We have entered a new era of innovation. Today a business owner can dictate an email to his phone; tell the phone to send the email; add an appointment to his calendar; and receive a reminder from his phone, computer or tablet to pick up milk on his way home-all while sitting in a car that parks itself-and that’s not even the tip of the iceberg. The technology and software that is out there now to assist businesses is beyond what anyone would have expected. For example, business owners can now run their business and work with employees completely remotely, via software such as Wandera that has zero-trust network access, by using software that allows them to share all they need for the job via one portal. The sky is the limit for business owners in this day and age.
The thought leadership of the business world is bringing creative solutions to problems their customers never even knew they had in the first place. Business owners live and breathe creative solutions-particularly when it comes to increasing the livelihood of their businesses and, in turn, increasing their own paychecks. Many LLCs and C-corporations try and save money on small business taxes by opting to be taxed as an S-corporation. As S-corporations are pass-through entities, they don’t have to pay corporate tax. And, in turn, their taxes are lowered. If you are an entrepreneur, you could opt to learn to file form 2553 online for your S-Corp election and make an educated decision about your business. Many companies, such as manufacturing companies, use ERP (Enterprise Resource Planning) in order to get the most of their business. These consultants help to grow your business in relation to your employees and your technology. There are many ERP consultants out there, such as SYTE and many more, that assist businesses in the rise of efficiency and ultimately, pay checks.
While new gadgets, technological advances and ever-expanding reach in today’s social media make the process of doing business more efficient than ever, there are many business owners out there who still have one potential problem that they can’t seem to solve, or may not even be aware of-business continuation planning.
Today’s business owner appears to be sorely underprepared for the endless amount of “what ifs” that could strike a business at any time: death, disability, divorce, retirement, illness or any other trigger that could leave the business in need of a way to fund the recovery from any of these situations. According to The New York Times, 87 percent of business owners surveyed in 2008 didn’t have a written plan in place.1
Most business owners are aware that they are not immortal and that the day will come when tough decisions will have to be made about the continuation of their business beyond their life. So why are they hesitant to take action?
Typically, it’s the same type of objection heard by those who may lack sufficient retirement plans: If it doesn’t appear to be an immediate problem, put it off for now. Business owners, in particular, tend to be more concerned with revenue, growth and operations rather than an abstract “what if” situation that doesn’t appear to need solving right now.
In addition to protecting the life of their business, there is also the nagging question of exit strategies, particularly around how current business owners plan to fund their own retirement. According to USA Today, about one third of business owners have no plan in place for retirement and about the same amount don’t even know how much money they’ll need at retirement age.2
While funding retirement is a concern for many Americans today, the pressure is perhaps more significant for business owners-particularly those of the smaller, independent variety who don’t have a ready-made corporate 401(k) plan already in place for them.
Business owners are generally more often the maverick type of thinkers, too busy running a company to deal with planning for the unknown. This is precisely why they need your help. It’s crucial that financial representatives make business owners aware of the potential problems, before the business is brought to a screeching halt. Some of the basic steps include:
?1.?Drafting a Buy/Sell Agreement. Think of a buy/sell agreement as a kind of will for a business. First, it’s a legally binding contract and one that is very specific to the particular business (this isn’t a one-size-fits-all deal), so an attorney must carefully draft and review this type of agreement with all parties involved.
Second, a buy/sell agreement needs to be reviewed periodically (just like a will) to cover the continually changing nature of a business-from changes in valuation, future goals or as ownership structures shift.
And finally, there needs to be a plan in place for how to fund the agreement when one of its triggers occurs.
?2.?Funding a Buy/Sell Agreement. One common strategy is to fund a buy/sell agreement using a “term and invest the rest” strategy. Basically, this means that the owners of a business agree to purchase each other’s interest in the business with separate term life insurance policies on each other’s lives, with each owner being the beneficiary of his partner’s policy. This covers the death trigger of a buy/sell agreement, so that if an owner dies, any remaining owner is paid the life insurance death benefit proceeds. The surviving owner(s) use the death benefit proceeds to buy out the deceased owner’s shares in the business.
But what about other triggers of a buy/sell agreement? For example, if one of the owners is ready to retire, where will the business owner(s) get the funds to buy out the retiring owner’s shares? The “invest the rest” part of this funding strategy essentially means that whatever funds the business owners don’t use with the term life insurance, they can put into some type of investment to fund the transfer of business shares from one owner to another, buying out the retiree.
