Case Examples of When To Use Life Insurance and The Type To Use!

Part 1

Part One- Two cases using life insurance.   

Over the years I have seen clients and advisors get hung up on which type of life insurance they should purchase, permanent or term insurance, making their situation much more complicated than it must be.   

In this article I want to break down the different situations where life insurance is needed and what type of life insurance I would    recommend.  Again, this is my opinion, but it is based on several facts within the situation.   

Example 1 – Young Business Owner with A Growing Business 

Our client is running a business and is investing much of his discretionary dollars into the business. His wife is a nurse and makes  good income. This helps him support the family while building his business.  

He has two young children, a mortgage, and a business loan. They are not concerned about income replacement at his death, as his wife can work anytime and anyplace as a nurse. However, they are concerned about debt, business debt and the college costs for the kids. The capital required was $1,000,000 

His earnings have been increasing consistently for the past five years, and his business has been stabilizing while growing. The income from the business is more predictable and, in a few years, he feels it will be easier to budget.  

In this case I suggested he purchase a 20-year term convertible term insurance plan.  

  •  The premiums are affordable and low  
  •  the term of the insurance would be adequate 

I could have suggested permanent life insurance under a split dollar or bonus plan however, I felt it would impede his ability to save money in his business and continue to expand. 

Case 2-The Sole Proprietor with No Market 

The problem with owning a sole proprietorship, is in many cases there is no market to sell the business. These small companies create a job for the owner, a salary, and a place to go. It affords them a good standard of living, and enjoyment in their work. The problem, however, is at their death, a long-term illness, or a cash flow crunch, or loss of key employees, they do not have a market to sell too immediately.   

One of the greatest risks is dying while owning the company.  The business is too small for the open market, and normally there are a handful of employees who do not have an interest in or the money to purchase the business.  

This is a time that the estate in many cases needs the cash to settle estate expenses.   

Competitors are more than happy to lend a helping hand by offering 10-20 cents on the dollar for the assets.   

As a planner, I can help them!  

I can arrange to have a buyer ready at any time to provide the spouse or estate of the owner, the going concern value of the business.  

  The payout would be tax free. The cost could be from 1/2% to 2% of the value put on the business.   

If the cost were 1% for example, and the business was worth $250,000, the owner would pay $2,500 a year for this guarantee.  

If the owner decided to sell the business to a willing buyer, the owner would receive back part or all their cost for the arranged guaranteed purchase.   

The “Arrangement” at death is that the spouse/estate would receive tax-free the $250,000 purchase value!    The spouse/estate could also keep the business, and sell the assets or the business (piecemeal, or the whole business). 

If the owner of the business had retired and sold the business to an outsider or another family member, the arrangement would return to the owner all the deposits the business owner contributed to the “Arrangement” over the years, plus a reasonable interest rate to help them in retirement.  

Not a bad plan when you consider the “Arrangement” is guaranteed if the business owner paid their 1% to the arrangement.  

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Common techniques and situations where life insurance is required!

When you apply for life insurance with a trust, how is it set up? What are some of the ramifications? 

Basically, a life insurance policy is purchased by the trust and is owned by the trust.  The Grantor pays the premium in the form of gifts to the trust.  By doing so, the life insurance is not part of the estate, the benefits are tax-free, and if done correctly, premiums are considered present interest gifts in most cases.  The combination of the trust (Irrevocable Insurance Trust), and the Life Insurance maximizes and leverages the amount of property which can pass to the estate!   

  • The Trust needs a Tax ID (EIN) from the IRS since this is a tax paying entity 
  • A non-interest-bearing checking account in the name of the trust is needed to deposit cash into to cover the premium payment.  
  • The Grantor makes gifts to beneficiaries of the trusts. Gifts are deposited into the checking account. Gifts are normally within the annual exemption limit. 

