September 30, 2013

The Power of Insurance Trusts to Maintain Family Business Assets and Sanity

Holland & Knight Shareholder Rights Blog
Michael J. Zdeb

Life insurance and irrevocable trusts are great tools to ease family business succession issues and mitigate exposure to shareholder oppression and disputes. Irrevocable life insurance trusts (ILIT), in particular, play an important role in the creation and preservation of wealth for countless families. Generally, ILITs provide a source of liquidity upon the death of the older generation at the helm of the business. This source of money can then be used to pay estate taxes and other major liabilities, avoiding the need to liquidate other family assets for these obligations. Frequently, the heirs' desires are to prevent the forced need to sell — or the lack of a market for — interests in the closely held (CHE) or family held enterprises (FHEs). The ILIT is uniquely positioned for this usage.

The Wealth Preservation and Peacemaking Power of ILITs If properly structured, the ILIT premiums can be funded with gifts to the trust while the cash value builds income tax-free within the policy and then the death benefit can be received without the burden of taxes upon death (and generation-skipping taxes at later dates). Other techniques exist, but the ILIT remains one of the most powerful tools for wealth preservation, especially with CHEs and FHEs.

A use of the ILIT that is not generally discussed is how this technique can prevent the disruptions and losses that can occur with the succession of ownership of the FHE. As ownership of FHEs transfers among younger generations, ownership interests frequently become diluted. This can result in ownership interests that are held by family members who are active in the enterprise and others who are removed from it. Once this occurs, it is not unusual for the views of the enterprise and expectations of how its economic benefits are shared to splinter. Those who are participating actively may have an expectation that their involvement would be recognized in a manner that might be disproportionate to ownership. Those outside may hold expectations of benefits that are a function of the lifestyle of the older generation, which may not be sustainable for larger numbers of a younger generation.

As the expectations of those active and inactive diverge, disputes can erupt among the family members. If all have interests in the FHE, this can result in conduct that is disruptive to the FHE. And since the frustration of "reasonable expectations" can be the basis for shareholder oppression cases, the worst-case scenario sometimes becomes reality and along with it comes complex litigation. These types of family business disputes are damaging emotionally and can rock family relationships, let alone lead to costly court battles and family rifts that last for decades.

Topics to Address for Family Business Succession Planning

As part of the ownership succession planning process, a number of topics need to be addressed. One of them is whether it is reasonable to create an expectation that all family members should hold interests and derive benefits regardless of active involvement in the enterprise. 

Given a particular set of family and business circumstances, a succession plan could be designed to avoid future issues by establishing the following expectations:

        a.   have ownership limited or narrowed to those active or expected to be 
        b.   those inactive family members whose lifestyles have been dependent 
              on the enterprise would be beneficiaries of alternative sources of 

Since expectations that are reasonable and known to the parties create standards for viewing conduct, the process and creation of a strong plan can be immensely helpful in avoiding future disappointments and frustration that oftentimes lead to protracted disputes and shareholder rights litigation.

How ILITs Can Be an Effective Means of Income

As an "alternative" source of wealth to replace or supplement FHE interest, the ILIT can be an effective and efficient technique. Family members not expected to actively participate can be beneficiaries of the ILIT while those who are active may receive ownership in and compensation from the FHE. Also, an FHE does not have to embrace an all-or-nothing approach. An ILIT could be a supplemental source of wealth outside the FHE, providing for varying benefits for all or creating capital for other ventures.

If coordinated with corporate governance strategies and setting reasonable expectations, the ILIT could serve as an important tool in providing for all family members regardless of interests in the FHE. ILITs also go a long way to avoid some of the costly and destructive disputes that can destroy market value for all family members involved.

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