Small Business Uses for Life Insurance

by Steve Goodman

CPA, MBA – President & Chief Executive Officer

Contact Steve today for more info.

Succession Planning and Buy-Sell Agreements

Succession planning is critical for business owners preparing to transfer their ownership interest in the business to partners or heirs should they die, become disabled or choose to leave the business for any reason. A buy-sell agreement is a legal document detailing how a business owner’s shares will be distributed when a triggering event occurs. Common triggering events include an owner’s death, disability, resignation, retirement, or termination.

The buy-sell agreement serves multiple purposes.

  • It provides a legal framework, agreed by all parties, to resolve the owner’s inability or unwillingness to continue running the business.
  • It ensures the continuation of business should one of these triggering events occur.
  • It provides a ready market for an owner’s shares such that his/her heirs not involved in the business can be paid in cash.
  • It sets a fair and predetermined price for the shares among all the parties to the agreement.
  • It can establish a business value for estate planning purposes.
  • It provides the capital to fund the transfer process, most often through life insurance.

Permanent or term life insurance is the preferred funding mechanism. With permanent insurance, the cash value provides a pool of money that can be used to fund the buyout in a tax-efficient manner. The death benefit is usually paid to beneficiaries tax-free while the cash value grows tax-deferred. Term insurance provides no cash value, but it is usually significantly less expensive than permanent insurance.

Other funding mechanisms include a sinking fund, an installment sale or borrowing funds. Life insurance as the funding mechanism offers many benefits compared to the alternative options making it the most common option.

There are two main ways to structure a buy-sell agreement using life insurance as the funding mechanism. Note that when a business structures a buy-sell agreement, life insurance premiums are not tax deductible.

  1. An Entity Agreement -The business entity purchases an insurance policy on each owner in the amount of the owner’s interest. When a triggering event occurs, the business buys the former owner’s interest in the business using proceeds from the policy. The organization then divides the former owner’s interest among the partners pro rata. This structure is popular when an organization has multiple partners. The entity will own one policy on each partner. One big drawback of an entity agreement is that the remaining owners may not receive a step up in basis (or they may receive a partial step up) on their shares. Also, insurance proceeds are subject to the claims of creditors.
  2. A Cross-Purchase Agreement — Owners purchase life insurance policies on each other in the amount of each owner’s interest. When a triggering event occurs, proceeds from the policy are used to buy the former owner’s interest. This structure is most efficient when there are just two partners as it minimizes the number of policies required.

Another type of structure is a so-called “wait and see” agreement. Owners wait until a triggering event occurs to decide how to proceed with distributing the former owner’s interest. The business entity will usually be given the first option to purchase an owner’s interest. If the entity declines, the owners have the next option. If they decline, the entity must purchase the interest. While this type of agreement provides greater flexibility, it also increases uncertainty.

Here are a few common questions regarding buy-sell agreements:

Q: Are there other types of insurance that can function as a funding mechanism?

Disability insurance can serve as a funding mechanism to cover instances where an owner cannot work due to a disability. The odds of becoming disabled are much greater than the odds of dying prematurely so adding disability as a funding mechanism is usually a smart strategy.

Disability buyout insurance is usually used for this purpose. In this scenario, the buyer decides upon the waiting period, usually 12, 18 or 24 months, that an owner must be disabled before benefits begin. The longer the waiting period, the lower the insurance premiums. A benefit period, or length of time that benefits are paid, must also be determined. Typical options include a lump-sum payment or payouts over two, three or five years. Note that disability buyout premiums are not tax-deductible — however, payouts received by the business or owners are tax-free. Payments to the disabled may be subject to capital gains.

Assume two partners, A and B. A buys a disability policy on B and B buys a disability policy on A.B becomes disabled. A receives tax-free payments from the insurance company. Policy proceeds paid by A to B are subject to capital gains to the extent that they exceed the cost basis established by the recipient.

Q: How important is business valuation as a component of buy-sell planning?

It is extremely important. Partner agreements with the terms and conditions of the company valuation and payment process identified greatly reduce the potential for conflicts and disagreements when a triggering event occurs. This allows the transition of shares to proceed smoothly thereby minimizing the disruption caused by a lost key executive.

Q: Can a business price for estate tax purposes be determined with a business valuation?

It depends. Businesses are valued for estate tax purposes at fair market value, which is defined by the IRS as “the price at which property would change hands between a willing buyer and a willing seller, with both parties having reasonable knowledge of the relevant facts.”

Three conditions must be met for a business valuation that’s conducted as part of buy-sell planning to be pegged for estate tax purposes:

  1. The price must be fixed or easily determinable using a formula.
  2. The buy-sell agreement cannot be used only as a mechanism to transfer business interests for less than fair market value.
  3. The obligation to sell the business interest must be binding for life.

More Cross-Purchase Strategies

A profit sharing plan can fund a cross-purchase buy-sell agreement. Not only will this provide for the purchase of life insurance, but the insured can be someone other than the plan participant. In-service distributions may also be available.

When funding a cross-purchase buy-sell agreement, taxes are based on the economic benefit costs, which, in turn, are based on the insured’s age. The death benefit proceeds are applied to the cross-purchase agreement. The pure amount at risk is not taxable upon the insured’s death, although the cash value is taxable. Also, any amounts used to fund the buy-sell agreement will reduce the participant’s profit-sharing accumulation value.

Employer Funded Retirement Planning

Another advanced planning strategy is to own life insurance inside a qualified retirement plan. This can relieve beneficiaries from the estate and income taxes as high as 70%, as well as required minimum distribution (RMD) rules. Profit sharing and money purchase plans, traditionally defined benefit plans, 412i plans, and ESOPs usually allow for the purchase of life insurance inside the plan.

