by Karen Murphy, MostChoice.com

According to a December 1998 study by Congress's Joint Economic Committee, estate taxes are the main reason small businesses fail to survive beyond one generation. 

Paying estate taxes that arise when a business owner dies can seriously hinder the success of a second-generation business. Operating without a plan to lessen this burden can be disastrous, with estate taxes claiming up to 55% of your assets. 

Estate taxes are generally due within nine months from the date of death and payable only in cash. If the business owner makes no provision to pay these taxes upon his or her death, the heirs may be forced to liquidate the business itself to cover the costs. 

Because it pays out a cash settlement upon death, life insurance can safeguard the future of your business by covering these taxes owed within a year after your death. In addition, its return on investment is quite good. Business owners may pay annual premiums of several thousand dollars for policies that will pay out a million dollars or more at death.

Providing the liquidity needed to pay taxes without depleting the business's working capital is another advantage of life insurance. Thus, it can cover the cost of the business during the time it takes to settle an estate. 

Finally, although insurance premiums are not tax deductible, the proceeds are free from income tax. If the decedent does not own the policy, the proceeds are not included in his or her estate. Life insurance premiums begin immediately and cease at death when the insurance proceeds are used to purchase the business. In contrast, the cost of heir or third-party financing will not begin until death and will continue until payments are completed.

Split Dollar Funding for Business Succession

When arranging for the transfer of a business from an older generation to the younger, a split dollar funding arrangement can be quiet useful. In this case, the cost of the insurance is split between the corporation and the younger members. 

The older members of the corporation are the insureds and the younger members are the applicants and owners of the policies. The corporation pays the bulk of the non-deductible premium each year. The proceeds, paid at death to the business, are income-tax free. At this time, the younger members are paid the difference between the face amount of the policy and the company's premium investment. 

Second-to-die Insurance

Second-to-die insurance covers a business owner and his or her spouse or business partner, but pays off only on the second death.

Much less expensive than individual life insurance, second-to-die insurance is generally used to fund estate tax liabilities. Using split-dollar with second-to-die insurance enables an individual to have his or her corporation fund the insurance premiums. 

By making an Irrevocable Life Insurance Trust the owner and the beneficiary of a second-to-die life insurance policy, it may be possible to substantially reduce the value of the benefit to the trust.

Key Person Life Insurance 

A key person life insurance policy can be structured to help avoid estate taxation as well as providing the funds necessary to assure a smooth transition at the loss of a key person.

In a key person plan, the business applies for, owns, and is named as the beneficiary of the policy bought for each key person within the business. The premium payments made by the business are nondeductible.

If you have partners, a key person policy may include a buy/sell agreement. In the event of your death, your partners would use the death benefit to buy your share of the company from your dependents. These policies may be of a split-dollar type, where the company and the key person share both the premium costs and the death benefits.

You can avoid estate taxation of the split-dollar death benefits if you arrange for the incidents of ownership to be help by a third party, such as an Irrevocable Life Insurance Trust or a family member.

Economic Benefit as a Gift

If the insured pays the premium for a policy owned by an irrevocable trust, the beneficiary is subject to income tax on the economic benefit. This economic benefit is considered a gift to the trust.

Because these gifts to the trust are measured by the economic benefit instead of the actual premium, the insureds often have not used their entire annual gift tax exclusions, allowing them to continue their other gifts to their beneficiaries. In addition, these gifts help reduce the insureds' estates.

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