It’s a common dilemma faced by business owners: They know they need to fund their business continuation plan, but too often that critical final element is left wide open. Even where a binding buy-sell agreement is in place, the arrangement may be unfunded or under-funded. Yet without the funding element, surviving owners will not be able to honor their legal obligation to the deceased owner’s estate or family.
Why are these agreements left unfunded? Often, a business may wish to direct cash flow to operations or expansion. Often too, owners look for a less expensive way by which to cover something they view as an expense they will not incur for years.
A client’s existing or newly created defined contribution profit-sharing plan may be an ideal source of premium dollars for clients who need to fund a buy-sell arrangement but are hesitant to do so out of personal income or business cash flow. Tax-deductible dollars going into the qualified plan can thus serve a dual purpose.
One can reasonably assume that a business that operates a profit-sharing plan would make annual contributions. Because these contributions are already built into a business’s cash flow, most business owners would view them not as an additional expense used to fund life insurance premiums, but rather as a redirection of a portion of already-budgeted dollars.
Additionally, new funds going into a profit-sharing plan are tax-deductible. The ability to use these tax-deductible dollars to help fund an additional business need is usually attractive to a business owners. There are limitations as to how much new money going into a profit-sharing plan can be applied toward life insurance premiums.
These limits, often referred to as the incidental benefit rules, assure that funds in a qualified plan are used primarily for funding retirement. Still, a respectable amount of new funds can be contributed toward the life insurance premiums.
Up to 25% of new contributions can be directed to term and universal life products; up to 50% of new contributions can be directed to whole life premiums. Where there are existing funds, often referred to as seasoned money, those amounts can be directed to life insurance without the constraints of new contributions.
Business owners who are years away from retirement may view the funds in their retirement plan as “dormant” assets. A plan that is correctly set up may allow a business owner to use these funds to handle a significant, current, business and personal issue.
There is no specific enforceable authority that directly speaks to this approach. Instead, it is based on a pair of Private Letter Rulings. These do not carry the weight of law, and several significant areas have not been directly addressed.
The 2 favorable private letter rulings issued regarding this technique are cited as PLR 8108110 and 8426090, respectively. Applicable only to the taxpayers who request them, private letter rulings provide an indication of the general thinking of the Internal Revenue Service.
The rulings, however, do not judge (1) whether the policy on the life of another is a permissible plan investment, as the rulings concerned considered an ERISA issue; and (2) whether the proposed transaction could affect the qualified status of the plan, as that issue was not within the scope of the ruling authority.
Typically, clients set up a defined contribution profit-sharing plan, or amend an existing profit-sharing plan, with language that allows for:
(1) the purchase of life insurance.
(2) in-service distributions.