Advisor's Guide to Life Insurance for Business Owners
In the past ten years, we have experienced numerous tax law changes which have reduced personal income tax rates to the lowest marginal rated in over fifty years. At the same time, additional restrictions and reporting requirements have been imposed on tax-qualified retirement plans, making them increasingly less attractive. These changes have led to the widespread use of specially designed life insurance policies by individuals and businesses of all sizes.
While many life insurance policies are purchased by individuals, it is possible for an employer to set up a bonus plan that is designed to pay insurance premiums for key employees. Depending upon plan design, premiums may or may not be currently deductible, but death and retirement benefits can be received free of Federal income tax under current tax law when structured correctly.
Specially designed life insurance products are structured to emphasize long term accumulation values and high payout at retirement by minimizing current death benefits. Premiums are limited only to extent of the death benefit purchased. Like qualified retirement plans, growth in excess of premiums is tax-deferred. Unlike qualified plans, however, account values during working years without tax penalties.
Life Insurance policies extremely popular with those who are interested in long-term accumulation of money. Surveys have shown that 85% of the Fortune 500 companies have life insurance programs for their highly compensated executives. The development of competitively structured life insurance products has now made it possible for virtually anyone to enjoy many of the product’s benefits. Here are some examples of how and why life insurance is being used:
- As a supplement to a tax qualified retirement plan (pensions, profit sharing plans, etc.)
- In lieu of a tax qualified retirement plan
- For shareholders of a corporation who want to accumulate funds for retirement and /or their buy-sell agreement
- For the business owner who needs a retirement program with the flexibility to make additional premiums during profitable years but to be able to reduce or possibly eliminate premiums when profits are reduced.
- For any individual who desires a systematic approach to accumulating money with availability of funds for education and /or retirement.
Highlights of Life Insurance Advantages
Life insurance is a tax-deferred accumulation vehicle. Properly designed, it will provide the insured and his or her family with tax-advantaged retirement income and survivor benefits. Some of the highlights of life insurance are as follows:
- Tax-deferred cash accumulation
- Income tax-free retirement benefits (when structured correctly)
- Income tax-free survivor benefits
- Unlimited premiums (maximums are based on the amount of death benefit purchased)
- Flexibility at retirement
- Retire when you want without tax penalties
- Liquidity in case of emergencies
- Creditor protection in most states
Paying the Premiums
Insurance premiums are typically paid with after-tax dollars by the insured. Since the insured owns the policy outright, he or she has complete control over the values and benefits.
There are some situations, however, where other approaches are more appropriate or desirable. These often arise when there is a substantial disparity between the tax brackets of the business and the owners and when there is a desire to benefit certain key employees. Some of the most popular approaches are as follows:
The employer pays a bonus to selected key employees for the purpose of paying the premiums. The bonus is considered taxable income to the employee and is therefore deductible to the business as an ordinary and necessary business expense. The employer may with to provide an additional cash payment to the employee to reduce or eliminate the taxes on the bonus. This plan can be made available to stockholder employees as well as common law employees.
Traditional Split Dollar
Under this arrangement, the employer and employee split the insurance premium. In many cases, the employer pays the entire premium. The employer owns the cash values up to the sum of the premiums paid. Additionally, the employer is the beneficiary of the death benefit up to the sum of premiums paid. The employee owns the cash value in excess of the employer’s outlay and designates a beneficiary for the remainder of the death benefit. The employee reports the current economic benefit (PS58 cost or the “one-year term cost”) as current taxable income. Employer premiums are not deductible under this arrangement. It is, however, possible for the employer to characterize a portion of its payments as compensation to the employee, making this part deducible. Generally, the portion deducted by the employer will be taxable to the employee. As in Executive Bonus plans, it is possible for the employer to pay an additional bonus to reduce or eliminate the employee’s taxes.
Split dollar plans are very popular when provided benefits for the key employees since the employer’s cost are recoverable from policy values. They are also popular with business owners for their personal plans when the business tax bracket is lower than their personal bracket.
Reverse Split Dollar
This plan is like the usual split dollar plan except the parties are reversed. In effect, the employee leases a portion of the death benefit to the business which pays the PS 58 cost. The employee owns the cash and designates a beneficiary for the balance of the death benefit. These plans are often structured so that the employer payment eliminates the employee’s premium. The death benefit leased to the employer can be used for key employee indemnification, stock redemption, funding for a Survivor Income Plan, or any other business purpose. At the end of the reverse split dollar arrangement, the employee regains 100% ownership of the policy values. He or she can then utilize the policy for post-retirement death benefits or use the cash value to produce a tax-advantage retirement income.
Loan Regime Split Dollar
In a Loan Regime Split Dollar plan, the participant of the plan is the owner of the policy. The company’s contributions are considered loans to the participant. Using a collateral assignment, the employee gives an interest in the policy to the employer which places a restriction on the policy limiting an employee can do without the firm’s consent. This interest is equal to the amount of premiums paid into the policy.
Because the premiums are considered a loan the participant does not have to pay taxes on the premiums. The company generally forgives the interest on this loan which does create a taxable event. The participant has to recognize income based on the AFR rate.
The employer is able to distribute a benefit to a key employee without removing value from the organization. The loaned-out amount remains on the balance sheet as an asset of the organization. Upon the death of the employee, the organization recaptures the entire amount.
You many review these strategies, and more, by visiting our "Business Owners in Growth Mode" section of our website. Follow the link below to check them out!
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Life insurance is a powerful tool that when used properly can improve and protect your client’s financial situation.
Life insurance may not be your area of expertise. You may want a resource dedicated to your clients’ specific goals and concerns.
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