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.

The first of these amendments allows for the purchase of life insurance on each plan participant and family member(s). Once in place, a business owner can purchase a policy on the life of a co-owner within his/her own defined contribution account. A portion of the annual tax-deductible contributions to the profit-sharing plan can be used to purchase the life insurance policy.

If there is a death, the death proceeds will be paid into the survivor’s profit-sharing account. Those funds can then be distributed and used to buy out the deceased’s business interest. Result: The survivors honor their commitment under the buy-sell plan and buy the deceased’s business stake from their estate or family.

To illustrate, consider John and Joan, each of whom owns a 50% share of Acme Inc. They are, respectively, 45 and 55 years old and are rated “non-smoker preferreds.” They have an unfunded cross-purchase agreement that obligates each to buy a $1,000,000 business interest from the other’s estate in the event one of them should die. The plan has been unfunded because they want a tax-deductible way in which to fund the plan.

Using their profit-sharing plan, John buys a $1,000,000 policy on Joan, and vice-versa. They can use some portion of their current tax-deductible plan contributions, or some portion of existing funds already inside their profit-sharing plan, to purchase a life contract. But each year, the 2 owners must recognize the economic benefit of the life insurance owned within their profit-sharing account, the benefit being an out-of-pocket cost. Typically, the recognition is handled under Table 2001, but some life insurance carriers offer lower, proprietary alternative term rates.

Were Joan to die, John would receive the risk portion of the death benefit (the portion over the cash surrender value of the policy) free of income tax. In turn, he can use those funds to buy out Joan’s stake in the business. The cash value portion of the death benefit is subject to income tax, though John is credited with basis in the policy for the economic benefits on which he has paid income tax. Alternatively, if a secondary guarantee lapse protection rider were used, there would be little or no cash value, but a guaranteed death benefit would be paid out to John.

Keep in mind that there is a price to be paid for the tax deductibility.

? Each year the owners will recognize taxable income based on the economic benefit of the life insurance within their plan.

? In addition to the annual economic benefit charge, not all of the death benefits are available to cover the purchase price. Any policy cash values must remain in the profit-sharing plan as an asset for retirement.

? Using a life insurance policy in a qualified plan may draw from assets that might otherwise be used to build funds for retirement.

? Because the plan design must accommodate the life insurance purchase and potential distribution of death benefits, this approach is limited to defined contribution profit-sharing plans.

? On many occasions there will not be a death, in which case the life insurance policy needs to be addressed. Many options will need to be weighed, including distributing the policy from the plan to the account owner or insured; plus ERISA, income and gift tax considerations. In these cases, it is important to work with a company that can help you value the policy under the parameters of Rev. Proc. 2005-25.

? Note also this concept is based on a pair of private letter rulings that do not extend to taxpayers other than those who requested the rulings.

While this approach will not work in every situation, where the right client exists, it may be ideal. It allows business owners to purchase life insurance on a tax-deductible basis or with funds that might otherwise lay dormant for years. By doing so, they are able to fund a business continuation plan and achieve significant long-term planning goals.