Any advisor who counts a business owner among their clients knows that telltale look, the one that says, “I already have too much on my plate running a company to worry about long-term planning stuff.”
All too frequently, the day-to-day concerns of running a company push vital business planning and big-picture strategic decisions to the back burner. Indeed, two-thirds of business owners lack a formal succession plan, including 7 in 10 business owners over age 50, according to the 2014 U.S. Trust Insights on Wealth and Worth Survey from Bank of America Private Wealth Management.
As much as business owners tend to focus on the seemingly more urgent near-term demands of running a company, sometimes they need to be reminded how important long-term business planning is and how valuable life insurance can be in that context.
“As the owner of a company, you have to make sure your business is protected from certain risks, and that you’re protecting your assets by taking care of your best employees,” says Elaine B. Eisner, co-founder of the Eisner Gohn Group, an insurance planning practice. “Life insurance is really good at providing that kind of protection for business owners.”
Protecting what the business owner built
Versatile as it is, life insurance is an indispensable strategic tool:
For business owners,
For its utility in business continuity/succession planning and estate planning,
As a form of compensation to attract and retain talent, and
As a means to protect employers against the loss of key employees.
For entities with more than one owner, such as partnerships, often the first order of business is protecting one another from the loss of one partner due to disability, death or retirement, says Hank N. Mulvihill, Jr., principal at Mulvihill Asset Management in Richardson, Texas. Here’s where advisors and their business owner clients often turn to buy-sell agreements underpinned with life insurance.
In some cases, such as with professional firms (legal, engineering, consulting, dental, etc.) a group of partners or senior executives cross-insure one another. So if one of them dies, the remaining partners in the group use the tax-free proceeds to buy that person’s stake in the firm (rather than the stake transferring to the person’s heirs, whom the other owners may not want as a partner).
Permanent life insurance also plays a large role in business succession planning, whereby the successor owners of a company are the beneficiaries of a policy that insures the life of the existing owner. When the existing owner dies, the successor owners use policy proceeds to acquire the company. Family-owned businesses often employ this type of maneuver, says Raymond Benton, principal of Benton & Associates in Denver, Colo.
The aforementioned strategies most commonly involve permanent life insurance that is either owned by the partners or the entity itself. Universal life with fixed premiums tends to work best for companies seeking cost assurance, Mulvihill says. In other instances, a well-funded whole life policy makes sense.
“If you’re looking for cash value to fund a retirement buy-sell agreement, it’s worth looking at a custom whole life contract or an over-funded universal life contract,” says Eisner.
For businesses that are highly cyclical or otherwise prone to cash flow fluctuations, a UL policy with flexible premiums can make the most sense, she adds. Meanwhile, businesses that can’t afford to pay the premiums on a permanent policy might look to a more affordable term life policy.
Key person planning
After business owners and/or partners protect themselves with buy-sell agreements, the next level of planning involves protecting the company from the loss of a key executive, such as a top revenue producer or a person who is otherwise indispensable to the organization because of their expertise, business connections, etc.
Companies who have such a “key person” — an owner or otherwise — often purchase a life insurance policy on that person, so if he or she dies, the life insurance policy “provides capital to help stabilize the company and give it operating cash while it finds a replacement for that person,” says Benton.
Life insurance is also a useful and highly tax-efficient tool for companies with an employee stock ownership plan (ESOP), Mulvihill points out. The company may purchase some form of permanent life insurance for key-person coverage to protect against the risk of the company not being able to cover its ESOP repurchase obligations.
Handcuffs and other talent-retention tools
“After you take care of the risk with owners and key staff,” says Mulvihill, “then you go to the goodies” — bonuses and other forms of compensation built around life insurance.
In a tightening labor market, it’s becoming more difficult for companies to attract and retain talent. Compensation programs built around life insurance are a potentially powerful way for small and mid-sized companies to compete for talent with larger, better-capitalized businesses.
For example, Eisner explains, a company may establish an executive bonusing arrangement whereby the company takes out a life insurance policy on a valued employee. Usually either the employer pays policy premiums (which are tax-deductible if the technique is executed properly) or shares premium responsibility with the employee (a split-dollar arrangement). Eventually that insurance policy — she generally favors a custom whole life contract for situations such as these — “should create a fairly robust tax-free income stream for a period of years during [the executive’s] retirement.”
These kinds of compensation arrangements are appealing “because they give the owner of a small to mid-sized business golden handcuffs to retain their most valued people,” Eisner says, and because “they are very easy to administer.”
Life insurance also is often used to underpin other compensation packages, including a non-qualified deferred compensation plan such as a SERP (supplemental executive retirement plan) for key employees.
In these arrangements, the employee purchases a permanent life insurance policy on his or her life and pays the premiums. The employer then pays the employee a bonus to cover (or exceed) the amount of the premium payments. The employee owns the policy, including the death benefit and any cash value that builds inside the contract.
These forms of non-qualified deferred compensation generally are best suited to highly paid executives and owners who want to set aside additional money for retirement, above what they’re allowed to stash in qualified plans, notes Benton. “It’s a nice complement to something like a 401(k) for more highly paid employees and owners. For them, the percentage of income they can set aside in a qualified plan may not be adequate to furnish a satisfactory retirement.”
Sometimes, he adds, the life policies in these arrangements are structured as split-dollar contracts, whereby, over time, ownership of the policy transfers fully to the employee via periodic bonuses.
In many such situations, the business owner will use a variable universal life policy to underpin a non-qualified deferred compensation plan, Benton says. “They can stuff it full of cash with the intention of generating growth in the policy’s cash value, which they can later draw down as income.”
For business owners, he adds, “it’s a way to shift cash from the business into their personal net worth.”
These types of policies are also handy to have on the balance sheet, notes Mulvihill, since the company and the individual may be able to borrow against them.
To further sweeten the compensation pot for top employees, he notes, a company might offer a hybrid form of life insurance policy that comes with a long-term care rider or feature that provides the policyholder with tax-free cash to cover long-term care expenses. “These are becoming very popular to retain top talent,” says Mulvihill.
All these forms of compensation represent “a great way to let your top employees know how much you value them,” says Eisner. “It shows them you’re going out of your way to give them additional, meaningful benefits. Here again, life insurance provides some really good, long-term golden handcuffs, which is important, especially with the labor market tightening.”
Entrepreneurs also often turn to life insurance as an estate-equalization vehicle. For example, says Mulvihill, in the case of a business owner who has multiple children but wants only one of them to inherit the company, the business owner may purchase a life insurance policy (usually a permanent policy such as UL), the proceeds of which would go to the child (or children) who aren’t inheriting the company.
Given the complexity of tax regulations governing estate planning, compensation plans and other business applications for life insurance, Eisner recommends bringing a tax attorney along with a CPA into discussions involving these techniques.
And since circumstances for a company and its owner(s) tend to change frequently, Eisner recommends reviewing your company’s life insurance needs and portfolio annually. As much as your entrepreneurial clients would rather be spending their time and energy dealing with the day-to-day stuff, they’ll thank you later for getting them to focus on long-term strategic issues that ultimately could make or break their business.