The type of investment could be an annuity, a certificate of deposit (CD from a bank or other investment vehicle. In some cases, business owners may fund other triggers of the agreement by getting a small business loan from companies such as Qualia Credit. Regardless of which investment vehicle business owner(s) decide to use, the following risks should be considered:
One of the most glaring is an issue that can hurt even the best-intended “invest the rest” scenarios-the owners don’t actually follow through on investing the rest.
Market risk can be another concern. A downturn in the market can ruin the best of plans, especially if there isn’t enough time until the date the funds are needed to overcome the loss of value in the investment fund.
If the intention is to finance a buyout, many business owners may find that financing is not easy to come by-if it is available at all.
What about liquidity? If an owner decides to retire prior to age 591/2, then there could be tax implications in accessing funds. Will the returns on annuities or CDs be sufficient to help make an investment cost-effective? A low return for an extended period of time could require a larger investment-one that the business owners may not be willing or able to make.
Term life policies are designed to provide protection in case you die within a specified period of time. What if the level premium period runs out before the owner decides to retire? What about the return on that portion of the expense? Term life policies do not build cash value, so the premium paid is a “sunk cost,” meaning that once the policy expires, the money sunken into it cannot be recovered.
This is not to say that traditional solutions don’t work. When properly administered and structured, these solutions can be an effective method of funding buy/sell agreements. However, there are other strategies that could address a variety of triggers in a buy/sell agreement.
?3.?Two Birds. One Stone. Permanent life insurance can offer a comprehensive solution. First, there are some basic advantages: protection against early death, plus death benefit proceeds to help fund an exit strategy. What about the risks listed above?
Permanent insurance can act as a forced savings vehicle. The premium payment covers the cost of the death benefit protection while also contributing to and building cash value in the policy.
With fixed universal life insurance, there is no market risk. With an indexed universal life (IUL) insurance policy, your client is not directly participating in the stock market. A zero percent floor and annual reset helps to protect your client from a negative interest rate credit.
By selecting a product that waives surrender charges, your client may have the ability to access the surrender value in the policy without penalty, mitigating concerns about the availability of financing.
The current low interest rate environment has had an effect on rates everywhere, but fixed universal life products generally offer returns higher than most other fixed vehicles, with minimum interest rate guarantees of 2 to 3 percent. IULs offer potentially higher rates of return. Many 30-year look back rates exceed 7 percent.
The internal buildup in permanent life insurance can provide cash accumulation and a generally income tax-free stream of income. Some IUL policies may credit interest on the cost of insurance charges, which may further limit the “sunk cost” of your client’s death benefit.
Keeping in mind that business owners are highly concerned with saving money, particularly on things that aren’t seen as a direct investment into the business, a cost-benefit analysis can be helpful. Funding a buy/sell agreement is not an inexpensive proposition, regardless of the option chosen, so it is important to point out that the goal is not to exceed the business owner’s needs. Instead, look to help meet the client’s needs for less out-of-pocket expense. Here’s an example of an IUL policy providing a “two birds, one stone” solution.
Tom and his twin sons, Steve and Lou, run an auto detailing business. Tom is 50 years old, in fair health, and his sons are both age 25 in excellent health. Tom owns 50 percent of the business (valued at $500,000), and his sons each own 25 percent. They have a buy/sell agreement in which the death of an owner would trigger an immediate cash need. Additionally, Tom would like to retire in 15 years, and the buy/sell agreement calls for his sons to buy out his 50 percent share of the business at that time.
In addition to the death benefit coverage, each of these business owners has different secondary objectives. Tom is looking for a way to help supplement his retirement income. His sons are seeking a way to accumulate cash value in order to buy out their father as he approaches retirement. With extra premium funding of life insurance on Tom’s life, they can potentially generate significant cash value to be used for the buyout of Tom’s share of the business.
Indexed universal life can be a product of great interest for these cases and can offer the following features:
??Zero percent premium load, which allows for quick access to cash value and faster cash value growth potential.
