The scene is familiar one. The client, seated at the head of his large conference room table, is the sole owner of a successful business that comprises a significant portion of his taxable estate. Joining him around the table are his estate planning and corporate attorneys, audit and tax partners from his accounting firm and his life insurance agent. Also sitting in, and leaning very close to the conversation, are two senior members of the client’s executive team.
A Very Taxing Situation
The subject of the meeting is how to deal with, meaning pay, the very considerable estate tax that will be due when the client dies. You see, the client is a widower, so there’s no marital deduction to defer the tax to the death of a surviving spouse.
The client established an irrevocable life insurance trust (ILIT) some years ago. The ILIT owns a policy that’s nowhere near sufficient to cover the estate tax. The beneficiaries of the ILIT were originally his wife and two, now usually adult, children, neither of whom are involved in the business. If you listen carefully to the banter among the professionals at the table, you’d hear them describing the ILIT as a grantor trust for income tax purposes. You’d also hear them point out that the ILIT has the usual provision about providing liquidity to the estate by way of loans or purchases of assets.
Discussions with this client about estate tax planning have never been fruitful. He has steadfastly refused to do any planning that would result in his having anything less than complete control of the enterprise. Even the acronyms for the various planning strategies are now crying out from the slide decks, “Hey, enough. He’s just not into us! Never was and never will be.” But the client, now more wealthy than healthy, is under some not-so-subtle pressure from his executive team to “do something” about the estate tax situation. So, he sent a message to the advisors, attaching a slide from one of their presentations. The slide is titled “Section 6166 - Deferral of Estate Tax.” He noted in the margin, “Let’s talk about this.” And so, the group has assembled in his conference room. What’s notably different about this meeting is that the client asked the corporate attorney and accountant to attend. He must be getting serious.
To prepare for the meeting, the estate planner, tax partner and insurance agent got together to collaborate on a slide deck. This client has no idea how fortunate he is to have these professionals working for him as a team. That’s because the use of IRC Section 6166 is often, maybe even historically, the basis for what I’ll politely refer to as a “robust point and counterpoint dialogue” among professional advisors and insurance agents. Not here. The estate planner and tax partner know that while Section 6166 allows for deferral of the tax, it’s silent on where to come up with the money to pay that tax. That’s why, when they’re in a situation like this one, with a client like this one and with executives like these two, not to mention a couple of very capable and inquisitive colleagues, they’d better be ready to tell the whole story and nothing but. That means, include the professional who can address the funding. For his part, the insurance agent knows that in such a setting, the client and yes, he himself, are best served by considering Section 6166 as a tailwind to life insurance, not a headwind.
The Presentation Unfolds
The estate planner and tax partner open the conversation by saying that they typically regard Section 6166 as a strategy of last resort. Their rationale for this position becomes evident as they walk the client, the executives and their colleagues through Section 6166, including coordination with IRC Section 303 redemptions by the company. They pay special attention to the "tripwires" in Section 6166 and elsewhere in the tax law that can pose real problems for the estate, the company and the family over the decade and a half that comprise the deferral period.
But at this stage of the game, everything should be on the table. Based on current valuation, there’s no question that the estate would qualify for Section 6166 deferral. But qualifying for the deferral is one thing. That’s just rote stuff for the client and his associates. Finding the money to pay the interest and principal is another and, for the client and his associates, this is the focal point of the discussion. Yes, as will be explained, the funds can be generated by the business. But the client should definitely consider the tax and economic benefits of using life insurance to supplement those funds.
Accordingly, the estate planner and tax partner turn the presentation over to the agent, who goes through some slides and policy illustrations depicting variations on the theme of the ILIT’s deploying the insurance proceeds in a Section 6166 context.
Getting Down to Business
The presenters pause to allow the rest of the group to digest all the material they’ve heard for the past hour. They think things are going well, so far anyway. They justifiably take pride in the way they’ve collaborated.
