Do you remember the first business advice that you received? For me, I can remember my father telling me, “You cant get rich working for someone else.” Unfortunately, like nearly all of the advice that my father has given me over the years, I have completely ignored it for the first 40 years of my life.
But, the longer I work in the estate planning field, the more it becomes clear to me–my father was correct on that piece of guidance. I have certainly found that many people who need estate planning services are owners of a small business.
Think about your best estate-planning clients. How do they earn their money? How many of them are the primary shareholder or a significant shareholder in a closely held business? For such clients, it makes no sense to distinguish between estate planning and business planning. After all, their business is the primary asset in their estate. In some cases, they consider the long-term success of their business as important as the financial security of their family. In fact, many such people assume that the long-term success of their business will provide long-term security for their family.
However, over and over again, I see the same thing occurring–insurance professionals not talking to their estate-planning clients about their business insurance needs. Some advisors feel that business uses of life insurance are complicated. These professionals have practices that focus on income replacement and estate planning. Business insurance is out of their comfort zone. If you are one of these professionals, you are missing a golden opportunity. And, worse yet, you are doing your clients a disservice.
While it might surprise insurance professionals who have focused their practices primarily on estate planning, business insurance is not complicated. In fact, it may be easier than estate planning. The following are several of the key facts that insurance professionals need to know about business uses of life insurance.
All closely-held businesses should have a fully-funded buy-sell agreement. Despite what you may have heard from Washington over the past year, it is not the estate tax that ordinarily causes closely held businesses to fail after the death of a significant owner. Rather, such businesses often fail because the owners have failed to plan for the succession of the business.
Succession planning should begin with a buy-sell agreement, a simple planning concept that is easy for your clients to understand. The corporation (or the other owners) purchases life insurance on the life of the owner, in order to buy out the owners interest in the event of untimely death.
Permanent life insurance is a perfect funding solution for a buy-sell arrangement because the tax-deferred cash value can be used to fund a buyout at retirement or upon the disability of an owner. The death benefit can be used to fund a buyout at death.
Recruiting, Rewarding, and Retaining Key Employees
Non-qualified executive benefits are a key to the long-term success of a closely held business. Recruiting, rewarding, and retaining key employees is the lifeblood of any organization. Without a competitive compensation package, key employees will be picked off by competitors. Business owners often find that it takes years to fully train a replacement after the departure of a key employee–assuming that a qualified candidate can be found. Not surprisingly, the employer will often pay the replacement more than the key employee was making before he or she left.
A key employee who has a compensation package that is enhanced with non-qualified executive benefits is much less likely to jump to a competitor than one who does not. After all, that is why non-qualified benefits are sometimes referred to as a “golden handcuffs.” Unlike qualified benefit plans, non-qualified plans can be made available to “select” employees. Such plans can be selective and specifically structured to meet the needs of the business and the individual key employees.
The Key to an Effective Retirement Plan is Tax-Deferred Savings. Deferred compensation can provide considerable benefits to owners of small businesses. Obviously, an owner does not need to worry about retaining himself or herself. However, basic financial realities make deferred compensation a powerful tool to the owners of the business. In effect, this is as easy as realizing that there is more advantage to save for retirement on a pre-tax basis. Example 1 (page 12) demonstrates the power of non-qualified deferred compensation to a business owner.
Qualified Plans Subject Highly-Paid Employees to Reverse Discrimination. Despite receiving some relief in the recently passed tax bill, highly-compensated employees are subject to qualified plan limitations that may cause their qualified plan retirement income to be less of a percentage of final salary than rank-and-file employees. Generally, if an employee earns more than $200,000, his or her qualified retirement benefits will not reflect the additional compensation.
Additionally, defined benefit plans limit annual benefits to the lesser of $160,000 or salary, and defined contribution plans limit an employees annual contribution to the lesser of $40,000 or 25% of salary. Example 2 (this page) demonstrates the impact of “reverse discrimination.”
