Consider these advanced planned techniques for small businesses: one that lets companies quick build a retirement nest egg for key execs using arbitrage; a second that leverages a maximum-funded VUL to produce tax-free income in retirement; and a third that minimizes the taxable value of a business but maximizes the sale proceeds to a departing owner.
If these solutions are not part of your portfolio, then read on. Experts interviewed by National Underwriter say that these and other solutions will become increasingly prevalent in coming years because of the innovative approaches they bring to ever-present business challenges–securing the cash needed to fund executive compensation, retirement planning and exit planning objectives.
Substituting Term for Permanent
Though the U.S. economy is improving, observers say many small businesses are either unable or unwilling to set aside cash for permanent life insurance to fund non-qualified compensation plans for key executives. As a result, less costly term insurance policies are enjoying an upswing in demand.
Term policies are increasingly being used, for example, inside IRC Section 162 executive bonus plans. In these arrangements, the business pays a bonus in cash that is used to fund the premiums on a term policy the key executive owns. The premium payments are tax-deductible to the employer and taxable to the employee.
“In today’s economy, executive bonuses tend to be smaller than in years past,” says Brett Berg, director-advanced marketing of the individual life insurance business at Prudential Financial, Newark, N.J. “But companies want to provide a level of death benefit protection comparable to what can be obtained with a cash value policy. And so they’re turning to term insurance.”
In many cases, he adds, business owners are also electing term policies with provisions that waive premium payment requirements in the event that an executive should become unemployed or disabled. Example: the PruTerm WorkLife 65 product from Pruco Life Insurance Company, a Prudential company.
In the event of a disability before age 65, the premiums are waived until the insured recovers or turns age 65, whichever is first. The one-time unemployment benefit waives one continuous year of premiums. Policy owners can also convert their existing term policy to permanent insurance at any time up to age 65 without having to undergo additional medical testing.
“The new benefits are very applicable in a business planning context,” says Berg. “We’ve seen the disability waiver used in both key person insurance and in policies used to fund buy-sell agreements.”
Premium Financing with a Twist
For many small business owners, the issue is not whether to substitute a death-benefit-only term policy for cash value life insurance, but how best to fund policy premiums. Profitable owners may be able to fund the premiums from cash flow, but hesitate to do so if they believe the cash could be more wisely deployed elsewhere, such as investments in new equipment. Others may lack the resources to meet retirement planning goals for themselves and key executives.
Enter Global Financial Distributors, an Atlanta, Ga.-based subsidiary of Entaire Global Companies, Inc., and a provider of funds used to purchase life insurance and annuities to meet business planning objectives. Serving primarily small business owners ages 45 to 65 and with $1.5 million in investable assets, the company lends and services small business loans in partnership with Global One Financial, an affiliated Entaire company that specializes in lending procurement for GFD borrowers.
Dubbed Leveraged Planning, GFD’s program lets small business owners secure a simple interest, non-amortizing loan to fund (among other applications) non-qualified executive bonus plans using a high cash value life insurance policy. While the business pays the loan interest, the tax-deferred cash value policy (which also serves as collateral for the loan) grows at a compounding rate, thus allowing the business to engage in arbitrage.
Translation: The business can leverage the growth differential between the policy and the loan interest to generate enough cash to retire the loan at the end of the agreed loan term (typically 5 years or less) and provide a nest egg for the key executive with the extra cash value.
If, as is often the case, the business takes an income tax deduction for the interest payments on the loan, then the effect of the arbitrage is all the greater, says GFD President Al Harrington. At the end of the loan term, he adds, business owners can roll the loan promissory note into a new one so as to accumulate more cash in the policy. They can also use proceeds from the sale of the business to pay off the note. Or, depending on the corporate structure, they can use offsets against profits to tax efficiently retire the note.
In the right situations, say Harrington, the premium financing arrangement can be a win-win proposition for the business owner and key executive. But he cautions that the program is not for every company–most especially those that have shaky finances.
“A home builder in Nevada thought this would be a great idea for him,” says Harrington. “We thought otherwise because the market for residential construction was weak. Also, this type of arrangement won’t generally work well for executives beyond age 70 because of the time required to achieve the desired arbitrage gains.”
What type of policy is suitable for the program? Harrington says that (assuming adequate interest crediting rates on the cash value) both universal life and traditional whole life insurance lend themselves well to the planning. But he would argue against using variable universal life, as additional collateral for the loan would be needed in the event of a market downturn.
“Remember, we’re dealing with the conservative portion of an executive’s retirement plan,” says Harrington. “The last thing we want to do is to put someone into a plan that doesn’t achieve the necessary cash accumulation and arbitrage potential.”
The Private Pension Option
VUL may be inappropriate for executive retirement plans where the policy serves as bank collateral, but the product could be an ideal vehicle for tax-favored cash accumulation when no such bank strings are attached.
Bryan Beatty, a certified financial planner and partner at Egan, Berger & Weiner, LLC, Vienna, Va., frequently recommends VUL as an alternative to other non-qualified investments–stocks, mutual funds, bonds, etc.–where the executive is looking to achieve growth on a tax-favored basis and won’t be needing to take retirement income for many years.
