Exploring the Four Pillars of Business Planning and Life Insurance

By: Bill Bell, JD, MBA, Vice President, Advanced Sales

With all due respect to 90’s R&B Superstars TLC, sometimes, it is okay to chase waterfalls (this will make sense in a minute).  Working with businesses and business owners is my favorite market for life insurance sales.  Why you ask?  Well, it is simple, when you are working with the right business, the opportunities for planning don’t stop.  I liken it to a waterfall.  Let’s use one of the world’s most famous waterfalls as our analogy, Niagara Falls.  Now if you have never been to Niagara Falls, I suggest you do so at some point in the future.  When I was a kid, my family lived just outside of Buffalo which was about an hour from Niagara Falls so as you can imagine, we went quite a bit for family outings (it was free and my dad never passed up an opportunity for free family entertainment – perhaps another blog will have an analogy to Forrest Lawn Cemeteries in Southern California which we also frequented quite a bit when I was a kid).  The thing that struck me even as a young person was not just the power and beauty of Niagara Falls, but, that it literally never stops.  24 hours a day, 7 days a week, 365 days a year (366 in leap years) roughly 44 million gallons of water a minute flows over Niagara Falls.  It has been doing so well before I was born and it will be doing so well after I am gone.  It is actually quite amazing when you think about it.

Working with the right business has a different beauty and majesty associated with it, but, the persistency is also there.  When I think about planning for businesses and business owners, I break up the opportunities into four categories: The Four Pillars of Business Planning and Life Insurance; which are business succession planning, retirement planning, executive compensation planning and estate planning.  The best part about working in the business marketplace is that even though the initial concerns and planning for the business owner may be part of one pillar, as the business changes, so does the business’ needs and so another pillar may need to be addressed.  Oh, and by the way, the planning needed for the first pillar addressed may change in the future and the second and the third and the fourth.  You can see where I am going here, the opportunities for planning may not stop just like the water at Niagara Falls doesn’t stop flowing.  In this piece, I am going to give a 1,000,000,000 foot overview of some of the strategies that we utilize for businesses and business owners that involve life insurance.  Of course, this is not an exhaustive list of all the strategies, but enough to help you see there are great options available that address all four pillars. 

Pillar I - Business Succession Planning

Generally, these are structures that allow for the orderly passage of ownership of a business interest between individuals or entities up the occurrence of a triggering event such as the death, disability or retirement of a business owner.

Cross Purchase

A simple structure that requires business owners to purchase a departing or decedent’s interest in the business upon the occurrence of a triggering event.  The life insurance component is usually structured in a cross-owned manner with the insured’s fellow business owners owning the coverage on his or her life.  For example, business owner A would own a policy on business owner B and vice versa.  Cross purchases are generally utilized by businesses with no more than three owners and favored because of both the step-up in basis provided to the purchasing business owner and its simplicity.

Entity Redemption

An arrangement which obligates a business to purchase a departing or decedents’ interest in the business upon the occurrence of a triggering event.  The owner and beneficiary of the life insurance is the business.  Entity redemptions are generally favored by businesses with more than three owners and where the owners would like the business to control the life insurance policies and the purchase of the ownership interest.  Please note, in many cases, an entity redemption does not provide a step-up in basis for the remaining owners so they may have additional tax exposure if they subsequently sell their interest in the business. 

Partnership Administration Succession Strategy (PASS)

An arrangement where a partnership or LLC taxed as a partnership is established to be the funding vehicle for a business succession plan.  The partnership or LLC would be the owner of the life insurance policies and the partnership or LLC operative agreement would be drafted in a manner to allocate portions of the cash value and death benefits of the policy to the other participants’ basis/capital accounts in order to maximize the potential tax implications for the remaining business owners.  PASS is a complex structure that requires sophisticated legal counsel.  It is favored by businesses with more than three shareholders that are looking to minimize the number of life insurance policies purchased, to have the policies owned by a special purpose vehicle to effectuate the buy-out of the ownership interests and to potentially provide the remaining shareholders a step-up in basis in the business.

Pillar II - Retirement Planning

So many business owners spend their time and resources making their businesses successful and they forget to take care of their own retirement (Really!!! – I see it all the time).  There are some great strategies that can provide significant retirement income for business owners on either a pre-tax or after-tax basis.

Defined Benefit/Cash Balance Plans

A qualified plan that provides for a predictable stream of retirement income and potentially significant tax deductions for the sponsoring business.  The maximum annual benefit that can be provided by a defined benefit plan in 2024 is the lesser of: 100% of the participant's average compensation for his or her highest 3 consecutive calendar years $275,000 per year starting at the participant’s retirement.  If life insurance is part of the plan, the life insurance policy is owned by the plan and the beneficiary is named by the plan participant (generally it is the participant’s spouse if they are married).  Defined benefit and cash balance plans are often favored by small businesses with few non-owner employees although there are situations where larger businesses can implement them.  Pass-through-entity owners (e.g. S-Corporations, LLCs, or Partnerships) often gravitate towards them because of the potentially sizable tax deductions provided by contributions to these plans.