Life Insurance and Business Succession Planning 

  • Equalization when leaving a business to family members when some of the members will receive the business while others will not.  Life Insurance can be the equalizer for the other children not receiving business interests.  
  • For businesses that are heavy in real estate, the life insurance can guarantee liquidity to cover maintenance expenses and lost cash flow. 
  • Life Insurance is a component of most buy and sell agreements to ensure the surviving partner has liquidity to buy out the interest of the deceased family member. 

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Types of Insurance:  Whole life, 2nd to die. What are the benefits of each?  

  • Second-to-die/survivorship life insurance can be in the form of a whole life or Universal life insurance policy.   It covers two lives and is paid at the survivor’s death.  It is normally when the capital requirements are needed at the death of the survivor.  Based on the mortality of two lives, it provides a discount for the insurance.  However, after the 1st insured dies, the premiums are normally needed, so a consideration would be the cash flow after a death of either one of the insureds.  However, if the capital requirement will be at the 2nd death, this type of policy is less expensive than buying two policies.   
  • Whole Life Insurance and Universal life are designed to stay in force for the insured’s lifetime. Whole life has guarantees, while Univeral life is albeit more flexible. It has the potential to cost more to keep in force for the whole of life.  However, universal life does offer guaranteed death benefit plans. Whole life and Universal Life can be used when the capital is needed for the lifetime of the insured.  
  • Term insurance is designed to last for a specific period before it expires.  Although term insurance is the least expensive initially, with outlay, it can become the most expensive over time.   However, it is a great plan to own when you have defined the capital exposure needed for a specific period and no longer. An example would be a bank loan for a brief period, a potential exposure or need not lasting for more than 20 years.   

Is life insurance death benefit tax free  Most of the time if arranged correctly.  However, there are a few exceptions when life insurance is not taxfree.   

  • Paid directly to the designated beneficiary (trust or individual) it will be paid tax free.   
  • The unholy triangle:  owner –dad; Dad gifts the policy ownership to daughter.  Daughter names her daughter as beneficiary.  At dad’s death there is a gift from Daughter (owner) to her daughter as the named beneficiary.  
  • Transfer for value:  This is when a policy is sold to another person as owner and paid to a non-exempt class, the policy will be taxable on the proceeds in excess of what the policy was sold for.  
  • Owner A, sells, his policy to his brother-in-law. At A’s death, the proceeds will be taxable in excess of what the brother-in-law paid towards the policy.  
  • However, if the brother-in-law was a Corportation (office of), a partner, a partnership, there would be no income taxes.  
  • Or anyone whose basis is determined by reference to the original transferor’s basis.  
  • The insured (or insured’s spouse or ex-spouse if incident to a divorce under Sec 1041) 

Avoiding the three-year look-back period when existing insurance is transferred to a trust.  

  • If the policy is already owned the insured can gift the policy to the trust, making a lifetime gift to the trust, the trust can then buy the policy for the interpolated reserve value of the policy  
  • Set up the trust before the purchase of the life insurance. Have the trust buy the policy, the trust would be the original owner and beneficiary.  

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What changes can be made to an irrevocable trust when the estate planning has changed?  

  • Decanting the trust varies from state to state. Decanting techniques can pass the assets into a new trust and take advantage of enhancements that may have appeared in the trust code since the original trust was created.  
  • Establishing a new trust for the life insurance:  The funding must be valued at the value of the old trust (namely the interpolated reserve value). It requires an exchange of assets. The trustees would also sign a contract of sale when the life insurance is transferred.  Certain procedures need to be in order.  

These are a few of the areas professional planners should be aware of when working on the estate of their clients.  These are some of the more complicated planning techniques, which come up often and are critical to making sure advisors are aware of the potential tax traps.   

I have found it best to work with the “team” of the client’s advisors so there is less of a chance to make mistakes when planning the estate of the business owner.   

To receive our FREE Estate Planning Guide for Business owners, BUSINESS OWNERS ESSENTIAL R-6:  CLICK HERE FOR THE DOWNLOADON the drop-down menu pick R-6 Business Owners Essentials. 

Creating Legacy By thinking Creatively !

