee’s investment experience during the CRT term. Earning a return equal to the 5 percent annuity rate will leave the charity the original $5 million principal.

Takeaway

CRTs can afford donors an efficient exit from an otherwise precarious tax position and make both the charity and the family better for it. Working with advisors such as Capital Strategies, Bradley’s team can recommend several ways life insurance, when structured intentionally and correctly, can elevate a client’s business or estate plan.

Do You Need Directors and Officers (D&O) Insurance for a Family-Owned Business?Family business owners may assume that D&O insurance coverage is necessary only for publicly traded corporations and large, non-family owned private businesses. That is not the case. Individual directors and officers of a family owned business may be subject to many of the same types of claims as their counterparts at other businesses—claims by employees, disgruntled shareholders, customers, competitors and government regulators.

The first line of defense for directors and officers is indemnification by the corporation itself.  Most corporate bylaws (and operating agreements for limited liability companies) contain indemnification provisions under which the corporation may be obligated to pay defense, settlement and judgment costs for individual directors and officers. The corporation’s indemnification, however, is only as good as the corporation’s ability to pay. And in a family-owned business, where a substantial portion of the owners’ personal wealth may be tied up in the business, indemnification by the corporation essentially means family owners making payments out of their own pockets.

Properly structured D&O coverage can help to shift the financial risk of claims to the insurance carrier. In addition, it will be difficult to attract and retain qualified directors and executives from outside of the family unless the corporation has D&O coverage. D&O policies generally contain three types of coverage:

  • Side C coverage is coverage for the corporation itself.
  • Side B coverage reimburses the corporation for money that it has paid to indemnify individual directors and officers.
  • Side A coverage provides coverage for individual directors and officers that are not indemnified by the corporation.

The coverage should be structured to protect both the corporation and individual directors and officers.

Before purchasing coverage, you should carefully review the key policy provisions with your broker or an independent insurance expert. Key provisions include the definition of “claim,” the policy limits, the deductible or self-insured retention amount, and the policy exclusions. As with most insurance policies, D&O policies contain a number of exclusions. Of particular importance to family businesses is the “family exclusion.” D&O policies routinely exclude coverage for claims brought by family members against the corporation or other family member directors and officers. Carriers want to avoid being pulled into family disputes and also avoid collusion between family members to fabricate claims. The family exclusion typically extends to multiple generations and will include shares held in a family trust. If you are concerned about obtaining coverage for potential claims by disgruntled minority family shareholders, you should carefully review the terms of the family exclusion with your broker before purchasing coverage.