Business Uses of Life Insurance
A business owner’s death creates three problems at once: the heirs hold an interest they may not be able to run, the surviving owners must deal with people they did not choose, and the business may lose the person its customers or lenders relied on. Life insurance answers each problem with cash at the moment of death. A funded buy-sell agreement is worked from valuation through premium and payout, key person coverage is sized, and a split dollar arrangement is run for five years. The names and figures are invented examples.
Funding a Buy-Sell Agreement
Ferndale Precision Tooling LLC is owned by Anita Rossi, 58, who holds 60%, and Kevin Mbeki, 44, who holds 40%. The LLC is taxed as a partnership. Their buy-sell agreement says that when one owner dies, the survivor buys the deceased owner’s interest from the estate at an agreed price. The owners set the value of the business at $1,500,000, so the price of Anita’s interest is $900,000 and the price of Kevin’s is $600,000. Without funding, the survivor would have to borrow or pay in installments, and the estate would be left holding an interest it cannot sell.
Cross Purchase
Under a cross purchase, each owner buys, owns and is the beneficiary of a policy on the other. Kevin buys $900,000 on Anita, and Anita buys $600,000 on Kevin. If Anita dies, Kevin collects $900,000 as beneficiary and pays it to her estate for her 60%, and he now owns the whole company. Because Kevin bought the interest himself, his cost in it rises by what he paid.
The premiums show a weakness. Suppose the policy on Anita, at 58, costs $13,500 a year and the policy on Kevin, at 44, costs $4,800. Kevin, the 40% owner, pays $13,500. Anita, who owns 60%, pays $4,800. The younger, smaller owner carries most of the cost because the older owner is the more expensive life to insure. The owners can bring the payments into line by adjusting compensation or by agreeing to a different split of premiums, but the agreement has to say so.
The second weakness is how fast the policies multiply. Each owner insures every other owner, so the number of policies is the number of owners times the number of owners less one.
| Owners | Policies needed |
|---|---|
| 2 | 2 |
| 3 | 6 |
| 4 | 12 |
| 5 | 20 |
A company with five owners would have to buy and keep track of 20 policies. That is the main reason larger companies prefer the entity form.
Entity Purchase
Under an entity purchase, the business owns one policy on each owner, pays the premiums and is the beneficiary. When an owner dies, the company uses the proceeds to buy the deceased owner’s interest. In a corporation this is the stock redemption plan. The survivor’s ownership percentage rises because the interest is retired: if Anita dies and the LLC redeems her 60%, Kevin’s 40% becomes 100% of what remains.
Using the same premiums, the LLC pays $13,500 plus $4,800, or $18,300 a year, and the cost reaches both owners through lower company profit, in proportion to their shares. Two policies cover two owners, and adding a third owner adds only one more. If an owner is also an employee of the company, the company’s ownership of the policy also brings in the employer-owned policy rules described under key person coverage.
The Gap That Appears Later
A policy fixes the dollars, and the price in the agreement can drift. Suppose three years later the business is worth $2,100,000. Anita’s 60% would now be $1,260,000, but the policy on her pays $900,000. The shortfall is $360,000, and the survivor must borrow it, pay it over time or renegotiate with the estate. A good agreement is reviewed whenever the valuation changes, at least once a year, and the insurance is increased to match.
Three points complete the picture.
- Who the insured must be. Co-owners ordinarily have an insurable interest in the other’s life, and Michigan requires the insured’s written consent where an individual insures another person for the buyer’s own benefit and the policy is $10,000 or more. The insured’s signature on the application counts as consent (MCL 500.2211(1), (2)).
- Change of structure. If the owners later move from a cross purchase to an entity purchase, the policies must be transferred. A transfer of a life policy for value can make most of the death benefit taxable, unless the transfer fits a statutory exception, such as a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer (26 U.S.C. 101(a)(2)). The tax result is worked later with the other income tax rules.
- The lawyer’s role. The agreement itself is a contract drafted by an attorney. The producer supplies the policy and the premium, and does not write the terms.
Key Person Coverage
A key person policy protects the business from losing someone whose work produces its income. The business owns the policy, pays the premium and is the beneficiary. The amount is an estimate of the loss, and a common method is the profit the key person produces during the time it takes to replace the person.
