What is the most common error made when insuring a business owner?
In a word: titling. A business might own a life insurance policy on the life of the owner or major shareowner and name another shareowner or the owner’s spouse as beneficiary – but third-party ownership can be tricky, and it is almost always a mistake to have a beneficiary who is someone or some entity other than the owner.
Here’s an example: A Michigan corporation purchases a policy on the life of the company’s president. As the owner, the corporation pays the premium, and as a benefit, allows the president to name his spouse and children as beneficiaries. What are the potential tax pitfalls? At death, the corporation has effectively made a gift to the beneficiary that is equal to the death benefit. The company could owe gift taxes, and the life insurance proceeds might be taxable to the beneficiaries. Furthermore, the premiums could be considered dividends and taxed to the president’s estate. As a rule of thumb, life insurance policies with owners other than the insured should have a beneficiary designation that matches the ownership designation. Too often, executive benefits or buy-sell arrangements can cause major tax traps when policy titling is poorly done.
What is the most important thing to know when working with business owners on their life insurance policies?
This period of sustained low interest rates is toxic for life insurance policies. Life insurance is a dynamic instrument, susceptible and vulnerable to interest rate conditions. In business, companies buy life insurance to fund promises to key people and to provide capital for stock redemption and buy-sell arrangements. They also purchase life insurance to provide cash injections if key people die. All of these noble purposes could go unmet if policies waste away while no one is paying attention, which is why agents must regularly review these policies.
Are all policies wasting away?
Some are just fine; others are actually over-funded, but the point is that these are dynamic instruments with moving parts, and periodic reviews are prudent. Corporate owned policies provide another good example: Many COLI plans are put into place to fulfill such promises as deferred compensation or supplemental retirement plans for executive classes. COLI plans are typically funded with variable life insurance, meaning the cash values rise and fall with the stock and bond markets. On the other hand, we recently looked at a corporate-owned group of policies purchased to fund stock redemptions that would keep company stock closely held. These policies were very conservative whole life plans with robust cash values. To look at these on the surface, you might believe that they are high-cash-value products with no exposure to stock market or interest rate volatility. However, these are very expensive, rather outmoded policies that, while safe, could be transitioned into more modern products that are equally safe but have more efficient cost benefits.
What other mistakes do business owners make with business life insurance?
The next item to consider is key person life insurance. Many small businesses have a big life insurance policy on the person who owns and runs the company. The business is the owner and the beneficiary. Sounds fine, right? Yes, key person can be a terrific idea, but you need to be careful when the key person is a stockowner. Let’s suppose you’re working with a business owner whose estate will pay federal estate taxes upon their death. The estate includes all assets, inclusive of the company stock valued at date of death. The stock’s value will now increase because the company will receive $5 million (or whatever the policy was worth), inflating the stock value and the estate tax bill. The net effect of key person life insurance in this scenario is a higher estate tax bill.
Business-owner clients need as much, if not more, advice than the average American regarding the right life insurance protection for themselves and their businesses. While every business owner’s situation is unique, questions like these will often arise, and it’s important to keep your clients’ interest top of mind when you are working to satisfy their life insurance needs.
Dan Cotter is principal and director of risk management at Rehmann. He can be reached at 440.356.4535 or firstname.lastname@example.org.
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