By Randy A. Fox, CFP, Founding Principal, InKnowVision, LLC

Many discussions of estate planning include the consideration of life insurance as one of the planning tools. In smaller estates, those that may not be taxable under current law, insurance may be appropriate for several reasons. Often, the breadwinner spouse will insure his or her life so that in the event of an untimely death, the surviving spouse is able to maintain the existing lifestyle. At the second spouse's death, the remainder of the insurance proceeds will pass to the heirs.

If this insurance is held properly outside of the estate, it will also be free of income and estate taxes. In other instances, parents may want to leave a "larger" estate than the total of their current assets. This is often done by purchasing a joint and survivorship (or two life policy), again in a trust that will be outside of the taxable estate that will distribute to the heirs after both of the parents are deceased.

Larger Estates Present Different Challenges

While these are common and non controversial uses of life insurance for many estate plans, larger, taxable estates present completely different challenges opportunities and applications for life insurance in various forms. In many instance there is a significant resistance to using life insurance as one of the many tools that can be applied to transfer wealth to the next generation. There is little doubt that life insurance is often misunderstood, used inappropriately, over promised and over sold. However, that does not mean that life insurance should be discarded when planning for large estates.

There are many situations when it may not only be the best answer, it may be the only answer to resolving some complex estate planning issues. What is vitally important to the success of utilizing life insurance in these instances is that the proper type and amount of insurance, from the best company available, with the appropriate payment schedule must be integrated into the entirety of the plan design. Furthermore, just as with all of the other elements of a complex estate plan, the life insurance component must be reviewed and maintained regularly.

Case Study: Family Business, Liquidity & Estate Taxes

Following are a few examples of common situations where life insurance may be the best solution for a large estate.

Case #1: John and Janet are 68 and 66 years old and in good health for their ages. They have three married children and are generally a close family. Their net worth is currently $23 million, $18 million of which is in the business that John has built over his entire working lifetime. Their oldest son, Tim, has worked in the business since college and is the likely successor to John. The two other children have shown no interest and have their own successful careers.

John and Janet face several serious issues. Like most parents, John and Janet want to treat their children equally but in this case, equally would mean leaving the non involved siblings a share of the company that Tim has spent his whole adult life working in. There is huge potential for family discord in these situations and a good chance that Tim will have tremendous resentment if his siblings are "handed" shares of the company.

Furthermore, under John and Janet's current estate plan, there is not enough liquidity to pay the estate taxes. Essentially, the company would have to be liquidated to satisfy the estate's obligations to the IRS.

Several planning techniques seem to be appropriate to enable this family to meet its goals. Recapitalizing the company shares in a "freeze" technique and selling to a defective trust for a note may be a good first step.  In this case life insurance won't solve all of the estate planning issues but it is certainly indicated. First, it can provide needed liquidity for an otherwise illiquid estate. Second, it may help to "equalize" the estate for the two siblings who aren't working in the business.

How much insurance and what type of insurance are the best in these circumstances? Additional calculations and considerations come into the picture. Keeping all policies outside of the taxable estate is of primary concern. Often, funding a guaranteed survivorship policy is the most economic approach. There is little need to build cash value and the policy might be owned in the same defective trust that purchases the recapitalized company stock. "Policy design", or the structure of premium cash flows over time, is often a critical element that makes this type of planning work.

Case #2: In the case above, presume now that all three children work in the family business. Does the use of life insurance become unnecessary? The family still faces a liquidity problem that may best be solved by utilizing life insurance. In this circumstance, it might be somewhat less than the prior example but it will most likely still help provide the best outcome. Even if we apply similar freeze techniques and move growth outside of the parents' estates, under current tax law, they will still face a sizable estate tax.. While it is often possible to zero out the tax through some combination of charitable gifts, the loss of those assets to charity might be replaced with life insurance.

Liquid Assets Can Be Wiped Out By Estate Taxes

Case #3: Take the same facts as case #1 but let's assume now that the estate is an $18 million business and $18 million of liquid assets. Many planners would look at this estate and suggest that there was adequate liquidity and no need for insurance. However, if you examine the estate carefully, you might recognize that at death, the most likely assets to be utilized to pay estate taxes would be the liquid ones. Effectively, two children would be disinherited or all of the liquidity of the estate would be wiped out. Adding in some discounting and sales to defective trusts or GRATs would relieve some of the tax burden. And, again, a charitable gift at death could zero out the tax but it doesn't eliminate the apparent disproportionate inheritance that accrues to the son who is running the family enterprise. The only realistic way to create more liquidity is to consider a purchase of life insurance.

These three cases are fairly representative of the fact patterns that are common in many high net worth families. Much family wealth is comprised of illiquid assets. It may be a family business, real estate holdings, collectibles such as art, antiques, cars, wine or baseball cards. Lack of liquidity always makes distribution of an estate evenly among heirs more difficult. One solution, while not the only solution, may be life insurance. The most creative planner cannot create needed liquidity out of thin air as much as we'd like to. Properly structured, properly owned life insurance may often provide the best answer.