Many of us own qualified plans such as employer sponsored 401k and IRA. Over the years they have contributed to the plans and have created a great amount of wealth.  While creating the wealth they received a tax deduction by making   contributions to the plans which were tax deductible.  Sounds good so far.  

However, there comes a time when the governments gratuitous treatment of qualified plans must end.  Now they want their money, In the form of taxes on the withdrawal of 100% of the money, not just the accumulation, but also the contributions which you received a deduction for (I always wondered why they did not just tax the amount of your contribution when you withdrew them instead of the whole account). 

Many seniors when they get to age 72 find they do not need the money to support their lifestyle but are forced to take the withdrawal (Required Minimum Distributions-RMD) anyways.  Recently, the required minimum withdrawal rules changed, and instead of taking the distribution at 70 ½, the distributions will start at 72.   

The segment of the population that does not need the distribution of the qualified money, have a few options that might end up being more helpful than just taking the distribution, paying the taxes, and then reinvesting the money, only to be taxed on the interest once again.   

LET US TALK LEGACY.  

Option 1:  Take the distribution.  Pay the taxes and re-invest the money once again, only to be taxed.  Upon death the money is distributed to your heirs.  Depending on the inheritance tax laws in effect at the time of your death, you may have federal and state taxes to pay on that asset left to the family. Once again, taxes.  So far, I have counted three taxes:  Federal taxes/state on the distribution.  Federal/state on the invested after-tax reinvestment, and Federal and state taxes on the distribution of the asset to the family.   

Option 2: Take the distribution of the qualified money which is taxable. The net after tax withdrawal is gifted into   the irrevocable trust.  The trust will use the money to buy a “second to die life insurance policy”, on life of the IRA owner (the grantor), and the spouse.    At the death of husband and wife, the policy will pay a tax-free amount to the trust.  This tax-free amount can be distributed tax-free to your beneficiaries at a future date.  

Note:  If this were a qualified account (Like a 401k or IRA), the balance of the account would be considered an inherited IRA if left to other than a spouse. Withdrawals would have to be made within ten years of death.  The withdrawals are taxable.    

If it were left to a spouse, they could continue the account, however, they would pay taxes on the withdrawal of the funds. Also, assuming no marital deduction (if left to other than spouse), there could be a federal/state inheritance tax on the value.  

Option 3:  Set up option 2, however, the balance of the qualified account(IRA), payable to the children, or grandchildren could be used to buy life insurance on the parents’ life, again recycling the RMD’S to create a tax-free legacy for the grandchildren. The distribution could purchase life insurance on the life of their parents, to pay for the life insurance over a ten-year period (inherited IRA’s need to be paid out over ten years). The proceeds of the life insurance would be tax-free to the grandchildren. They would not have to make mandatory distributions from the life insurance, unlike the inherited IRA. The children, who may be the beneficiary of the trust in option 2, would also not have to take mandatory distributions from the life insurance. Consequently, both generations would save a lot of taxes, inherit much more, and have a plan which did not force them to liquidate inherited assets.  

THE NUMBERS:   

Option 1: Take RMD and invest the money 

Assume the IRA was worth $1,000,000 that dad owned:  Assume he takes out the mandatory distribution of $37,000. He paid taxes (35%) and net $24,000 (rounded down). Let us say he invested at 4%. In 20 years, he would have accumulated $743,000. His gain would have been $92,000, which he would pay tax on. His net value of the account would have been $650,000 to leave to his children and grandchildren. After tax, the net ROI would have been 2.81% before federal and state inheritance taxes.  

Option 2:  Take RMD and buy a 2nd to die life insurance policy and put into an irrevocable trust while living (there is no need to wait to age 72 to do this).  

The 2nd to die life insurance policy would be worth $1,000,000. At his and his spouse’s death, the beneficiaries of the trust would receive $1,000,000 tax free. None of the life insurance proceeds would be subjected to inheritance taxes (fed/state), unlike in option 1. The ROI on the death benefit would be the equivalent of a net of 6.56%, or pretax rate of 10.10% on investment, (we are assuming parents paid $24,000 for 20 years, then died). By having the life insurance/trust, he would have left $350,000 more to his children and grandchildren compared to if he had invested the money at 4% gross. When you take into consideration inheritance, federal and state on option 1, option 2 would have been even more of a gain.  

