LEGAL OUTLINE FOR CALIFORNIA INSURANCE AGENCIES
CHAPTER SIX
TRANSFERS TO THE NEXT GENERATION
6.1 Durable powers of attorney in case of disability.
An agent is much more likely to become disabled during his working life than he is of dying. Often there are important actions that must be taken while he is disabled. A conservatorship can be set up if necessary to take these actions, with the security of court supervision and bonding requirements, but conservatorships are relatively expensive and cumbersome. If an agent has someone he can trust to act for him, a durable power of attorney is a less expensive and simpler alternative.
Durable powers of attorney can be given to make business decisions, from filing tax returns to selling the interest in the agency to establishing living trusts. They can also be given to make health care decisions. They normally take effect only if the agent is disabled and cannot act for himself, and end when the agent recovers his ability to act.
6.2 Transfers to the next generation.
If an agent intends to transfer the agency to a child or children, without being paid for all or part of the agency's value, steps taken well before retirement can ease the gift and estate tax cost of this transfer.
In a nutshell, an agent with less than $600,000 in net assets does not need to worry about estate and gift taxes. A married agent with $1.2 million in net assets can avoid estate and gift taxes with proper planning. Agents with still more can substantially reduce their taxes by planning well ahead of time.
Agency owners should not use lifetime transfers without carefully considering what their cash needs will be. It makes little sense to impoverish the parents in order to save death taxes for the children.
This outline is not a full discussion of estate planning options. It is intended to give a basic explanation, and to cover some options particularly applicable to insurance agencies.
6.3 Basic death tax information.
- Unified credit against estate and gift taxes.
Everyone has a 'unified credit' for estate and gift taxes, that shields $600,000 from estate or gift tax. A husband and wife can shield $1.2 million from estate or gift tax, if they plan properly and do not waste the credit of the first to die.
A spouse can leave an unlimited amount of property to the other spouse without estate or gift tax, due to the unlimited marital deduction. Using the marital deduction leaves the unified credit unaffected.
To avoid losing the unified credit, the first spouse's estate passes up to $600,000 to the next generation in a taxable manner (using the credit to absorb all the tax), and leaves the balance to the other spouse tax free by using the marital deduction. One way to do this is outright taxable lifetime gifts. Another is to use a 'bypass trust' of up to $600,000, which leaves a life estate to the surviving spouse, and remainder to the children, in a way that is taxable in the estate of the first spouse to die. The unified credit offsets the tax.
- Annual gifts that are gift tax free.
A person can make gifts of present interests of $10,000 per donor per donee each year, without tax.
For example, a husband and wife could make gifts of $20,000 a year to each child without tax. This gift could be in stock in the agency.
- Deduction against generation skipping tax.
In addition to the estate and gift taxes, there is a generation skipping tax for transfers that skip a generation (such as from grandparent to grandchild). There is presently a deduction sheltering the first $1 million in generation skipping transfers. For a large enough estate, it makes sense to use this deduction, and avoid a tax in the estate of the children. This can be done with a 'direct skip', such as a gift or bequest directly to grandchildren. It may be done with a 'generation skipping trust', which pays income to the children for life, allows invasion of the principal if required under an ascertainable standard relating to their health, education, or support, and with the remainder passing to the grandchildren on the death of the children.
- Effect on income taxes - basis step-up.
If a person holds an asset until death (that isn't income in respect of a decedent), he achieves a step up in income tax basis to its value for death tax purposes. This includes such assets as an interest in an agency, agency stock obtained in an agency merger, or securities purchased in an ESOP rollover. For income tax purposes, it makes sense to hold an asset until death, rather than sell it and pay a capital gains tax.
Income in respect of a decedent is not stepped up in basis.
Property held as community property achieves a basis step up as to both the decedent's half and the half belonging to the surviving spouse. Joint tenancy property normally achieves this basis step up as to one half only.
Life insurance proceeds are normally received income tax free by the beneficiary. They may also escape death taxes in the insured's estate if properly handled.
6.4 Wills, trusts, and gifts.
- Wills and testamentary trusts.
A testamentary trust is established by will. It should be contrasted with a living trust established by a trust instrument while the person is alive, and to which the person transfers his property by deed or similar instrument of transfer.
Testamentary trusts make the lives of the donors simpler. A will is relatively simple and inexpensive to prepare or change. The assets passed by will are subject to probate, but there is a simple and quick procedure for transferring property to a surviving spouse.
- Living trusts.
A living trust is more expensive to set up initially (because assets have to be transferred to it), and one has to hold most or all his assets in the trust to make it effective in avoiding probate. However, by avoiding probate it avoids some fees at death (though fees are still incurred to terminate the trust and file any necessary tax returns). It is more private than a testamentary trust, and is usually faster in distributing some assets to the beneficiaries.
Living trusts traditionally have been useful for older persons who need a trustee to manage their affairs, though this can now be done in California by a Durable Power of Attorney.
