Where Does Life Insurance Fit In An Estate Plan For A Farmer or Rancher?

Overview

During life, many farmers and ranchers are focused on building their asset base, making sure that the business transitions successfully to the next generation, and preserving enough assets for the next generation’s success.  Historically, farm and ranch families haven’t widely used life insurance, but it can play an important role in estate, business and succession planning.  It can also help protect a spouse (and dependents, if any) against a substantial drop in income upon the death of the farm operator.  It can also provide post-death liquidity and fund the buy-out of non-farm heirs.

Planning with life insurance for farmers and ranchers – that’s the topic of today’s post.

During Life

A primary purpose of life insurance during the life of the insured farm operator is to provide for the family in the event of death.  In that sense, life insurance can provide the necessary capital to build an estate.  But, it can also protect income and capital of the farming or ranching business which could be threatened by the operator’s death.  Selling off farm assets, including land, to pay debts after the operator’s death will threaten continuity of the business.  Life insurance is a means of providing the necessary liquidity to protect against the liquidation of operating assets.

Unfortunately, my experience has been that many legal and tax professionals often overlook the usefulness of insurance as part of the overall plan.  This can leave a gaping hole in the estate and business plan that otherwise need not be there.  The result is that many farm and ranch families may feel that “the land is my life insurance.”  But, what if funds are needed to be unexpected expenses at death?  What about debt levels that have increased in recent years?  Is it really good to have to liquidate a tract or tracts of land to pay off expenses associated with death and retire burdensome debt?

So how can life insurance be utilized effectively during life?  That depends on the economic position of the operator, the asset value of the operation and the legal and tax rules surrounding the ownership of life insurance.  Of course, the cost of life insurance must be weighed against options for accumulating funds for use post-death.  Also, consideration must be given to the amount of insurance needed, the type of life insurance that will fit the particular situation, and who the insured(s) will be. 

From an economic standpoint, life insurance tends to provide a lower return on investment than other alternative capital investments for a farmer or rancher.  It’s also susceptible to inflation (not much of an issue in recent years) because of the potentially long time before there is a payout under the policy.  But, also from an economic standpoint, life insurance proceeds are generally not included in the beneficiary’s gross income.  I.R.C. §101(a)(1).

For younger farmers and ranchers, premium payments can be reduced by putting a term policy in place to cover the beneficiary’s premature death.  The term policy can later be converted to a permanent policy.  That’s a key point.  The use of and plan for life insurance is not static.  Life insurance wanes in importance as a mechanism to help build wealth as the farm operation matures and becomes more financially successful and stable.  The usage and type of life insurance will change over the life cycle of the farm or ranch business.   

After Death

From a tax standpoint, life insurance proceeds are included in the insured’s gross estate if the proceeds are received by or for the benefit of the estate.  As such, they are potentially subject to federal estate tax.  However, the current $11.4 million exemption equivalent of the unified credit (per person) takes federal estate tax off the table for the vast majority of farming and ranching estates.  In addition, if the proceeds are payable to the estate, they also become subject to creditors’ claims as well as probate and estate administration costs.  If the beneficiary is legally obligated to use the proceeds for the benefit of the estate, the proceeds are included in the estate regardless of whether the estate is the named beneficiary.  It makes no difference who took the policy out or who paid the premiums.  But, the proceeds are included in the decedent’s gross estate only to the extent they are actually used to discharge claims.  See, e.g., Hooper v. Comr., 41 B.T.A. 114 (1940); Estate of Rohnert v. Comr., 40 B.T.A. 1319 (1939); Prichard v. United States, 255 F. Supp. 552 (5th Cir. 1966). 

But, there is a possible way to have the funds available to cover the obligations of the decedent’s estate without having the insurance proceeds being included in the estate.  That can be accomplished by authorizing the beneficiary to pay charges against the estate or by authorizing the trustee of a life insurance trust to use the proceeds to pay the estate’s obligations, buy the assets of the estate at their fair market value, or make loans to the estate.  Treas. Reg. §20.2042-1(b)(1).  In that situation, the proceeds aren’t included in the decedent’s estate because there is no legal obligation (i.e., duty) of the beneficiary (or trustee if the policy is held in trust) to use the proceeds to pay the claims of the decedent’s estate.  See, e.g., Estate of Wade v. Comr., 47 B.T.A. 21 (1942).  However, achieving this result requires careful drafting of policy ownership language along with the description of how the policy proceeds can be used to avoid an IRS claim that the decedent retained “incidents of ownership” over the policy at the time of death.  I.R.C. §2042.  In addition, the policy holder’s death within three years of transferring the policy can cause inclusion of the policy proceeds in the decedent’s estate.  I.R.C. §2035. 

Other Uses of Life Insurance

Loan security.  Life insurance can be pledged as security for a loan.  This means that a farmer or rancher can use it as collateral for buying additional assets to be used in the business.  In this event, the full amount of the policy proceeds will be included in the decedent’s gross estate, but the estate can deduct any outstanding amount that is owed to the creditor, including accrued interest.  It makes no difference whether the creditor actually uses the insurance proceeds to pay the outstanding debt. 

Funding a buy-sell agreement.  For those farming and ranching operations where the desire is that the business continue into subsequent generations as a viable economic unit, ensuring that sufficient liquid funds are available to pay costs associated with death is vitally important to help ease the transition from one generation to the next.  Having liquid funds can also be key to buying out non-farm heirs so that they do not acquire ownership interests in the daily operational aspects of the business.  Few things can destroy a successful generational transition of a farming or ranching business more effectively than a sharing of managerial control of the business between the on-farm and off-farm heirs.  Life insurance proceeds can be used fund a buy-out of the off-farm heirs.  How is this accomplished?  For example, an on-farm heir of the farm operator could buy a life insurance policy on the life of the operator.  The policy could name the on-farm heir as the beneficiary such that when the operator dies the proceeds would be payable to the on-farm heir.  The on-farm can then use the proceeds to buy-out the interests of the off-farm heirs.  In addition, the policy proceeds would be excluded from the operator’s estate. 

There are other approaches to the addressing the transition of the farming/ranching business.  Of course, one way to approach the on-farm/off-farm heir situation is for the parents’ estate plans to favor the on-farm heirs as the successor-operators.  But, this can lead to family conflict if the younger generation perceives the parents’ estate plans as unfair.  Whether this point matters to the parents is up to them to decide.  Another approach is to leave property equally to the on-farm and the off-farm heirs.  But, this approach splits farm ownership between multiple children and their families and can result in none of the families being able to derive sufficient income from their particular ownership interest.  This causes the ownership interest to be viewed as a “dead” asset.  Remember, off-farm heirs often prefer cash as their inheritance.  Sentimental ownership of part of the family farming or ranching operation may last for a while, but it tends to not to be a long-term feeling for various reasons.  Sooner or later a sale of the interest will be desired, real estate will be partitioned and the future of the family farming operation will be destroyed.  A life insurance funded buy-out can be a means to avoiding these problems. 

Conclusion

Today’s post merely introduced the concept of integrating life insurance in the estate/business plan of a farmer or rancher.  Other considerations involving life insurance include a determination of the appropriate type of life insurance to be purchased, the provisions to be included in a life insurance contract, and the estate tax treatment of life insurance.  Ownership planning is also necessary.  As you can see, it gets complex rather quickly.  However, the use of life insurance as part of an estate plan can be quite beneficial.