Careful with that insurance axe, Eugene.

Family-owned businesses often obtain life insurance to help with succession and liquidity issues. If an owner dies with the business constituting a valuable asset of the estate, so much so that there is estate tax, the business owner doesn't want to have his heirs sell the business to pay the taxes.

The tax law does allow the deferral of taxes for a period of time, sometimes up to 15 years after someone has passed away. But even with this deferral, the taxes still must be paid, and the question is still whether the business has the cash to do so.

Owners often look to a key employee or non-family member who already may own a piece of the business. Does that person want to buy out the majority owner's interest? And can she afford it? Often, the answer is "yes" to the first question and "no" to the second.

To solve this dilemma, people turn to life insurance. The key employee buys insurance on the owner's life so that, when the time comes, the employee has the money to buy the business. Seems reasonable.

But be very, very careful. The structuring here is key, and we often see the same mistake: Sure, the key employee buys the insurance and pays the premiums. But -- here's the mistake -- too often the money to pay those premiums comes from the business itself, either directly in the form of a bonus to the employee, or more subtly through "salary adjustments" to the employee's compensation. There are few, if any, circumstances in which a key employee or minority shareholder can fund the insurance obligation without obtaining money, either directly or de facto, from the company.

What's wrong with this picture? The business owner is funding his own buyout. Here's an example: A client owns 90% of a business worth $5 million. The 10% shareholder owns a life insurance policy on the owner's life in the face amount of $4.5 million, requiring, let's say, payment of $20,000 yearly in premiums. The owner gives yearly bonuses of $30,000 to that shareholder to allow her to make these hefty premium payments. The owner has done nothing more than fund his own buyout, because 90% of that yearly $30,000 belonged to the owner anyway.

What's the real solution? Have the owner fund a policy through an irrevocable life insurance trust -- making his family the beneficiaries.

That way, the family can use the proceeds (via a loan from the irrevocable insurance trust to the decedent's estate) to pay for estate taxes; there's no need to rely upon the key employee, who may be slow (or simply fail) to pay for the business.

Let the key employee or minority shareholder figure out for herself (now or later) how to pay for the company. Or just ignore the buy-sell arrangement and have the estate's executor sell the business at the appropriate time. Of course, because that time is the owner's death, from his perspective, the time will never be "appropriate."

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