This strategy offers many potential advantages. For example, the premiums are tax-deductible and if you die before your spouse, he or she will have a self-completing retirement fund. And your heirs will receive the death benefit (less the cash surrender value) income-tax free.

However, there are also some potential disadvantages. The cost of term insurance is taxable. Insurance costs subtract from accumulation value in a defined contribution plan. Contribution limits that apply to the plan will restrict how much insurance can be purchased. The death benefit adds to the taxable estate if the beneficiary is not a surviving spouse.

With term, variable life, and universal life policies, up to 25% of employer contributions can fund the purchase of life insurance. With whole life policies, the percentage increases to 50% of employer contributions. The qualified plan may also payout the accumulated plan value in addition to the death benefit.

For defined benefit plans, the percent of cumulative contributions incidental death benefit rule offers more flexibility than the 100 times the monthly projected benefit rule. If the 100 times rule is used, the plan cannot distribute the value of accrued vested benefits in addition to life insurance.

Life Insurance in Profit Sharing Plans

Profit sharing plans offer the most funding flexibility. The plan may allow for 100% of employee contributions to be available immediately. After two years, 100% of employer contributions may be available to employees, while 100% of the employee’s account may be available after five years.

If someone owns life insurance inside of a qualified plan when he/she die, their beneficiaries will receive the death benefit (in excess of cash value) income-tax free, but they will pay tax on the cash value. The death benefit may be subject to estate taxes. There may be a credit for economic benefit amounts taxed.

Consider the following example:

Bob owns a life insurance policy within a profit sharing plan, but he dies at 55 years of age. The death benefit is $2 million and the cash value when he dies is $200,000. Over the life of the plan, he has paid $10,000 in economic benefit taxes. The cash surrender value, less paid economic benefit costs, will be taxable to Bob’s heirs.

Bob’s heirs will receive $1.8 million of the death benefit tax-free. Of the remaining $200,000, $190,000 is taxable as a payment from the retirement plan. His heirs will receive $1.81 million income-tax free.

If one decides to remove a life insurance policy from within a qualified plan, there are several options. One can terminate the policy, have the plan distribute the policy to the named insured (he/she will pay a 10% penalty if under age 59½), buy the policy, create a grantor trust to buy the policy, or have the trustee take out a maximum policy loan and transfer the policy to the named insured.

Key Person Life Insurance

Some businesses rely heavily on the expertise, management skills, and experience of one or more key employees. Key person life insurance helps protect such businesses from economic loss should a key employee unexpectedly die. A business may use the proceeds from a key person life insurance policy to recruit, hire, and train a replacement. They may also use the proceeds to provide a cash cushion to help cover cash flow shortfalls after a key employee’s death.

The insurance proceeds can assuage the anxiety felt by shareholders, lenders, and employees after a key employee dies. Creditors may be especially cautious about lending more money following a key employee’s death. Life insurance can buy time for the organization to calm the waters following a loss.

If the key person does not die while employed, the business can allocate the policy’s cash value for other purposes. If the key employee is an owner, the proceeds can help fund a buy-sell agreement. Policy proceeds can also provide deferred compensation or retirement income for a key employee if he or she doesn’t die while employed.

The business can endorse a portion of the death benefit to the key employee for him/her to designate a personal beneficiary. In this scenario, the key employee must recognize imputed income from the economic benefit associated with the right to name a beneficiary. The policy can be distributed to the key employee at some point if there is no predetermined intention of doing so. The key employee must recognize the fair market value of the policy as income in the year of distribution. The company can claim a tax deduction for distributing the policy provided it is deemed reasonable compensation.

The process of instituting key person life insurance begins with the key person’s written consent to be the insured. The business buys the policy naming the business as the beneficiary. The amount of coverage purchased will depend on how much the business could lose if the key employee dies. The premiums are not tax-deductible, but the death benefit is usually tax-free. The key employee’s estate

excludes the death benefit for federal estate tax purposes unless the key person is a sole controlling shareholder.

Keep in mind that income inclusion and exception rules apply to any type of company-owned life insurance, including key person insurance. According to IRC Sec. 101, death benefit proceeds are income-tax exempt to the extent of premiums paid by the company. Any excess proceeds are considered to be ordinary income to the company. However, there are exceptions to this rule if the following employee notice and consent requirements are met:

  1. The key employee is notified in writing of the business’ intent to buy insurance on his or her life, including the maximum face amount of coverage.
  2. The key employee provides written consent for this insurance to be bought and acknowledging that the coverage may continue after he or she is terminated.
  3. The key employee is notified in writing that the business will be the beneficiary (either directly or indirectly) of the policy.

While still employed, the key man policy is owned by the company. The company may borrow against the cash value of the policy, but only for policies covering key employees (officers or 20% owners). The amount of loan interest paid that is deductible is subject to an interest rate cap.

Employee Benefits

Businesses can use the corporate split dollar to pay all or a portion of life insurance premiums for their employees. Corporate split dollar is a premium sharing arrangement. With an Economic Benefit Regime/Endorsement Split-Dollar arrangement, the business owns the life insurance policy and the rights to the cash value. However, the employee’s beneficiaries receive the death benefit via an endorsement. This strategy enables employees to purchase life insurance at a lower cost.

With a Loan Regime/Collateral Assignment Split-Dollar arrangement, the employee owns the life insurance policy, along with the rights to the cash value. The business will receive a portion of the death benefit via a policy assignment, while the rest of the death benefit will be distributed to the employee’s beneficiaries.


CPA, MBA – President & Chief Executive Officer

About Steve Goodman

For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.

He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.

Email Steve today for the business succession planning you deserve.