Re-Imagining Your Tool Box for the Small Business Client

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.”