Key person insurance can be an essential component of business continuation planning. The business, or the owners and key persons who are essential to operating the business, purchase these policies. If an owner or key person dies or becomes disabled, this insurance could help make up for lost sales or earnings, assist in satisfying the owner’s interests with his or her estate, or cover costs such as finding or training a replacement. It can also be designed as a retention incentive for key employees who agree to continue with the company after an owner’s death.
Here are a few options that companies have used to fund key person insurance arrangements.
Stock Redemption Plan
The simplest way to fund a business continuation plan is with a life insurance policy on each business owner (or key employee as part of their compensation package). The business entity purchases each policy in an amount equaling each owner’s respective business interests.
The company pays the premium and is the policy owner and beneficiary of each policy. If an owner or key employee dies, the company receives the proceeds of the policy and uses the proceeds to purchase the deceased owner’s business interest at a previously agreed upon price. The deceased owner’s estate receives instant liquidity at a fair market value for their business interest.
Cross Purchase Plan
In this plan, the company is not a named party in the agreement. Each business owner purchases a policy on each of the other owners in the amount equal to each owner’s business interests. Each owner is a policy owner and a beneficiary. If an owner dies, the remaining owners or key employees receive the proceeds of the life insurance policy and use those proceeds to purchase the deceased owner’s business interest at a previously agreed upon price. The surviving owners receive a “step-up” in the cost basis of their business interest.
In this funding arrangement, either the company or the owner/key employee can be responsible in part or for all of the policy premiums. This arrangement can also negotiate the level of benefit from the policy if an owner dies. It provides more flexibility to business owners based on their tenure and percentage of ownership.
The tax treatment of such benefits can be complex, depending on the nature and role of the owner/key employee. Employees may be taxed for proceeds under normal compensation tax rates. Proceeds for shareholders may be treated as dividends, but there are some distinct differences for S Corp shareholders compared to C Corp shareholders. For individuals characterized as partners, the tax treatment may again vary, depending on the nature of the partnership and the role of the individual in the company.
Irrevocable Life Insurance Trust
Yet another option for business continuation funding is a business irrevocable life insurance trust. The insurance policy is funded by a split-dollar arrangement or through a Section 162 bonus to the employee. The policy is owned by the trust with the cash value collaterally assigned back to the business entity. This is structured in a split dollar arrangement. At the business owners death the company will receive the greater of the premiums paid or cash value, with the trust receiving the balance of the death benefit proceeds on an income and estate tax-free basis. This trust is often favored by family-owned or closely held businesses that want to keep ownership within the family long-term. The life insurance proceeds and business interests purchased by the surviving owners can avoid estate tax inclusion for generations. The use of Irrevocable Life Insurance Trusts can be a very efficient way to create liquidity which is income tax free and outside of the taxable estate.
If you have questions about business continuation and owner estate planning options, or you are concerned about a certain tax impact, talk to us at MFB.
Author: Bob White, CPA, PFS, has been an accountant with MFB for over 30 years. In addition to holding the CPA designation, Bob is also a personal financial advisor. He has extensive experience in income tax planning for high-net worth individuals, closely held businesses, multi-generational business succession planning, gift and estate tax planning, and in real estate transactions. Bob holds his securities Series 7 and 66 along with his New York State licenses for health and life insurance. Contact Bob at firstname.lastname@example.org.