Policy loans from life insurance policies generally are not subject to income tax, provided the contract is not a modified endowment contract (MEC), as defined by Section 7702A of the Internal Revenue Code. A policy loan or withdrawal from a life insurance policy that is a MEC is taxable upon receipt to the extent cash value of the contract exceeds premium paid.
Distributions from MECs are subject to federal income tax to the extent of the gain in the policy and taxable distributions are subject to a 10 percent additional tax prior to age 591/2, with certain exceptions. Policy loans and withdrawals will reduce cash value and death benefit. Policy loans are subject to interest charges. You should advise your clients to consult with and rely on a tax advisor or attorney for their specific situations.
??Waiver of surrender charge, which is an optional benefit that waives surrender charges unless the policy is surrendered as a 1035 exchange. This can help give peace of mind in knowing funds are available, even if an unexpected early need arises (e.g., a buy/sell trigger that isn’t otherwise fully funded, such as a disability).
Surrender charges vary by product, issue age, sex, underwriting class and policy year. Withdrawals or surrenders may reduce the ultimate death benefit and cash value.
??Table shave feature, which can be used when a waiver of surrender charge option is elected.
When a person applies for life insurance coverage, his health is evaluated and a corresponding underwriting rating is applied. A table shaving feature allows certain substandard underwriting rates (known as “table ratings”) to be improved to a “standard” rating. A standard rating generally indicates average health and involves a lower life insurance premium than do substandard ratings.
? Guaranteed interest rate bonus on an index account. While short term cash value is a desire, longer duration cash value performance is also an issue. This feature can help the policy perform for the longer durations as well.
Some companies offer a conditionally guaranteed interest bonus to further help your clients build long term cash value accumulation. Interest bonus may be earned when a company declares a current interest rate that exceeds the guaranteed interest rate. Interest bonus percentages are not guaranteed and subject to change; however, once a policy is issued, the percentage will not change.
What Objections Might You Encounter?
Fully funding a buy/sell agreement with permanent life insurance can be expensive. Alternatively, term life premium is a “sunk cost.” Life insurance policy surrender charges can decrease that amount, potentially causing a business to book a loss at the end of the year.
A key to overcoming this objection is to consider a carrier that provides options, such as an early cash value accumulation. A waiver of surrender charge option can help eliminate those charges.
What if money is tight? If the business owners do not have the cash flow to fully fund their life insurance policies, then this option does not work. If they like this option but can’t afford it now, then you need flexibility.
Term life insurance can provide a lower cost option in the short term, but it’s important to consider an option that provides conversion privileges that can help solve an immediate need for death benefit protection, while also providing the ability to convert as cash flow improves. The clients can benefit by locking in their insurability now and guaranteeing that a permanent life insurance solution remains an option in the future. The agent can benefit by earning a commission now, along with the possibility of another sale if the client converts the policy later.
By providing your client with more features, flexibility and benefits than the alternatives, using permanent insurance to fund a buy/sell agreement can help benefit your practice’s bottom line. Present it with your regular menu of products and services for the small business clients in your book and help increase your revenue without increasing your marketing and prospecting efforts.
Footnotes:
?1.?”Are Baby Boomers Ready to Exit Their Businesses?” Barbara Taylor, The New York Times, February 10, 2011. Retrieved from http://boss.blogs.nytimes.com/2011/02/10/are-baby-boomers-ready-to-exit-their-businesses/
?2.?”Many Small-Business Owners Aren’t Prepared for Retirement,” Laura Petrecca, USA Today, March 1, 2012. Retrieved from http://usatoday30.usatoday.com/money/perfi/retirement/story/2012-03-01/small-business-retirement-options/53324004/1
The opinions and ideas expressed by the authors of this article are their own. North American Company does not endorse or promote these opinions and ideas.
Neither North American Company nor its agents give tax advice. Please advise your customers to consult with and rely on a qualified legal or tax advisor before entering into or paying additional premiums with respect to such arrangements.
IRS Circular 230 Notice: Any U.S. tax information included in this written or electronic communication, including any attachments, is not intended as tax advice, was not intended or written to be used, and it cannot be used by you or any taxpayer, (i) for the purpose of avoiding any penalties that may be imposed on you or any other person under the Internal Revenue Code or applicable state or local tax law provisions, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Index Universal Life products are not an investment in the “market” or in the applicable index and are subject to all policy fees and charges normally associated with most universal life insurance.