Case in point: a 45-year-old client who was retiring early from a construction business in which he was part owner. Beatty says he won the client’s approval to fund, over a three-year period, a VUL policy using a portion of $7 million in cash the departing owner received from the sale of his shares in the business to the remaining partners.
The VUL policy was also maximum-funded: The initial $250,000 investment supported both an increasing death benefit and cash value, maintaining a minimum IRS “corridor” between the two to keep the policy from converting to an income-taxable modified endowment contract. Upon reaching age 75, says Beatty, the client can begin taking retirement income from the accumulated cash value–thus generating an income-tax private pension.
This case, he adds, was unusual because of the client’s early retirement; others that have elected the technique continued to work, building a tax-favored retirement nest egg in a VUL policy alongside a 401(k) or other qualified plan assets. But irrespective of their retirement outlook, says Beatty, clients should satisfy three requirements for the strategy to work: (1) have a high net worth (generally $2 million-plus); (2) have a long time horizon (in this case 30 years) between the policy purchase and draw-down of the cash value; and (3) incur a lower cost on the policy than in taxes.
“People don’t often compare the internal charges of insurance against assumptions as to future capital gains and income tax rates,” says Beatty. “This has to be weighed in the analysis. If the cost of insurance is greater than the cost of taxes, then you probably shouldn’t use this technique.”
The One-Way Buy-Sell
For owners who are looking to sell their business to a key executive, tax issues often pale in comparison to a more basic concern: how to enable the exec to finance the transaction and, thereby, contribute to the owner’s own retirement fund. One solution: to establish a one-way buy-sell agreement between owner and exec, the deal informally funded with an employer-owned (and high cash value) key person policy on the executive’s life.
Marketed by Principal Financial Group, Des Moines, Iowa, under the name, “Select Buyout Plan,” the arrangement calls for the business owner to pay the executive a lump sum bonus (from the policy’s cash value) at a predetermined date. The exec then uses the funds to acquire a stake in the business, and, thereafter, leverage the minority interest to obtain a loan to purchase the remaining shares.
If, conversely, the key employee should die before the agreed transition date, then the employer will receive the death benefit, a financial cushion that can be used to sustain the business until the key exec is replaced or provide a retirement fund for the owner.
Steve Parrish, a national advanced solutions consultant for Principal Financial, says that business owners need to take care to structure the plan so to avoid IRC Section 409A restrictions governing the timing of distributions, acceleration of benefits and timing of deferral elections for non-qualified deferred compensation plans.
“So long as you pay the funds as a lump sum within 2 1/2 months of the date the money is fully vested and owed to the key exec, then you don’t have to follow all of the complex rules concerning deferred comp,” says Parrish. “Also, you have to be careful not to tie the funds formally to the buy-sell agreement, as a provision of 409A doesn’t allow this.”
While keeping the IRS at bay, business owners and their advisors should also be prepared to address a common concern of the key executive: buying out a business that maybe overvalued. To that end, says David Seems, a managing partner of Business Advisors LLC, Englewood, Colo., the business should be regularly appraised using an agreed-on valuation formula.
“When developing a buy-sell agreement for a landscaping company in Denver, we satisfied both parties with a valuation process–we used Principal Financial’s valuation software in arriving at a formula–that was approved by an outside CPA,” says Seems. “At the end of 10 years, and within 30 days of the plan’s trigger date, 30% of the valuation is to be paid to the departing owner from the key person policy’s cash value. The buyer will then have a bankable deal–the ability to acquire a majority interest in the business via a loan.”
One-Way Buy-Sell, v. 2.0
To be sure, the valuation decided on by the buyer and seller need not reflect for all purposes the fair market value of the business. Wayne Minich, president of Applied Financial Concepts, frequently recommends a technique that minimizes the valuation reported to the IRS in order to reduce the seller’s capital gains tax on the transaction.
To illustrate, Minich cites a hypothetical S-corp. with a fair market value of $1 million, but a “lowest defensible value” (for IRS reporting) of $500,000. The owner sells 40% of the company to the key exec for $200,000, the exec funding the minority purchase from cash flow and S-corp. distributions during a three-year period.
In a second phase, the seller helps the buyer acquire a bank loan of $600,000 to purchase the remaining stock, the loan based on the original $1 million appraised value of the business. Upshot: The seller receives $950,000 (versus $800,000 using a conventional installment note); and receives the sale proceeds in 3 years, rather than 7 to 9.
As to life insurance, the transaction calls for two policies: (1) a $1 million permanent policy owned by the buyer on the seller’s life, which lets the buyer acquire the seller’s interest and recover the cost of purchasing the company if the seller should die during the buy-out period; and (2) a $1 million key person policy the seller owns on the buyer to protect again the latter’s premature death.
“We brought this technique into our practice with help from the Business Enterprise Institute in Golden, Colo., says Minich. “My two sons and I are in business together and we’ve incorporated the arrangement into our own succession plan.”