Business owners can use life insurance to protect their businesses and provide important benefits to their employees. Without proper planning and funding, many businesses neglect to continue to the next generation.
Here are 4 ways life insurance coverage is used in business planning:
1. Key Person Insurance
Business owners are often concerned about protecting the business from the death of the key employee whose knowledge and contributions to the company are invaluable. The lack of a key employee may result in not just a loss in sales, but also a potential loss of brand value, important contacts and goodwill. The company's credit position can also be at risk.
The business owner can protect the business in the loss of a key person by implementing a Key-Person insurance plan (also known as Key-Man) in which the organization purchases and owns a life insurance policy on the life of a key employee. By implementing such a plan, the insurance advisor:
- can illustrate how a life policy offers liquidity to keep the business running during a transition in the event of the key person's premature death or disability;
- provides cash needed to hire a qualified replacement and/or to purchase the additional human capital or assets necessary to keep the business operating;
- helps to replace lost profits.
2. Business Succession Planning
The owners of a successful business, including a closely-held family business, should plan for the transfer of the business to another generation. Various kinds of Buy-Sell plans can go a long way in transferring business interests to surviving business owners in the event of the death of 1 of them. However, having a Buy-Sell arrangement is only 50% of the task. Funding the Buy-Sell may be the other part of the look. With no funding, the arrangements themselves may be compromised. Further, it is best to establish the Buy-Sell arrangement when a formal valuation of the business value is completed.
Generally, there are 2 main types of Buy-Sell arrangements:
- Cross Purchase Buy-Sell
- Entity Purchase Buy-Sell, or a Stock Redemption Agreement
Cross Purchase arrangements make reference to each business owner having a policy around the life of each one of the other business owners based on each business owner's share from the business. Typically, the arrangement will look to buy-out whoever is due to inherit the business interest of that deceased owner, often the surviving spouse or family member. Because this arrangement could be very cumbersome when there are more than 2 owners, an Entity Purchase agreement is usually considered as an alternative when there are more than 2 owners.
Entity Purchase arrangements refer to the entity or business owning each policy, with the life insurance proceeds being paid into the business, at which point the business facilitates the buy-out from the interests or shares with the surviving members of the family who inherited them. Often, these Entity Purchase agreements are set up as stock redemptions.
There are various other methods to set up a buy-sell arrangement, including a One-Way Buy-Sell or a Cross Endorsement Buy-Sell:
- One-Way Buy-Sell is exactly what it really sounds like: only one from the two parties purchases life insurance around the other's life. Typically, this is the case between a mature and a younger employee, like a father and a son, because the younger one is designated as the successor.
- Cross Endorsement Buy Sell is helpful when the business owner wants to own the policy on his life and prefers to endorse to the surviving business owner a portion of the death benefit to facilitate the buy-out. This kind of Buy-Sell is appealing but does come with a few tax issues relative to transfer-for-value rules that the client's attorney will need to assess.
Business Succession for Families could be a bit more complex and could require consideration of how to equalize inheritance among heirs not involved with the business. To this end, arrangements for family business transfers may include using succession trusts for example:
- Sale to a Defective Trust, or Sale of Asset to Grantor Trust (IDGIT/DIGT/SAGT)
- Grantor Retained Annuity Trust (GRAT)
- Irrevocable Life Insurance Trust (ILIT)
Sale to Defective Trust, or transfer of the business to a grantor trust (IGIT/DIGT/SAGT), a GRAT, or an ILIT allows the business to transfer over time through using an installment note, annuity payment, or a one-time liquidity event, to the designated successor, respectively. Life insurance can fund these types of 'succession' trusts to provide the liquidity needed to pay income and transfer taxes, to equalize an inheritance, and/or to supply the repayment from the note connected to the sale or transfer.
3. Executive Benefit Plans
Executive Benefit plans are used by employers to attract, retain and reward key employees from the business. There's two main types of plans in this category:
- Executive Bonus Plan
- Restricted Bonus Arrangement (REBA)
Executive Bonus Plan, refers to an employer paying a bonus to the executive within an amount equal to the annual premium on the life insurance policy that is owned by the executive and is on his or her life. The executive, because the owner of the policy, has the right to name the beneficiaries of the policy and to benefit from the potential accumulation of cash values around the policy, if any. This can serve as a valuable non-qualified benefit to the executive since it provides income protection for survivors, as well as access to tax-favored cash values for the executive to use toward supplementing and diversifying his or her income from other sources at retirement. In addition, the policy can include a rider to cover longer term care expenses on a tax advantaged basis. In this manner, the cash value life insurance policy provides the flexibility to cover various needs over lifetime without committing the policy today to any one need.
When an employer imposes a vesting schedule around the bonuses to create a 'golden handcuff', or an incentive to remain with the company, the Executive Bonus Plan becomes a Restricted Bonus Plan or REBA. The restrictions can be minimal or extensive. The more extensive the restrictions are the more complex and the greater administrative it might become. Although the executive owns the policy subject to the restrictions, the restrictions are typically in the form of restricted access to the policy's potential cash values.
4. Deferred Compensation Plans and Supplemental Executive Retirement Plans (SERP)
Executives, like all employees, are limited within the amount they can contribute to a qualified plan, like a 401(k) or 403(b) plan, annually. A non-qualified plan like a deferred compensation plan– also known as a salary deferral plan or 401(k) mirror plan– may help executives to save more for retirement. Although the contributions to the plan can't be made on the pre-tax basis like contributions to a 401(k), the contributions grow on the tax-deferred basis like a 401(k). And unlike a 401(k) plan, the amount that could be contributed to a salary deferral plan is unlimited. A Salary Deferral Plan can mirror a 401(k) plan in that the executive makes contributions to the plan while the employer may match those non-qualified contributions.
A Supplemental Executive Retirement Plan (SERP) is yet another type of non-qualified plan that an employer can sponsor. However, in this kind of plan the employer makes all of the contributions on behalf of the executive. When the employer makes the contributions to the plan, they're non-deductible. However, when the advantages are paid out, the employer has got the tax deduction at that time and the employee pays taxes as he or she receives the benefit.
Both of these types of non-qualified plans allow executives to save more for retirement on a tax-deferred basis to supplement other employer-sponsored plans, if any. These types of plans generally have vesting schedules on the employer matches that serve as incentive for executives to remain with the company.