Note:  Any balance left in the qualified account at the parent’s death, could also be used by the beneficiaries (children or grandchildren) to buy life insurance on their parents, much like their parents/grandparents bought life insurance via the trust.  

Considering the new rules on inherited IRA’S, using the life insurance as leverage can make a lot sense. As mentioned, this strategy is highly effective for families in the situation where the RMD is not needed to fund their current lifestyle.  

BEWARE FINANCIAL ADVISORS: THIS IS AN EASY TAX TRAP YOUR CLIENT COULD MAKE! LEARN A FEW EXEMPTIONS AND YOU WILL STAY OUT OF TROUBLE!

 Recently, we worked on a case which involved an endorsement split dollar plani, where the split dollar agreement involving the trustee   of an irrevocable trust was terminated pursuant to a “rollout. The agreement was between the employer and the trustee (endorsement split dollar). The result would have been a “transfer of value,” in which the death benefit exceeding the consideration would have been taxable income.  

If the split dollar plan were a collateral assignment split dollar, there would not have been a  “ taxable event”, as the sale of the policy would have been made to an exempt party, the insured, (grantor and the insured are one in the same).  Under the endorsement Split dollar, the company was selling to the trustee, not an exemption entity.  

Transfer for value jeopardizes the income tax-free payment of the insurance proceeds. Under the transfer value rule, if a policy is sold for consideration, the death proceeds will be taxable as ordinary income, more than the net premium contribution.  

Besides the outright sale of the policy, there can also be a taxable event if the owner is paid in consideration to change the beneficiary. This would be a transfer of value; thus, the death benefit is taxable beyond the consideration paid for the policy. The consideration paid to change the beneficiary can be any amount.  

Consideration does not have to be money, it could be in exchange for a policy, or a promise to perform some act or service. However, the mere pledging or assignment of a policy as collateral security is not a transfer for value.  

Transfer for Value Exceptions:   

  1. Transfer to the insured 
  1. Transfers to a partner of the insured 
  1. Transfer to a partnership in which the insured is a partner 
  1. Transfer to a corporation in which the insured is a stockholder or officer (but there is no exception for transfer to a co-stockholder.  
  1. Transfer between corporation in a tax-free reorganization if certain considerations exit.  

A bona fide gift:  is not considered to be a transfer for value, and later payment of the death proceeds to the donee will be paid income tax-free.   

Part sale and gift transfer actions are also  protected under the so-called “transferor’s basis exception”  which  provides that the transfer for value rule does not apply where the transferee’s basis in the policy is determined  whole or in part by reference to its basis in the hands of the transferor.   

Another transfer for value trap can occur in the situation when you have a “trusteed cross purchase buy and sell agreement”, to avoid a problem of multiple policies when there are more than just two or three stockholders. When the trustee is both owner and beneficiary of just one policy on each of the stockholders, a transfer for value may occur when one of the stockholders dies and the surviving stockholders then receive a greater proportional interest in the outstanding policies which continue to insure the survivors. This can be remedied by either using an Entity Redemption where the Corporation purchases the interest of the deceased stockholder’s interest.  

This can also cause exposure of transfer of value when transferring existing life insurance policies, insuring stockholders to the trustee of a trusteed cross purchase agreement, which does not fall within one of the exceptions to the transfer of value rules.  To avoid this initial ownership problem, the trustee should be the original applicant, owner and beneficiary of the polices.   

A Great Benefit Every Business Owner Should Be Aware Of! 

Over the years in the small business arena, when retirement is mentioned, the discussion usually focuses on programs like 401k, Profit sharing, SEP’S, and Simple Plans.   

 They are all very good plans and every business should offer one of them to their employees for the purpose of having a benefit plan where employees can save for their retirements.   