The group regroups. The corporate attorney and accountant definitely want to hear more. They know the client, they know the company and they know how valuable this relationship is to their respective practices. They think this “Section 6166 thing” could be a breakthrough in a situation that’s becoming more acute with every passing year. The engagement of these two professionals is absolutely critical because, at the end of the day, the client will turn to them for advice. The engagement of the two executives is also key, because they’ll need to be comfortable that whatever is proposed will “work.” That’s why, when the meeting resumes, the presenters get down to business. “OK everybody. Let’s talk about how this could work. Don’t hold back on your questions.” One executive quips, “I think we’re gonna need a bigger slide deck.”
The client raises his hand. “Right off the bat, I’ve got two problems with this. First, I’m not interested in paying those big premiums with my own, after-tax money. Second, I got tired of all that rigamarole with my ‘irredeemable life insurance trust’ years ago. You know how unsettled my life is these days. The last thing I need is to put more money and more life insurance into something that’s irrevocable. I’ll listen. After all, that’s why you’re all here. But you better know I’m concerned about those things.”
It takes a team effort to overcome these initial objections. The estate planner rushes to the defense of the ILIT, saying that it’s basically the only show in town for keeping the insurance proceeds out of his estate, which is a sine qua non for someone with a taxable estate. And it was drafted to be as flexible as possible. The agent, in turn, addresses the client’s reluctance to pay the premiums himself by suggesting a split-dollar plan between the company and the ILIT, which, conveniently, is a grantor trust. And it just so happens that he has an illustration for that as well. The client is initially taken with how split-dollar would take some of the burden off him. But the executives, who’ve been there and done that with split-dollar, remain to be convinced.
This is where it gets interesting, trust me.
The client turns to his executives, “What do you think?” Anticipating a business and financially-oriented response from these two business and financially-oriented individuals, the presenters and their colleagues are surprised when the executives respond, “Frankly, our major concern is with your kids. No offense, of course. But they have no stake in the business. They also have very lavish lifestyles. We could absolutely see them saying to the trustee of the ILIT, ‘Don’t even think about lending our insurance proceeds to the company or the estate or to anybody for that matter. We want the money now.’ And that would be a problem!”
The client smiles. Smart guys! So, the corporate attorney suggests that they get the client’s relationship manager at the trust company on the line. Sure enough, the trustee says that they would have to take the beneficiaries’ objections seriously. The trustee could envision a scenario in which the kids object to the ILIT’s loans to the company or the estate on the grounds that the return on the loan is not sufficient or that, without the leadership of their father, the creditworthiness of the borrower will have been impaired. The trustee would certainly require the kids to sign off on any plan to lend proceeds or buy assets or whatever. “But,” says the trustee, “As your estate planner knows, there are a couple of things that can be done to give you more assurance that the funds will be used as you intend. We can talk about that when the time comes.”
The executives ask whether the company could own the insurance policy and apply the proceeds to a series of redemptions. That would alleviate the concerns about the client’s personal cash flow, the ILIT and the kids. “You must have read ahead in the deck,” says the agent. “That’s something we need to think through,” say both the estate planner and the tax partner. “There are issues. Like the impact of the insurance proceeds on the valuation of the company for estate tax purposes. We’d also have to be concerned that the kids would contest the stock price for the redemptions, and so on.” The corporate attorney asks, “Can’t we set the price with an agreement?’ To which the estate planner replies, “That would work contractually, but could be a problem for other reasons. Not saying we can’t get there from here, but we’d have to be very careful.”
Collaboration is Key
Collaboration creates openings for all professionals.
We’ll leave the conversation here to let the presenters finish their work and lead the group through a recap of the material. It’s been a productive meeting, and they’re on their way to a solution, which may or may not ultimately involve Section 6166. Most important, the client is in good hands, and with all of the key advisors now involved, nobody’s going to let him make today’s solution tomorrow’s problem.
The point of this hypothetical situation, and this article in particular, is that both the problem and the solution involve far more than taxes and insurance. They involve people, a lot of people, which means that the planning has to be holistic, multi-dimensional and multi-disciplinary. Because the technical expertise to devise the plan may not be as critical as the skill to get it across to a diverse audience and implemented by a control-oriented client, the whole group of professionals has to work as a team. That’s called collaboration.
My hope is that readers will use this case study in their study groups, varying the facts and circumstances to help them consider the case from different business, tax and insurance planning perspectives.