Make Life Insurance Your Business Partner

Margaret Muldoon

By Margaret Muldoon | May 2, 2017

Business owners know firsthand that building their business and staying successful requires significant time and resources. Yet many small business owners are not aware of critical business planning areas that put the future of their businesses at risk if left unaddressed. These key areas include:

  • Retirement Planning to avoid the risk of relying solely on your business for retirement income, and to help your employees save for their retirement;
  • Succession Planning to ensure your business continues if one of the principals leaves or dies;
  • Key Employee Planning to retain the employees important to the long-term success of your business.

Let’s look at each of these areas in turn.

Using your business to fund your retirement planning requires PLANNING

Let’s look at the statistics. Seventy eight percent of business owners plan to use their business to fund their retirement. The more startling statistic is the level of funding they expect the sale of their business to cover. Business owners expect to fund 60 to 100 percent of their retirement through the sale of their business! As a business owner, have you looked at the value of your business compared to how much income you will need in retirement? Do you know the value of your business? Now is a great time to have a discussion about retirement and succession planning with your financial adviser to determine your retirement goals and needs.

It seems natural to want to rely on the business you have spent a lifetime building as the foundation for funding retirement. The typical business owner has 45 percent of their personal assets tied up in their business. Yet, using your business to fund your retirement is an area that can be fraught with risk, and it also requires a well-thought-out succession plan.

After all, if you are not running the business, who is? If you are depending on an income stream from the profits of the business, can you depend on the long-term health of the business while you are not running it?

One solution is to sell the business, but only three percent of entrepreneurs are looking to buy an existing business. It is hard to find people ready to take over a business, which is why many business owners look to family members or employees as potential successors. Again, a buy-sell agreement can be put in place to outline the terms of the transfer beforehand, and life insurance can help fund it. Actually, the protection of insurance can work both ways. Insurance on the current owner can help pay for the purchase, while insurance on the future purchasers can help protect the retirement plans of the current owner.

Another solution that should be considered includes providing a company sponsored qualified retirement plan such as a 401(k) plan to help the business owner and employees save for retirement. Additionally, owning permanent life insurance in retirement not only provides assurance that loved ones will be taken care of, it can allow your other retirement investments to recover from market downturns and strengthen their income strategy.

Why is succession planning so critical?

After you address saving for your retirement, the next step is to address the succession of your business but if you haven’t taken the time to address this you are not alone. According to a recent CNBC poll, only three out of every 10 business owners have a succession plan. But out of these three, how many of these plans are properly structured or properly funded? Just having a plan doesn’t mean you are set. The next step to take is to put a buy-sell agreement in place that establishes exactly who is taking over the business and the financial terms that help make it happen.

The consequences of not having an agreement in place can threaten the very existence of the business. These include loss of family income; potential disputes among survivors; loss of business value and goodwill; liquidation of the business; no guaranteed buyer; potential unwanted partners; potential loss of key employees; loss of business credit; and loss of customers. There are many unfortunate stories of businesses that failed (and families torn apart) due to the lack of a properly structured and funded succession plan.

Life insurance can play an important role in a succession plan. For example, having an insured buy-sell agreement in place:

  • Creates a guaranteed market for business interest – establishes a fair and agreed upon price and terms of payment in advance.
  • Provides funds for payment and protects the interests of both business associates and heirs; and also enhances estate liquidity.
  • Assures continuity of management and ownership; and improves relations with business creditors.
  • Is cost effective and tax advantaged.
  • Provides for immediate payment – the event that creates the need also creates cash; the amount of cash is guaranteed and known in advance.
  • Enables costs to be paid in advance when all owners are active and the business is fully operational and profitable.
  • Avoids a forced sale of business assets, leaving cash flow and capital unencumbered.

Key employees are your biggest asset

The impact of losing a key employee can be devastating to a business owner and can result in lost sales, lost clients and production downtime while looking to hire and train a replacement. That is why key employee planning is one of the three primary planning considerations for business owners, along with retirement, succession and estate planning.

As a business owner, you likely understand the importance of providing employee retirement benefits, often in the form of traditional qualified retirement plans like 401(k), SEP IRA or Simple IRA plans. Key employee benefit plans let you go further, providing additional benefits for the employees that make the biggest difference to your company and providing an effective way to recruit, reward, and retain top talent.

The purpose of key employee planning is to reward a company’s most important people, including owners and partners, to increase their loyalty and retain their services long-term. Key employee plans are selective non-qualified benefits that can be customized to each employee’s goals, including tax-efficiency and life insurance protection.

Key employee planning generally comprises three types of plans funded by life insurance, specifically Section 162 Executive Bonus Plans; Split Dollar Life Insurance Arrangements; and Non-Qualified Deferred Compensation Plans.

Section 162 Executive Bonus Plans use annual bonuses to purchase a life insurance policy owned by the key person. Bonuses, which are used to pay premiums, are tax-deductible by the company and taxable to the executive. The executive increases personal life insurance protection and may control cash value, which can provide retirement income.

Split Dollar Life Insurance is a life insurance purchase arrangement in which the company and key person share costs, where the company will eventually recover its costs from cash value or the death benefit. The plan minimizes the out-of-pocket cost of life insurance to the executive while creating some degree of “golden handcuffs” that tie the executive to the company long-term.

Non-Qualified Deferred Compensation (NQDC) plans are popular non-qualified retirement income supplements that provide more significant golden-handcuff benefits. Employees agree to defer current compensation until separation or retirement, while also avoiding current taxation on that income. Plan contributions may be funded by employees, the company, or both. Life insurance, owned by the company, can achieve multiple benefits including: 1) death benefit protection for the executive’s surviving spouse or family; 2) key person insurance to protect the company; and 3) retirement income for the executive through cash value loans or withdrawals.

Life insurance is critical to any business

Life insurance can be an excellent partner in many aspects of business planning. Properly structured life insurance can provide a tax favored source of liquidity for many purposes, including helping to supplement your retirement needs, providing the funds necessary to execute a buy-sell arrangement; and helping your key employees to meet their needs in ways that supplement typical employee benefit plans. As you can see, life insurance can be a valuable business partner.

For informational purposes only. Not meant as specific financial advice for your specific situation. Please talk to a licensed professional before taking any action.

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