 However, not every employer wants to take on the burden of funding retirement for their employees for many reasons.  The reasons range from a lack of cash flow, employee groups who would rather take the money home.   

 In situations where the employer feels they would like to use their company to create a benefit for themselves, and not the employees, they should look into an executive compensation plan called the CEEP (Corporate Executive Equity Plan).  The CEEP is a hybrid of a few types of benefit plans used for the higher paid group in companies and for the owners.   

 The term “non-qualified “, refers to a plan that normally is not used for the masses, but used for a selected group of people.  As an example:  Employer A can decide that they want to put a plan in for employee B, C but not employees D-Z.  In most cases the plan itself would not be tax-deductible as a “plan”, however, it can be tax deductible under certain conditions. 

How the CEEP works!  

Mr. Jones owner of the Big Dip Donut shop decides that he wants to allocate $25,000 a year into a retirement plan for himself and no other employees of the company.  For the most part, he can’t have a qualified retirement plan without offering it to the employees.  Even a “Simple Plan”, which is the easiest to implement would have drawbacks.    Continue reading “A Great Benefit Every Business Owner Should Be Aware Of! “

Case Study#5 Using Corporate Dollars To Keep Wealth Out Of The Business But In Your Pocket

This is the case of Joey Bag of Donuts and his pursuit of keeping wealth outside of his business.  You see, over the years working with Joey Bag of Donuts we told him that leaving too much of his wealth in the business can be problematic, especially when the time came when he needed to exit his business.  He heard me tell him many times, that someday he will leave his business by either a death, disability, or retirement, and taking the wealth with you when you need it the most, can be a problem, if you don’t have the right exit strategy.

There are many reasons wealth gets lost in a business when it is sold.  It can range from bad planning to bad luck, but Joey Bag of Donuts always remembered to keep as much of his personal wealth outside of the business as possible.  By the way this is why he purchased his company building and put it in a separate LLC.  Joey Bag of Donuts also believes in putting as much of his income to the company pension plan, again, outside of the business.

We also taught him to have his company support whatever it can legally towards his personal lifestyle.  For example, his cars, gas, some entertainment, health insurance, retirement, and other things are paid for through company.

Joey Bag of Donuts wanted to put more money away for himself and his family’s future, but didn’t want to use his own funds, so why not have the company support more retirement contributions?

We already had a profit-sharing plan, and he was sharing company contributions with his employees.

We decided that a non-regulated plan was the best way to go, so we developed a plan for only him.  The plan is a combination of two concepts.  We call this the CEEP PLAN (CORPORATE EXECUTIVE EQUITY PLAN).

The plan is a discriminatory plan, so Joey Bag of Donuts can pick himself or anyone else he wants, unlike a profit sharing or 401k plan, which is a regulated plan.

THE PLAN:  As you can see, the company made all the contributions, and took the deductions for them.  Joey Bag of Donuts was the sole participant of the plan. His cost was “0” out of pocket and he ends up with almost $800,000 of cash at retirement.  He also could turn the cash into a tax-free income stream.  In this case it was $67,500 tax-free income. The stream of income is worth more than $1,215,000.  Along with that he has a death benefit of $2,300,000 payable to his family tax-free.

THE BOTTOM LINE:  Joey Bag of Donuts gets retirement income using corporate funds.  All the contributions can be applied to just his account.  He also has the use of the account before retirement, like a  “family bank”, along with the ability to withdraw funds tax-free.[1]  There would be no 10% penalty if withdrawn before 59 ½.  Continue reading “Case Study#5 Using Corporate Dollars To Keep Wealth Out Of The Business But In Your Pocket”

Shift Corporate Income For Your Personal Retirement! 

 If you own a business, using a split dollar life insurance plan can help you shift business income to you on a tax effective basis, without involving other employees!

 Split dollar life insurance refers to the concept of two or more parties splitting the benefits and costs of a life insurance policy, such as the premium, death benefit and cash value.   

