Case Examples of When to Use Life Insurance

CONTINUATION:  PART II (CASE 3&4) 

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

Case 3 and Case 4  

Example 3 – The Buy and Sell Funding 

The company has three owners, should one of them die, the surviving partners would have to buy out the survivors of the deceased partner.   They have four choices for the funding of this potential liability.  The agreement states the stock must be purchased by the owners, or the entity:  

1. Sinking Fund 

2. Borrow the money 

3. Payout over a period  

4. Life insurance  

When looking over the costs, life insurance was by far the least expensive compared to the other options, and tere where assorted reasons why some of the options did not make a lot of sense:  

Borrowing the money; if they could get the loan, (doubtful that a bank would loan money to a company that just lost a key owner), it would cost principal and interest and may have an impact on the profit and loss statement.   

Sinking fund; Unless they put money at risk, they would have to settle for an exceptionally low rate of return (near 0). Plus, if death happened sooner rather than later, they would not have saved enough to pay the liability needed to purchase the interest.  Also, the sinking fund would cause them to commit a much larger contributions to the plan, thus eliminating cash to invest in their company.  

Life insurance: This was a cost of 1% of capital for a guaranteed payment. In this case, we could have used term, however, at some point the owners would have to change the plan over to a permanent coverage type of plan.  This would give them a guaranteed premium and longevity to the plan, to fund their buy and sell.   

The liability of purchasing the partners’ shares, is a long-term proposition, possibly lasting generations.   Permanent life insurance was the reasonable choice. The life insurance had “double duty dollars”, allowing them to use the cash value to purchase the partners out in the future when they retired.  

Example 4Keep the Star Key Man 

The owner of a successful business wanted to make sure they enticed the key person running the business to stay with the firm. The key person makes things happen in the firm. It allows the owner to take more time off, create more profits, and they benefit from the efforts of the key person.  

We put in a supplemental retirement plan, just for the key person, and the owner was willing to invest $30,000 into an executive compensation plan.   When the funding was discussed by the team of advisors, which were consisted of the CPA, attorney, the business partner, business consultant, and I, the following suggestions were made:  

– Put money in a mutual fund 

– Give the employee stock of the company 

– Purchase cash rich life insurance program 

– Have company stockbroker build a stock portfolio for the key person 

When it was all said and done, the life insurance program on a permanent basis was the clear winner:  

Reasons:  

– Benefits would be paid tax-free to the employee at retirement 

– The contributions would have little if any impact on the key person’s income tax opposed to the other methods 

– If the key person died before retirement, the insurance plan could complete a tax-free benefit he would have received had he retired, giving his family protection and security. The other options did not have that available.   

– The life insurance plan had guarantees, while the other suggestions did not 

  • The Employer had an arrangement to recover their full cost to the plan, where the other programs had a charge to earnings” against the company.  

Adding it up, the cash rich life insurance was a very clear winner.   

I have given you four uses of life insurance.  In each situation, the question to use term insurance, or permanent comes into plan.  There are a few simple questions to ask:  

A. Is the reason for the insurance permanent or short term. 

B. If it isn’t long term today, will it end up being long term. 

C. If it is determined that the need for the insurance is less than 15 years, without exception use term?  

If the answer is long term, or if it will be long term, I have used term if there was a cash flow issue, but with the idea of changing the plan when cash flow permitted.  

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Life Insurance USES For Business Owners! The Uses of Permanent and Term Life Insurance!

In my very long career as a professional advisor and insurance agent, there were many occasions when I worked with CPA’s, and attorneys that were misinformed about the type of life insurance that would be appropriate in certain situations in a business arrangement.  

Many times, I found that the advisors were basing their opinions more on their personal feelings rather than the actual case fact pattern.  In most cases, when I explained to them the long-term nature of the need, or even the short-term nature, they had a better understanding of the situation, excepting my suggestion of the type of coverage to be used.    

I do believe in term insurance and that it has a place. I have used it over the years in situations where we felt the insurance benefit was only needed for an ascertainable period.   An example would be to fund a liability in a company where the company is new and does not have the cash flow to pay the larger permanent coverage.   

Another area would be when the need is temporary, such as a short-term bank loan, or an outstanding company loan.     

I have experienced clients purchasing term insurance because the premiums were very low, at least for that time frame.  I have had clients tell me they would buy term and invest the difference.  They don’t invest the difference.  They wake up one morning only to realize the term insurance started to increase in premium at an unsustainable rate to pay, and the client still needs the coverage.  Oh, yea, they didn’t invest the difference. Trust me on this, they never do.   

As a side: Term insurance was designed not to be in force when the insured dies. Insurance companies make a lot of money on term insurance because they know the policy will not be in force when the insured dies (based on their mortality data).   

Term insurance was designed to do one thing. Cover the capital liability for the period which the liability will exist.  

Now that that is out of the way, let me review some areas where permanent insurance works, and in many cases works better than any other financial vehicle.   

