Successful businesses recognize the important role that insurance plays in risk management. Businesses commonly insure their buildings and equipment against a variety of hazards, as well as insure against other potential liabilities. However, a business’s most valuable assets are often its people. Business-owned life insurance can cover a variety of needs, such as:
»Offsetting the financial loss caused by a key employee’s premature death.
»Providing funding for a variety of plans aimed at attracting, retaining and rewarding key executives.
»Funding a buy-sell agreement.
Before we explore these applications for life insurance in a business context, some background is in order.
Term vs. Permanent Insurance
In its most basic sense, life insurance can be grouped into two categories: term and permanent. As the name suggests, term insurance policies are typically issued with level premiums and face amounts for a specified duration. Common durations are 10, 20 or 30 years. Premiums are relatively low during the initial term. However, after the initial term they increase annually and often quite substantially. Individuals who still have a life insurance need when the initial term expires may apply for new term policies; however, they will have to medically requalify, so options may be limited for those whose health has deteriorated.
Many carriers offer a conversion privilege that allows the insured to exchange the term policy for a permanent policy without requiring new evidence of insurability. However, the product set available for conversion may be more limited than what is available for initial purchase. If a policy is not renewed or converted, term insurance will provide only a temporary solution. Permanent insurance, on the other hand, will generally not only provide a death benefit for the life of the insured (assuming funding requirements are met) but can also include access to cash value.
One tenet in the world of business accounting is that if you are unable to get a tax deduction for a business-related expense, then at least make sure you are able to achieve cost recovery. Section 264(a) of the Internal Revenue Code expressly prohibits taking a tax deduction for premiums paid on a policy in which the business has a beneficial interest.
An “interest” in a policy could include, but is not limited to, ownership, all rights to cash values and the right to receive a death benefit. These would all apply to the arrangements discussed here. So, given that a deduction is disallowed in these cases, cost recovery becomes increasingly important.
Key Person Insurance
In this arrangement, the business will own, and be the beneficiary of, a life insurance policy on a key employee, which will help the company survive should the employee die. The insurance proceeds could be used to train a new employee, replace lost revenue and even mitigate potential loss of credit. The main purpose of key person insurance is to provide a death benefit, but it can also be used as a way to provide the key employee with supplemental benefits in the more likely event that the individual retires versus passes away, which can be an effective means of retaining key employees.
Term insurance may be used for key person arrangements. However, a term policy will only provide cost recovery to the business if the key employee passes away while it is in force, which would be unexpected for most working-age adults.
Endorsement Split Dollar
When an employer recognizes the need to insure a key employee’s life, the employer often will also recognize the value of keeping the key employee employed. An endorsement split dollar plan provides a way to accomplish both objectives. Since the policy is owned by the employer, the employer’s key person objectives can be met. By applying for more death benefit than just the amount for key person coverage, the key employee can be allowed to “endorse” the excess death benefit for their own family’s protection.
The key employee’s cost is measured by either the IRS 2001 one-year term rates, or the rates published by the life insurance carrier if available. The employee’s actual out-of-pocket cost is normally only the income taxes on the one-year term rates and not the term cost itself. The employer also has the option of increasing the employee’s compensation by an amount that offsets the additional tax cost.
By using a flexible-premium permanent life insurance policy, the employer has the option of selecting the amount of premium funding that comfortably fits the employer’s objectives for cash value accumulation. The employer may decide to ultimately transfer ownership of the policy to the insured key employee via a bonus at some future date (quite often coinciding with the employee’s planned retirement age). The bonus can be structured so that it meets the short-term deferral exception to the more complex requirements of IRC Section 409A.
If the business transfers the policy to a non-owner employee, the policy’s fair market value is included in the employee’s taxable income. The employee might use a portion of the policy’s cash value to offset the income tax cost of the ownership transfer. The employee can receive the distributions from the policy income tax free if the policy is properly structured. Upon the transfer, the employer will include in its taxable income the difference between the policy’s FMV and the employer’s basis in the policy. However, the employer should also receive a deduction equal to the policy’s FMV if the transfer is considered reasonable compensation to the employee.
Funding Buy-Sell Agreements
A buy-sell agreement is a legal agreement that dictates what happens to a business when one of the owners dies, becomes disabled or retires from the business. These arrangements typically come in two main forms: entity purchase (sometimes referred to as stock redemption) and cross purchase. This article will focus on entity purchase. In this type of arrangement, the business is the owner and beneficiary of the policy and pays the premium. This is very similar in structure to a typical key person arrangement; the difference is that the death benefit in a buy-sell is used to purchase the shares from a deceased owner’s spouse or estate rather than using it to replace the loss of a key employee.
Term insurance may be used in a typical buy-sell arrangement. However, what happens in the more likely event that the business owner retires? The term premiums now have become a nondeductible, nonrecoverable expense. This contrasts with permanent coverage, where the cash value component can serve many needs in a buy-sell scenario in addition to only the death benefit.
Consider a situation in which one of the owners retires from the business. Obviously, there is no death benefit to fund the buy-sell at that point, but the policy itself could be transferred to the retiring owner. The FMV of the policy could then be used as a component of the buyout agreement and perhaps be used to jump-start an installment sale. If the business does not transfer the policy for any reason, it could, at the very least, surrender it for its cash value.
Another issue to consider is the valuation of the business itself. If life insurance is the funding mechanism being used for the buy-sell, what happens if the value of the business changes over time? The death benefit on a term policy remains level throughout its duration so, in some cases, this may be insufficient to cover the buy-sell need as the business grows and prospers. One solution is to use a permanent life insurance policy that allows for an increasing death benefit, which includes the initial death benefit of the policy combined with the cash value component in any given year. Although this may not keep up with an increase in business value dollar for dollar, it will help the business owners get closer to where they need to be.
Term insurance can be an effective tool in business-related planning if the benefit is received at a desired time. However, this rarely ends up happening. Although term coverage requires less cash flow to fund than permanent life insurance does, permanent policies can provide many unique benefits to comprehensive planning for businesses. These benefits ultimately may cause permanent life insurance to be less costly in the long term.