Ngozi Adeyemi runs sales for a Grand Rapids distributor and is responsible for $1,200,000 of revenue a year. The company’s contribution margin on that revenue is 18%, so her work yields $1,200,000 × 0.18, or $216,000 a year. The company expects replacing her to take 18 months, during which the margin is lost: $216,000 × 1.5, or $324,000. Recruiting and training a successor adds $58,000. The estimated loss is $382,000, and the company buys $400,000.
Two rules apply because the employer is the beneficiary. Michigan gives an employer an insurable interest in its directors, officers, managers and nonmanagement employees, but only with the insured’s written consent. For nonmanagement and retired employees the coverage is also limited to an amount reasonably commensurate with the employer’s projected unfunded liabilities for employee benefit plans (MCL 500.2210(2)). The federal rule is stricter in its own way. When an employer owns a policy on an employee, the death benefit is tax free beyond the premiums paid only if two things are true. Before the policy is issued, the employee must have been told in writing of the intent to insure and the maximum face amount, consented in writing to the coverage, including its continuing after employment ends, and been told that the employer will be a beneficiary (26 U.S.C. 101(j)(4)). The insured must also fall within an exception, such as having been an employee within the 12 months before death, being a director or a highly compensated employee when the policy was issued, or having the proceeds paid to the insured’s family or used to buy the insured’s equity interest from them (26 U.S.C. 101(j)(2)). A producer who sells key person coverage gets these papers signed at the application, and keeps copies.
Split Dollar and Executive Bonus
Both arrangements help a business reward an employee with life insurance.
Split Dollar
In a typical split dollar plan, the employer owns the policy and the employee names the beneficiary. The employer pays each year an amount equal to that year’s increase in cash value, and the employee pays the rest of the premium. At the employee’s death or when the plan ends, the employer recovers what it paid.
Take a $500,000 policy on an employee aged 45 with an annual premium of $9,000.
| Year | Cash value at year end | Employer pays (increase in cash value) | Employee pays |
|---|---|---|---|
| 1 | $1,200 | $1,200 | $7,800 |
| 2 | $4,600 | $3,400 | $5,600 |
| 3 | $8,300 | $3,700 | $5,300 |
| 4 | $12,300 | $4,000 | $5,000 |
| 5 | $16,500 | $4,200 | $4,800 |
The employee has paid $28,500 over the five years, and the employer $16,500, which equals the cash value. If the employee dies in year 5, the employer takes $16,500 from the proceeds, and the beneficiary receives the other $483,500. As the cash value grows, the employer’s share rises and the employee’s falls, which is why the arrangement suits an employee who wants coverage at a low early cost. The employer’s recovery is protected by the cash value in every year, so its risk is small. The tax treatment of the employee’s share depends on how the arrangement is documented and is a matter for the plan’s tax adviser, so a producer does not quote it.
Executive Bonus
An executive bonus plan is simpler. The employer pays the executive a bonus equal to the premium, and the executive owns the policy and names the beneficiary. The bonus is compensation to the executive, so the executive pays income tax on it, and the employer generally deducts reasonable compensation. Unlike split dollar, the employer has no claim on the policy. Employers sometimes add a restriction on the policy so that the executive cannot surrender it freely, but the policy is the executive’s.
Lesson summary
- A buy-sell agreement fixes a price and funds it with insurance so that the survivors can buy the deceased owner’s interest. Cross purchase has each owner insure the others, and entity purchase has the business insure each owner.
- In the worked case the older owner’s policy cost $13,500 and the younger owner’s $4,800, so a cross purchase put most of the cost on the younger, smaller owner. The entity paid $18,300 in total.
- The number of cross purchase policies is the number of owners times the number of owners minus one, so five owners need 20 policies.
- A buy-sell price must be revisited as the business grows. A value of $2,100,000 made the $900,000 policy $360,000 short.
- A person who insures another for his or her own benefit needs the insured’s written consent on policies of $10,000 or more in Michigan, and the insured’s signature on the application counts (MCL 500.2211).
- Key person coverage is sized by the profit lost until a replacement is productive plus replacement cost. Michigan requires an employer to have the written consent of the employee insured, and federal law requires written notice and consent, and an exception such as recent employment, for the death benefit to remain tax free beyond the premiums paid.
- In split dollar the employer pays the increase in cash value each year and recovers its payments from the proceeds, and in an executive bonus plan the executive owns the policy and pays tax on the bonus.