Business Succession:   

Many times, when I review the Business Succession Document, I find that the life insurance does not correspond to what the agreement says. Either the life insurance is underfunded, lapsed, or will be terminating soon, as it was term insurance.   

In this case permanent life insurance would have been the best solution as it has double duty dollars.  It would fund the death of an owner, help fund the retirement of an owner, or help should the owner become ill, help with income when needed.   Until the business owner transitions his position; the insurance would be needed.  This could be for many years. 

Example:  Sole Proprietor 

Many sole proprietors will tell you they don’t have a market for their business.  In essence they have a job, not a business.  However, through insurance planning, they could create a market.  For the cost of 1-3% of what the business owner feels their business is worth, there is a ready market.  At the owner’s death, the life insurance company (for 1-3% of capital), will step in and pay the family the value of the business, with tax-free dollars.   

The family also can sell the business assets without a fire sale.  Even if they sell it for pennies on the dollar, they made out better than without having the life insurance.  In this way, the business owner can keep the family in the lifestyle they have become accustomed too.  

If set up correctly, the sole proprietor could have paid the premiums through the business check book. Depending on the business structure, the premiums would be taxable to the owner, however, the cash flow comes from the business.  If the sole owner was a C Corp, they could have used split dollar and paid the taxes on the economic benefit, or the taxes on the loan regime. Either way it would have been a less expensive way of providing the market value for the company, while making sure the family received the business value, tax-free.   

This is an example of where permanent coverage is the best.  The owner of the business can also have a plan that will pay them a retirement income from the policy, while they are trying to sell the business.  An example of double duty dollars.    

The life insurance also has triple duty dollars as it can be used to help fund the costs of estate taxes, probate and settlement costs at the business owner’s death.  

PROFIT  PROTECTION 

 Most profitable organizations have key persons and key groups.  They are the people who if they didn’t come to work tomorrow, would have a negative effect on the earnings of the company.   

Once you define them, insuring them will protect your profit center.  Not only will you protect you earning and profits, but the insurance would also create new tax-free dollars at a key person’s death.  

The benefit will help the owner:  

  •  Find a replacement for your key person 
  • Fund the “usually the first one doesn’t work cost”, search for the key position and person 
  • Absorb the period where no profits are being generated by the new key person(s), for the period of the learning and adjustment period 
  • Create benefit where you can lower or eliminate turnover with your key person group 

There are “double duty dollars” using permanent life insurance.  Not only are you protecting your profits from a loss, and the cost of capital to replace, but you can also use the life insurance as an executive benefit to keep the key person from leaving the company.  The cash values of the policy can create a very rich tax-effective retirement benefit on top of the normal retirement plan.   

You can create a benefit with vesting schedules and restrictions which give the owner control over the cash values and create a benefit where you are rewarding the key person(s) with a very high retirement benefit if they stay.  This type of benefit is very effective in lowering turnover of your key people.  A salary, bonus is forgotten and expected, however, a special key person benefit is substantial and hard to walk away from.   

This again is another area where permanent life insurance works, and where term does not. 

Golden Handcuffs 

In many small companies there are key groups that are the major reason for the profits.   They know the company, know how things work, and in many cases act like an owner of the company.  They are the group that create the profits, allow the owner to live a nice lifestyle and allow the owner to come and go as they wish.   

These are the people you want to keep for life!  However, they are well known. The competition knows them very well.  Not surprisingly, the competition makes it a point to meet them when they can, such as at trade shows, industry meeting, and gatherings, hoping to test the waters to see if they can sway them away with some type of financial offer.   

They are that good, and if your competition could sweep them away from you, the owners world would change overnight.   

 THE GOLDEND HANDCUFFS  

To keep this key person or group, you need to create something they can’t afford to walk away from. A benefit so good, that even your competition would find it hard to offer to them. This is all possible by using the proper permanent life insurance policy, and the combination of well-established tax law.   

Over the years I have done many comparisons using mutual funds, annuities, stock, and company earnings, but nothing compares to the combination of a permanent life insurance policy and the tax law which allow this type of benefit.   

Using “Golden Handcuff” programs allow you to write the rules, have a vesting schedule, recover your costs, take tax deductions, and other design flexibilities.    

 By using the leverage of the tax code, and life insurance tax code, you can create a non-walkaway benefit for your profit center.   

Example:  We just finished a plan, where the key person will walk away with a substantial income at retirement.  The employee’s cost was less than $266 a year.  The employee received a large deduction and had complete control of the funds until the employee retired.  The employee would have to make over 40% ROI on his contribution to the plan in order to receive the benefits he will be receiving.   

Not only will the employee have a great retirement benefit, if he died prior to retirement, his family would have received $74,500 tax free for the next 10 years.   

As you can see, there are some very good uses of permanent life insurance, and in many cases the best and most economical solution.   

A Tax-deductible Life Insurance Plan 

One area that many small business owners are not aware of is section 412(I), where owners can design having a life insurance policy with 100% tax deductible premiums.  Normally, this is a plan that works very well with small companies and a few employees.  Again, another area where permanent life insurance works the best.