Life Insurance in Farm Transition Planning – Part 2

In the last post, we discussed the different types of life insurance.  In this post we will explore the benefits and disadvantages of life insurance in farm transition planning as well as strategies for using life insurance.

The Value of Life Insurance in Farm Estate Planning

Liquidity for Estate Taxes and Debts:

When a farm estate is passed on to the next generation, estate taxes and debts can create significant financial burdens. Life insurance provides the liquidity needed to cover these expenses, helping to prevent the forced sale of farm assets.

Equalization Among Heirs:

In many farm families, not all heirs are involved in daily farm operations. Life insurance can be used to compensate non-farming heirs, ensuring fairness while preserving the farm for those who continue the operation.

Succession Planning:

For farmers transferring ownership of the farm to the next generation, life insurance can be a crucial part of succession planning. It provides the financial resources to buy out other heirs or business partners, ensuring a smooth ownership transition.

Protection Against Loss:

In the event of the sudden death of a key family member, life insurance can provide the necessary funds to keep the farm operational during the transition period.

Disadvantages of Life Insurance in Farm Estate Planning

Cost of Premiums:

Life insurance, particularly permanent policies like whole or universal life, can be costly. The ongoing premium payments may strain the farming business, especially if cash flow is tight.  Also, the premiums are not usually a deductible business expense.

Insurability:

Not everyone qualifies for life insurance. Individuals with pre-existing health conditions may be denied coverage. Additionally, as the applicant ages, premiums increase, potentially becoming unaffordable at some point.

Complexity of Policies:

Permanent life insurance policies, such as universal or variable life, can be complex and require careful management. Without proper oversight, these policies may lapse, resulting in the loss of coverage and forfeiture of premiums paid.

Limited Cash Flow Benefits:

While life insurance provides liquidity at death, it may not offer significant cash flow benefits during the policyholder’s lifetime. Cash value accumulation can be slow, particularly in the early years.

Examples of Using Life Insurance in Farm Transition Planning

Off-Farm Heirs:

Andy and Betty own Family Farms. Their son Chris has returned to manage the farm, while their daughter Darla has pursued a successful career elsewhere and is not involved in the farming operation. Andy and Betty have a net worth of $3 million, but most of it is tied up in the farm, leaving little liquid cash. They purchase a second-to-die policy for $1 million and name Darla as the beneficiary. Upon their deaths, Darla will receive the $1 million death benefit as her inheritance, while Chris will inherit the farm, ensuring he can continue the operation without financial strain. This plan balances the needs of both heirs, providing liquidity to the off-farm heir while preserving the farm for the on-farm heir.

Debt:

Ed and Fran recently purchased a farm and owe $1 million on the property. They worry that if they die prematurely, the farm may struggle to meet the debt payments. To mitigate this risk, they purchase a second-to-die policy for $1 million. The death benefit will be used by their heirs to pay off the land debt, helping to secure the farm’s future for the next generation.  Any death benefit not needed to pay debt can go to their heirs.

Ownership Buyout

George and Harry are brothers who own and operate Family Farms LLC.  They expect to continue farming for another 10 years.  If either George or Harry die while they are farming, they want the surviving brother to be able to continue the farming operation by buying out the deceased brother’s ownership.  The LLC is valued at $2 million.  The brothers want $1 million to go to their family upon their death but do not want to burden the other brother with $1 million of debt.

George and Harry purchase $1 million, 10-year term policies for each other.   If either brother dies in the next ten years, the surviving brother will receive $1 million death benefit which will be used to buy the deceased brother’s ownership.  The $1 million in sale proceeds will go to the deceased brother’s family. The surviving brother will not need to worry about taking on debt to make the buyout. By using term policies, George and Harry were able to provide buyout funds while keeping the premiums costs significant lower than a whole life, universal or variable policy.

Effect on Estate Taxes

The death benefit of a policy is included in the estate of the policy owner.  For example, if Ida owns a $1 million whole life policy which pays out to her beneficiaries upon her death, the $1 million death benefit will be included in her federal taxable estate.  This presents a planning issue if life insurance is purchased to help pay estate taxes.  Owning a life insurance policy will compound the estate tax liability of the estate.

A relatively easy solution to this issue is to use an Irrevocable Life Insurance Trust (ILIT).  With this strategy, an ILIT is established that will purchase the life insurance policy.  The grantor of the trust will pay the premiums on behalf of the ILIT and beneficiaries.  Because the ILIT owns the policy and not the grantor, the death benefit is not included in the grantor’s estate.

Continuing the above example, Ida establishes an ILIT and the ILIT purchases a $1 million whole life policy.  Ida pays the annual premiums on behalf of the ILIT. When Ida dies, the policy will pay $1 million to the ILIT.  The ILIT will then distribute the $1 million to Ida’s heirs.  The $1 million is not included in Ida’s taxable estate.

Conclusion

Life insurance can be a valuable tool in farm estate planning and transition or succession planning, offering liquidity, equalization among heirs, and protection against financial hardship. However, it is essential to carefully weigh the pros and cons of different policies and consider the long-term costs and management responsibilities. Life insurance is not needed for every transition plan.  Farmers should consult financial advisors, estate planners, and insurance professionals to determine how life insurance may or may not fit their specific needs and goals. When structured properly, life insurance can help ensure the farm remains a viable operation for future generations while also providing financial security for heirs.