Life Insurance Retirement Plan (LIRP)

The simplest but often most effective advanced planning strategy.  A LIRP quite simply is a personally owned max-funded cash value life insurance policy that will be used by the owner as a source of supplemental retirement income via policy withdrawals and loans (for more information, please see my previous blog titled, What’s Tax Rate Risk?).  LIRPs are in many cases the choice for business owners that cannot implement a qualified plan like a cash balance plan.  The premiums for a LIRP are not tax-deductible, but, if the policy is structured properly, the withdrawals and loans may be tax-free.* 

Pillar III - Executive Compensation Planning

Continuity of management in the C-suite and beyond can make or break many businesses.  Strategies that help to not only retain key-executives but recruit new ones can be a true differentiator in the quest to have that top-management team in place.

Supplemental Executive Retirement Plan (SERP)

A promise to pay a benefit to a key-executive in the future such as at retirement or another specified date.  A SERP is the ultimate executive retention strategy because all of the “contributions” to the plan are made by the business and SERPs allow for a vesting schedule that the executive has to meet in order to get his or her benefit.  SERPs are often informally funded with cash value life insurance policies owned by the sponsoring business.  The life insurance policy’s cash value provides the liquidity to pay out the SERP benefit and the death benefit provides the business with death benefit protection to keep the business afloat if a key-executive passes away.  SERPs do not provide the sponsoring business with an upfront tax-deduction, the deduction generally occurs when the benefits are paid to the executive.  

Restricted Endorsement Bonus Arrangement (REBA)

A max-funded life insurance policy owned by the executive paid for via bonuses from the sponsoring business.  The bonuses are taxable to the executive and potentially tax-deductible for the sponsoring business.  A form is filed with the life insurance company (at Penn Mutual it is called the Modification of Ownership Rights: Restricted Bonus Plan) which restricts the policy owner’s access to the cash value of the policy.  The business and the executive enter into an agreement that sets the terms for when the cash value can be accessed.  REBAs are often chosen by businesses that want relative simplicity and a potential up-front tax deduction.  In many cases, the choice between a REBA and a SERP comes down to what is more important for the sponsoring business.  If control (i.e. a strong vesting schedule) is required, a SERP is the way to go.  If an upfront tax deduction is required, a REBA is the way to go.

Phantom Stock Plans

In many ways a Phantom Stock Plan is like a SERP.  The key-difference is that in a Phantom Stock Plan, the executive’s benefit is driven in part of solely by the value of the sponsoring business.  Phantom Stock Plans are often used as a method to provide key-executives with upside potential associated with the value of their employer without giving them actual ownership in the business.  Phantom Stock Plan can be very effective but they are complex and should only be implemented by financial professionals with an expertise in that marketplace or financial professionals that partner with someone that has that expertise.

Split Dollar

Split dollar is an arrangement between two parties to share in the cost and the benefits of a life insurance policy.  Next month’s blog will be focused solely on split dollar arrangement so stay tuned.

Pillar IV – Estate Planning

Many business owners are in the position of having a taxable estate and what they do with their business interests should be part of any sort of comprehensive estate plan. 

Discounted Gifting

In some cases, business owners will continue to personally own their business interest and plan for estate taxes through trust planning and so forth.  In other cases, however, business owners move a portion of their business interests outside of their estate through gifting to an irrevocable trust. In some cases, gifting of minority interests of a business or non-voting/limited ownership interests may provide a discounted valuation for lack of marketability, lack of control, or both.  The size of the discount must be determined by the client’s legal advisor and a valuation expert.  Once those ownership interests are inside of the irrevocable trust, the cash flow generated may be used to pay life insurance premiums for a trust-owned policy.

Intentionally Defective Grantor Trust (IDIT) Sales

A sale of a business interest to an intentionally defective trust in exchange for a note is a great way to get future appreciation of that business interest outside of the business owner’s estate.  The note will be included in the estate, but, any appreciation of the business interest will belong to the trust.  The note will be an interest bearing note with an interest rate equal to at least the appropriate applicable federal rate (AFR).  In many cases, the cash flow generated by the business interest paid to the trust will exceed the interest due to the seller.  In that case, the difference can be used by the trust to pay life insurance premiums.  IDIT sales are complex transactions that require sophisticated legal counsel to implement.

Seasoned Money in Profit Sharing Plans

In some cases, business owners have qualified plan or IRA balances that they don’t need for retirement income.  It may make sense for those business owners to roll those moneys into a profit-sharing plan.  Money that is considered seasoned in a profit-sharing plan may not have limitations regarding how much can be used to pay life insurance premiums.  In some cases, business owners will use profit-sharing plans as a way to purchase the life insurance they need for estate planning without reducing their current cash flow.  The ultimate goal in this strategy is to have an intentionally defective trust purchase the policy from the profit-sharing plan for its fair market value.

So as of right now, I am just north of 2,000 words and I haven’t really scratched the surface on all of the different opportunities within the four pillars in the business marketplace. So, what I am saying, is, don’t be afraid to chase that waterfall, it may be quite refreshing at the end of the day.  It is a marketplace that is underserved but can provide wonderful planning options for business owners and financial professionals alike.  The Advanced Sales Team at Penn Mutual has the tools and knowhow to help you identify these opportunities and implement these strategies. Please reach out to Penn Mutual’s Advanced Sales Team for assistance. Connect with us via email at advancedsales@pennmutual.com or give us a call at 800-818-8184, option 8.

_{*For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Sec. 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2)(i.e. the transfer-for-value rule); arrangements that lack an insurable interest based on state law; and an employer-owned policy unless the policy qualifies for an exception under IRC Sec. 101(j).}

_{Penn Mutual is not affiliated with TLC, Niagara Falls, or Forrest Lawn Cemeteries.}

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