The primary types of non-qualified executive benefit programs are the Supplemental Executive Retirement Plan (SERP) and the Salary Deferral Plan (i.e., Deferred Compensation).
A SERP is a company-sponsored salary continuation plan designed to provide key employees with retirement benefits in excess of IRS limitations. A SERP designed to restore benefits “lost” by IRS limitations is sometimes known as an “Excess Benefit Plan.” However, a SERP can go beyond simply restoring benefits lost because of qualified plan limitations. In fact, employers have almost unlimited discretion in rewarding key employees.
A SERP is not a “contributory” plan. Selected employees do not contribute to a SERP. Rather, SERP benefits are funded exclusively by employer contributions.
A Salary Deferral Plan allows an employee to make an unlimited pre-tax deferral of compensation–including salary, bonuses, or incentive pay.
One type of Salary Deferral Plan is the “401(k) Restoration Plan.” This plan (sometimes referred to as a “401(k) Mirror Plan”) is similar to a qualified 401(k) plan since employee contributions are based on a percentage of the employees salary with employer matching. However, unlike a qualified 401(k) plan, there does not need to be restrictions on the amount the employee contributes.
Non-qualified deferred compensation plans must be “unfunded.” Most non-qualified deferred compensation plans are considered “unfunded” for ERISA purposes because the employer “informally” sets aside assets to fund or finance the employers contractual obligation. Funds are only “set aside” to specially designated accounts where employees may be allowed to direct the investment of funds.
The employer enjoys greater flexibility because it is not subject to most ERISA vesting and fiduciary requirements. Even with informal funding, the employees benefits are at risk of the employers bankruptcy, and the funds are still subject to the employers creditors. Employees are only general unsecured creditors of their employer.
Life insurance funding is ordinarily the most efficient way to fund a plan. A corporate-owned life insurance contract is often the most cost-effective way of financing deferred compensation obligations. The after-tax cost can be minimal, and employers may achieve actual gains with creative insurance planning.
Life insurance is a tax-favored investment, generally allowing current income tax deferral. Moreover, life insurance is the only funding vehicle that can fully pay the obligation from day one using the death benefits. The employer may also fund the benefits from policy cash values. Employer costs can be recovered with tax-free death benefits or cash value withdrawals.
In summary, many of your estate planning clients have one or more business insurance needs. Clearly, many closely held businesses lack a fully funded buy-sell arrangement. Without a buy-sell arrangement, it will be difficult for the business to continue after the retirement, disability, or death of its primary shareholders.
How many of your clients are owners of a closely held business? How many of these clients do not have a fully funded buy-sell arrangement? If you dont know how many such clients you have, how come? Arent you missing a tremendous opportunity?
How many of your clients are shareholders in such a business? Do you know if your clients are among those that dont have a non-qualified executive benefit plan in place? Again, if you dont know the answer to this, you are missing a tremendous opportunity.
Business uses of life insurance need not be complicated. You need not be a “COLI” producer to help your clients with their business insurance needs. It is as simple as partnering with an insurance company that has a turnkey business insurance program.
What does a turnkey program require? First, the company should have an easy-to-use business proposal system and an experienced support team to help you with that proposal system. Second, it should have a full range of insurance products to fit the spectrum of business insurance needs. Third, it should offer sample deferred compensation plan documents for the benefit of you and your clients legal advisors. Fourth, it should offer experienced plan administration to supply you with the necessary information to keep the plan in force after it is sold.
Business insurance uses of life insurance are not that complicated. And, most importantly, some of the best prospects may already be your clients!
is senior counsel, director of advanced markets and small-business insurance, Manulife Financial, Boston. He can be reached via e-mail at Randy_Zipse@manulife.com.
For a primary shareholder in a
closely held business, it makes no sense to distinguish between estate planning and business planning
Reproduced from National Underwriter Life & Health/Financial Services Edition, June 11, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.