When Estate Plans Falter Along Family Lines, Tax Insurance Can Repair Rift

Insurance has been a long-established and reliable estate planning tool that many estate planners use to manage future tax burdens. Life insurance is often used as part of the planning process, and tax insurance is now being seen as a valuable solution to manage the tax uncertainty that comes with estate settlements and family business restructuring. While widely-used in M&A transactions and by tax credit investors to bring certainty to their investments, the use of tax insurance has expanded into the realm of complex estate tax management. Yet many wealth managers and tax and estate attorneys are unaware that insurance can play a similar role with estate plans that veer off track—adding a layer of certainty to an uncertain outcome for high-net-worth families trying to avert an unanticipated and significant tax hit.

As advisors and attorneys know, estate settlement can hit any number of roadblocks, whether contentious or amicable, including disagreements over settlement terms, unforeseen circumstances that alter family dynamics, or even mistakes. Parties can restructure a will to resolve these issues, but often with unintended consequences—such as a tax bill in the tens to hundreds of millions of dollars.

When these families seek to restructure an estate plan, concerns over who will bear the burden of adverse tax consequences can be an impediment to amicable settlements and sensible go-forward business plans. Families don’t have to endure prolonged conflicts, large exposures or the high costs of traditional indemnity agreements though—they have another option. They can obtain tax insurance to cover certain losses such as additional gift taxes payable from a position that fails to qualify for its intended tax treatment, all while keeping the settlement on track.

In this way, tax insurance becomes a strategic risk management tool to avoid the economic pain of those taxes and support the transfer of wealth to the next generation and the continued operation of the family business in a practical manner. Beneficiaries can obtain that tax certainty at a fraction of the potential exposure, while avoiding the oftentimes lengthy and costly process of petitioning the IRS for a private letter ruling. In addition to potentially prolonging an arduous settlement process, a private letter ruling will not add any comfort with respect to valuations or other fact-based issues that can be insured.

So, what is tax insurance? It is an insurance solution that offers programs over $500 million, and with the entrance of additional “A” rated or better insurers to the market, the ability to place programs over $1.5 billion per risk has been enhanced. It can be considered the insurance version of a private letter ruling. A policy will clearly define the intended tax treatment of the situation at hand - for example, that the restructuring of an estate will not give rise to income or gift taxes. Down the road, if the IRS successfully challenges that position, the insurers will pay certain assessed amounts (for example, tax and interest), contest costs and a gross-up for any tax due on the insurance proceeds themselves. The policies are customized to fit each situation but contain few exclusions and are generally straight forward. So long as the insured does not misrepresent the situation and acts consistently with the requirements of the policy, that insured can expect to be protected against these future covered losses.

As a strategic tool, these policies can be used to resolve disputes or conflicting agendas with potential tax implications in any number of settings. It is a solution that is gaining awareness in all areas of tax planning, and wills and estates is no exception.

At the time of execution of a will, disagreements and disputes are not uncommon. Tax insurance is a tool to help overcome disagreements and provide a solution where reasonable minds may differ on complex issues. For example, despite significant upfront planning by experienced tax professionals , family members and other beneficiaries can still find themselves in a standstill while their advisors are faced with the onerous task of respecting intent of the deceased and simultaneously preserving intended tax benefits. When family members split an estate, they might discover, for instance, that the terms in the will are in conflict with other documents governing the underlying property, such as court-approved agreements made in connection with a divorce settlement. Enforcing those agreements, however, may or may not trigger gift tax depending on interpretation. To overcome this uncertainty, the beneficiaries could insure themselves against an adverse tax determination by the IRS and avoid the need to set aside million in reserves or an escrow.

In another scenario, insurance can be used to create a layer of protection from an underlying tax exposure discovered during the settlement negotiations. Family members could, for example, discover a prior tax position taken by the author of the will that, if reviewed and successfully challenged, could result in a significant tax assessment to one or more beneficiaries in the future. Negotiation and settlement of the estate thus could be on hold until a solution is presented to overcome this risk. In these types of cases, tax insurance serves as a replacement for an indemnity agreement against any future challenges to the tax position, allowing the estate to be settled.

Insurance can also be used to cover a defect discovered in an estate plan. Circumstances shift and family dynamics often change in the years after a will is written and before it’s executed, resulting in scenarios not intended or anticipated by the author. But the correction of these “errors” can be insured.

That situation could be a case, for instance, where one sibling inherits a family business leaving a second with a prominent management position but no ownership stake. The family might choose together to change the ownership structure as a way to retain the sibling as the manager of the business. Though we frequently see family members with the common goal of finding a solution to an insurmountable issue, alternatively when relationships have gone completely sour, tax insurance can be a helpful tool to help ease negotiations. For example, multiple siblings may be seeking to split the inherited business thus requiring a complicated restructuring for tax purposes. Advisors may have differing views on the proposed structure and likely tax outcome of a restructuring, and depending on the relationship of the parties, an indemnity may not be an efficient solution.

Today’s tax structures and their implications are material and complex and could significantly compromise efficient estate and business planning. Insurance is frequently used to help wealthy families resolve issues to settle estates in the same way it helps Fortune 500 companies resolve issues in M&A deals. It also is a tool for family offices to achieve a level of tax certainty as they plan for the future as families need to plan for uncertainty in the same way companies do.

Insurance is ultimately a powerful tool capable of much more than traditional downside protection, one that helps attorneys and wealth managers enhance plans to minimize taxes, preserve assets, and keep settlements on course while forging stronger, more productive ties among parties. Expanding their network to include these tax insurance resources can also help position them as the center of an extended advisory team prepared to address any number of eventualities.

Gary Blitz is Co-CEO of Aon Mergers & Acquisitions and Transaction Solutions/Head of Tax, part Aon plc (NYSE: AON), a leading global professional services firm providing a broad range of risk, retirement and health solutions. Jessica Harger is Managing Director of Aon’s Transaction Solutions team as part of its Tax Insurance Practice.

¹ Note that the focus of this article is on the use of tax insurance in connection with the settlement of estates and restructuring of family businesses. Various other insurance opportunities may be available at the estate planning stage, which is outside the scope of this discussion.