When you expect a family member to take over your business after you’re gone and you have other family members not in the business, you could have an estate equalization problem. A hypothetical example best explains how estate equalization works with one efficient way to equalize an estate – life insurance.
Jason owns a $10 million business that he expects to pass on to his successor, daughter Nicole. Jason has two big problems if he is to fulfill his dream. First, he has plenty of non-liquid business, but little cash, and his estate will need cash to meet eventual estate taxes. The federal estate tax exemption is capped at slightly over $5 million per individual, so Jason’s estate would have to pay taxes, beginning at 40%, on the other $5 million – or more if the business appreciates. Jason’s second problem is that he has a son, whom Jason wants to inherit an amount equal to the value of the business Nicole gets.
It’s important to note that under the Tax Cut and Jobs Act, Pub. L. 115-97, the federal estate tax exemption increases to about $10,000,000 in 2018. This will potentially reduce the need for some to have life insurance as a part of their estate plan.
Life Insurance Provides Needed Cash
Unfortunately, Jason doesn’t have the cash to make that happen. In fact, he doesn’t even expect to have enough liquid assets to meet state and federal estate taxes. But he does have a partial solution – life insurance. For pennies on the dollar, term life insurance provides a death benefit that is income tax-free, but not estate tax-free, to beneficiaries.
Jason’s solution to the estate tax problem includes a life insurance trust. Jason, as the grantor, creates one and transfers an existing life insurance policy on his life to the trust. He can also gift cash to the trust to buy life insurance on his life. The trust becomes both owner of the policy and beneficiary of the death benefit. When Jason dies, the trust documents dictate that the assets in the trust, including the life insurance benefit, go to beneficiaries named in the trust document. These assets are now estate tax-free.
In this scenario, the life insurance benefit equalizes the estate and takes care of estate taxes so that Nicole can continue to run the company her father founded.
If you establish a life insurance trust, you cannot act as its trustee. Consider a bank or other financial institution to take on this task. The trust must also exist at least three years before you die.