Edwin Moses was the king of the 400 meter hurdles and is considered one of the greatest athletes in the history of track and field. His winning strategy was simple: take only 13 steps between every hurdle, pulling away in the second half of the race as his rivals tired and changed their stride patterns to 14 or 15 (or more) strides. His simple strategy, backed by a legendary work ethic, led to two Olympic golds and a decade-long, 122 race winning streak – a feat unrivaled in the history of track and field.
Working with Business Owners
Business owners are gold medal clients for insurance professionals. Business insurance cases typically involve multiple product solutions and unlock a variety of planning opportunities, not to mention referrals to other business owners.
Business owners want to use the company checkbook to pay themselves first. After all, they shoulder the risks associated with business ownership and typically contribute years of blood, sweat and tears into the endeavor. As fringe benefits go, a qualified retirement plan may suffice for rank-and-file employees, but it will not complete the picture for most business owners.
The insurance advisor must learn to overcome the “pass-through hurdle” standing in the way of many business life insurance cases. The vast majority of businesses are pass-through entities with earnings flowing through to the business owner’s personal tax returns. Limited liability companies (with few exceptions), S corporations, partnerships and sole proprietorships are examples of pass-through entities comprising the majority of businesses in the United States.
What does this mean? Payment of life insurance premiums using the company checkbook for a personally owned policy is not tax deductible for most business owners. This is often a considerable hurdle to clear. Business owners have been drilled for years by their accountants and the financial press that income tax deductions are the beginning, middle and end of all business planning decisions.
Clearing the Hurdle
Clearing the pass-through hurdle involves a simple strategy: personally owned life insurance. Taxable business earnings provide the premium. The insurance premium is nondeductible; however, policy cash values grow tax-deferred and can be accessed via properly structured loans and withdrawals on a tax-free basis as long as the policy remains in force.
One of the few political issues nearly all people agree on is the future of income tax rates. Do you know anyone who thinks income tax rates will decline in the coming years? Nearly everyone agrees that income tax rates are “on sale.” Tax rates are sure to be re-examined in 2013 when the 2010 Tax Relief Act expires, particularly for taxpayers in the middle and upper income tax brackets.
Clients and prospects who believe income tax rates are on sale should be interested in a strategy where they trade income taxes today for tax-advantaged cash flow later. This is the same logic that has created much of the excitement surrounding Roth IRA conversions. Today is a prime time for you to explain that the absence of an income tax deduction is a good thing.
This strategy provides tax diversification. All seasoned advisors know it is unwise to pour everything into one “tax bucket.” There is simply too much tax risk. The life insurance policy serves as an additional tax bucket to help your clients diversify their savings and investments. It compliments their other buckets such as qualified plans, taxable investments, real estate and municipals (to name just a few). By having more buckets, clients will enjoy added flexibility to deal with future tax law changes that are coming. You are clearing the hurdle.
The personally owned policy is off the company’s books, away from company creditors. In many states, personally owned life insurance receives favorable protection from personal creditors (check your state laws for your state’s rules). Also, there is minimal legal work or administration with this strategy. And let’s not forget that the death benefit provides family protection and estate planning opportunities.
When discussing this strategy, business owners become excited about policy cash values, the aptly named “living benefit.” To avoid unintended tax traps, the policy should not be a modified endowment contract (MEC). With MECs, cash flow is taxed last-in, first-out (gain first) and the pre age 59 1/2 10 percent penalty applies. Most insurance illustration programs are designed to protect against unintended MECs with pop up warning banners or disclaimer language but advisors should be diligent to double check illustrations and read the fine print.
Also, to maximize cash flow, there is the risk of cutting the bread a little too thin on illustrations when illustrating loans and withdrawals. For universal life or whole life, at a minimum, illustrate the policy carrying to age 100 at one percent below the current interest or dividend crediting rate. For variable universal life, a gross return of 8-9 percent is the comfort level for many advisors. Please remember, if the policy lapses, all gains become income taxable – this is not what your client wants. Be careful.
Finally, adding the waiver of premium rider for disability should be your default setting. This powerful rider provides a premium funding safety net if the business owner insured becomes disabled. Where available, advisors should put this option on the table.
A Winning Strategy
When working with business owners, simple strategies can be the most elegant from a tax and business planning perspective. In our rush to promote the “latest and greatest” strategies, we sometimes bypass time-tested solutions. As an insurance professional, your charge is to help people understand the power of permanent coverage.
And don’t forget, be like Edwin Moses – work hard and lengthen your stride!
David Szeremet, JD, CLU, ChFC is Assistant Vice President, Advanced Sales for Ohio National Financial Services in Cincinnati, Ohio.