Living trusts can be revocable (and most are) or irrevocable. Irrevocable trusts are particularly useful in connection with life insurance. If all incidents of ownership are properly transferred, the insurance proceeds can be excluded from tax in the estate of the insured, and even from the estate of the beneficiary.
Agency owners should not choose between living trusts and wills (with testamentary trusts) without an explanation of their differences. There is no tax difference between living trusts and wills establishing testamentary trusts. A living trust generally increases the up front costs incurred immediately, but reduces the total cost of after death administration. These administrative costs are minor compared to potential tax costs.
- Gifts.
A completed gift usually removes the property from the taxable estate of the donor. Exceptions include gifts with retained life interests, or gifts of future interests.
Most gifts of $10,000 per year per donor per donee are ignored for gift tax purposes. Gifts greater than this require a gift tax return, although no tax is payable until the $600,000 shielded by the unified credit has been exceeded.
6.5 Reallocating partnership interests.
For an agency operated as a partnership, allocating larger partnership interests to younger family member partners over a period of time, as the younger partner's responsibilities grow, increases the interest of the younger partner.
6.6 Producing new accounts in a new entity.
Methods of 'estate freezing' have been severely restricted by legislation. There are still possibilities within the context of insurance production agencies.
Younger generation members of an established agency might form a new business entity owned by them. Producing new accounts through the new entity causes it to grow, while the old one handling the old accounts is stable. In effect, a cluster is created. This approach does not involve a 'transfer' from the parents. What it does is to insure that the fruits of the children's efforts in new production are not taxed in the estates of the parents.
6.7 Uses of life insurance.
Insurance producers, even those who do not have life licenses or life departments themselves, are in a better position to evaluate and purchase life policies than the average person. Insurance policies may give pure life insurance on one or several lives, and they may also constitute investment vehicles that defer tax on earnings until they are cashed in.
Insurance buyers, like computer buyers, need to consider the purpose of the insurance before choosing the policy.
One purpose might be to pay death taxes on the death of the second spouse. At the death of the first spouse, death taxes may be deferred by use of the marital deduction. This could be important in the case of an agency where the children do not want to sell the agency, and will need cash to pay taxes.
Another purpose might be to fund an agency buy-out.
Life insurance buyers may be able to avoid death taxes on insurance proceeds in the estate of the parents, and even in the estates of the children by use of generation skipping devices. This requires at a minimum that the parents get all incidents of ownership in the policy out of their estates. It is usually preferable to use an irrevocable insurance trust for this purpose.
Estate planning is a highly complex matter, and producers should seek specific professional advice with regard to their individual situations.
CHECKLIST ON ESTATE MATTERS.
- Do you have a current will (or a pour-over will if you have a living trust)? Have any important events transpired since you did your will, such as a divorce, remarriage, arrival of new children or grandchildren, etc.? Have you considered a trust? Have you considered durable powers of attorney to avoid a possible expensive conservatorship, and to provide for your health care?
- If you are married, are your assets over $600,000? If so, you may want to use both unified credits, which could save close to $200,000 in tax. Are you using the marital deduction, or have a good reason not to?
- Is a gift giving program an option to consider? Gifts of $10,000 a year per donor per donee are frequently used.
- What happens to your agency interest if you die? Have you provided for the agency to continue? Who will acquire and pay for your interest? What security does your estate have? Have some payments been structured so that they are income in respect of a decedent and subject to two taxes (partnership or deferred compensation may be)? Have some been structured to be income tax free (insurance payments may be)?
- Are your children producers? Is a separate entity for their new production a realistic option?
- Do you have life insurance? What is its purpose? Have you gotten it out of your estate, or shielded it with a marital deduction?
- Have you any charitable beneficiaries? If so, have you considered possible benefits of lifetime gifts as well as testamentary ones?
- If you have a terminal situation, have you planned to step up basis in your assets, and avoid income in respect of a decedent?
CONCLUSION.
A property and casualty insurance agent, unlike many other professionals such as lawyers, builds an asset over the years that he can sell or transfer, his expirations and good will. It is probably the most valuable asset that the agent owns. It is also a fragile asset that can
dissipate quickly on disability, retirement, or death if someone is not there to pick up the reins. Therefore, at as early a stage as possible, he needs to look ahead at the best ways to protect that asset, and to sell or transfer it when he retires or dies.
Unfortunately, there is no 'one size fits all' program for producers. Forms that attempt to do this are often misleading and sometimes dangerous. This outline has attempted to raise the questions a producer should pose, and to suggest possible answers. However, it is not a substitute for specific professional advice from a lawyer, accountant, or expert insurance consultant, depending on the issues involved. The author, being a lawyer, of course assumes no responsibility for any damages resulting from anything in this outline.
Francis G. Willmarth
P. O. Box 769
Orinda, CA 94563
(510) 254-2476
(707) 882-2657