An American humorist once wrote: "Fun is like life insurance, the older you get, the more it costs." Even though life insurance is a cost to your farm, life insurance can play an important role in a farm succession plan. However, most farmers do not understand the types of life insurance, how life insurance may be used in a farm succession plan and how to choose life insurance so that unpleasant surprises can be avoided.
Types of life insurance
There are two basic types of life insurance: term and permanent. In a term insurance policy, a policy owner pays a premium for financial protection that lasts a specific period of time. The only potential benefit is the payout upon death and the policy itself has no value for the policy's owner during the insured's life. In contrast, permanent insurance accumulates a cash value for the policy's owner during the insured's life in addition to a payout upon death.
The two most common variations of permanent insurance are whole life and universal life. In a whole life policy, mortality costs are guaranteed, the face amount is guaranteed and the cash value is guaranteed. In a universal life policy, mortality costs may fluctuate and the face amount is guaranteed only so long as there is sufficient cash value. Also, another variation in permanent insurance is the investment element of the policy. For example, some policies are invested in bonds, some in the insurance company's general interest account and some in market mutual funds.
Generally, four different parties are involved in the creation of a life insurance policy: 1) the insured, 2) beneficiary, 3) owner and 4) premium payor. In some insurance policies, there can be more than one insured. A policy that pays a death benefit at the second death of insured individuals is called a "second-to-die policy". This type of policy is common when parents are transferring a farm to one or more farm children and wish to have something to leave in their estate plan to the non-farm children. A policy that pays a death benefit at the first death of two or more insured individuals is called a "first-to die policy". This type of policy is common when farm owners want to have funds available to purchase the ownership held by a deceased co-owner.
Life insurance is often a tool commonly used in farm succession planning. The following are some ways insurance policies are used.
As stated above, life insurance can be used by farm parents to provide their non-farm children with equitable treatment. Life insurance proceeds paid upon death are not subject to any income tax. In addition, if the parents' estate is large enough to be subject to estate tax, the insurance may also be owned by an irrevocable trust which will remove life insurance from the parents' estate for estate tax purposes as well.
In a farm succession plan, a buy-sell agreement can establish a fair price for a deceased, disabled or retiring farm owner's interests. A life insurance policy may be used to provide the cash necessary for the remaining farm owners to continue. For example, even when there isn't a death, life insurance can be surrendered to help pay for a lifetime purchase of a farm owner's interest.
It is important to know the factors that are important in selecting life insurance. The following are some important considerations:
Carrier Financial Strength. Insurance companies are rated by independent rating companies. It is important to find a carrier with excellent financial ratings.
Diversification. Most people do not invest all of their money in a single investment. Likewise, for those with a great deal of insurance, it makes sense to diversify insurance by carrier, product and investment mix.
Ownership/Beneficiary Structure. It is important to review the different parties involved in the insurance contract. Although the death benefit of a life insurance policy is usually tax free, the death benefit could be subject to income and/or estate tax if the ownership and beneficiary arrangement of the policy is not structured properly.
Policy Control. Whether an individual or entity owns the policy is an important consideration. For example, if the farm entity owns the policy, any policy cash value or death benefit proceeds could be subject to the farm entity's creditors. Also, it should be discussed whether or not the policy proceeds are included in a purchase price formula of the farm entity's buy-sell agreement.
Life insurance can play an important role in a farm succession plan. However, a farm succession plan should never be designed for the insurance. Rather, the insurance should be designed for the farm succession plan. A life insurance professional who is completely honest about the policy's suitability for the farm's owners and is transparent about a policy's costs, sales commissions and other fees can be an important person on your farm transition team of advisors.
Schneider is a partner in Twohig, Rietbrock, Schneider and Halbach, S.C., a Chilton law firm that specializes in ag law. Call Schneider at 920-849-4999.