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