The most common type of split dollar life arrangement involves an employer and the employee or owners, with one part owning the policy, one or both parties’ contribution to the annual premium, but both parties having a vested interest in the policy benefits.   

Split dollar plans are inexpensive and easy to administer as an executive benefit arrangement.   

Here is how it works:  

One party establishes a cash value life insurance contract under the ownership of the key executive.   

The employer receives a “collateral assignment” against the policy, entitling the corporation  to receive the lesser of the policy cash value or the outstanding loan balance.   The loan is based on the premiums contributed by the company.   The same assignment entitles the employer to a portion of the policy death benefit, equal to the outstanding loan balance.   

 The key executive pays the taxes each year on the foregone interest on the loan from the corporation to pay the premium.   

At some point in the future, the split dollar arrangement terminates when the employer’s loan is repaid (typically from the policies cash value), leaving the executive “free and clear” ownership of the accumulated gain in the life insurance policy.   

 The executive can access the accumulated gains in the policy by borrowing against it, which will typically allow for tax-free access to the values.  The policy loan is repaid to the insurance company at the death of the executive, and any residual death benefit is paid to the executives’ named beneficiaries.  

Split dollar is an easier benefit to implement than deferred compensation, and less expensive for the employer.   

 Advantages:   

  • Easy account entries 
  • Recovery of the cost for the employer 
  • Performance objectives to trigger the funding for employer 
  • Very little if any impact on company balance sheet 
  • A “golden handcuffs” for the employer and ability to set restrictions when cash value can be accessed  

 Today’s newer types of life insurance policies enhance the benefits of a split dollar plan  Continue reading “Shift Corporate Income For Your Personal Retirement! “

What If I Want to Take Care of Myself?

Business owners have experienced a well-publicized meltdown in traditional financing. Now they want to know how they can prevent themselves from being vulnerable again!

Become Your Own Bank

What if you set a goal today to accumulate money on your own? Shore up reserves for use in emergencies in your business, or for business opportunities, investments and personal retirement. You take care of your employees, your vendors and your customers. What if you think about taking care of yourself? Traditional savings vehicles are not as attractive as they were in the past. Many companies have eliminated pension plans. Those companies that haven’t are finding that, in many cases, the owner can’t put a substantial amount away for himself. Today’s business owner wants to accumulate money for the future’s “what ifs” without depending on outside financing sources.

Set up a SIP

The solution is a supplemental income plan, or SIP. If properly designed, a SIP accomplishes several things. The growth is tax-deferred. If accessed correctly, the gain is tax-free. There are no contribution rules and no required distributions. Moreover, there is a pre-retirement survivor benefit paid to the family in case of the death of the business owner, also tax-free. With the cash flow rigors of owning your business, putting money aside gets more difficult every day. Traditional methods no longer work or are no longer attractive. Safety is a greater concern now than in the past. Business owners want to control their own financial destinies without depending on credit lines, business loans and outside financing. What if, going forward, you finance your own business purchases? Every cent you pay in financing costs is lost forever. Eliminate these costs in the future and use your SIP for purchases, investments, opportunities and emergencies. The savings on financing goes back into your pocket. This is perhaps the best recession-era lesson for business owners to absorb today and to never forget in the future. Do not rely heavily on outside funding in the form of loans, vendor financing or even business credit cards.

Today’s business owner wants to accumulate money for the future’s “what ifs” without depending on outside financing sources.

Do It for You

Right now, business owners must take care of themselves because no one else is going to do this for them. Valley business owners constantly tell me they are tired of lying awake at night, staring at the bedroom ceiling and worrying about cash flow. A supplemental retirement plan is simple. It does not involve any administration or fees. There is no ERISA or IRS involvement. Where is the best place to invest as you bulk up your SIP? In the past, you had two choices. You had market-driven vehicles that we now realize can be a roller coaster ride or safe vehicles that yielded small or no returns. Here is a new option for you and your professional financial advisor to consider. Life insurance—a product that has been around for more than 200 years—may present the flexibility and growth you seek.

Continue reading “What If I Want to Take Care of Myself?”