Starting your own small business comes with volumes of hurdles, strategic life insurance is only one of them. Still, we try to reverse the misconception that only large corporations can take advantage of the strategies business life insurance can offer.
Corporations and life insurance companies have created dozens of ways over the years to minimize tax burdens and retain exceptional employees through life insurance. The most popular strategies include:
- Executive bonus plans
- Non-qualified deferred compensation plans
- Key person life insurance
- Buy-sell agreements funded with life insurance
- Stock-redemption plans funded with life insurance
- Group life insurance
Executive Bonus Plans
Offering unique bonus plans to key employees can help you retain talent. In this case, those bonus plans are individual life insurance policies for your key employees, where the company pays the premiums.
This works through a Section 162 Plan. It lets you (the employer) either single-bonus or double-bonus a specific employee. Single-bonuses cover the premiums on a permanent life insurance plan and the tax on the bonus income. Double-bonuses directly pay the premiums, then give the employee a second bonus to cover the amount of taxes on their bonus of the premium payment.
How They Work
The employer sets up an individual life insurance plan for the key employee. This is typically a whole life plan – see the next section on best types – where the insured employee can access the cash value accumulation.
The insured also chooses the beneficiary. This almost always is the spouse or child, not the company.
You can create a restricted executive bonus plan where the employee cannot access the cash value until they meet certain conditions – usually a length of employment.
Best Type of Insurance for Executive Bonus Plans
Most employers offer whole life. It’s the type of permanent life insurance with the lowest premiums. It’s also the simplest, with fewer moving parts that both employer and employee need to understand.
You could also consider an indexed universal life policy for faster growth on the cash value.
Executive bonus plans are tax-deductible to your business, provided they count as reasonable compensation in the eyes of the IRS. Your accountant or tax professional can help with that.
The insured employee will owe taxes on their bonus, which you would typically cover in the bonus amount.
Non-Qualified Deferred Compensation Plans
Many companies offer well-compensated employees Non-Qualified Deferred Compensation Plans to give the employee the option of reducing their current tax burden. By deferring part of their income while they’re enrolled in this plan, they have the potential to choose a lower tax bracket strategically.
It also functions as an employee retainment tool if you add a vesting schedule.
How They Work
Non-qualified deferred compensation plans allow your employees to set aside a portion of their income, for now. This defers the taxes they would otherwise owe on the income until it gets paid out a specified future date.
Best Type of Life Insurance for NQDC Plans
Any type of permanent life insurance works well for funding NQDCs. You’re looking for the cash value accumulation feature.
Whole life offers stable growth. Indexed universal life grows faster in most cases, but it’s also more complex to set up.
When your business uses life insurance to fund your obligations under a non-qualified deferred compensation plan, you also create income-tax benefits for your business. Payments to the plan are deductible in most cases, just like regular wage or salary payments. You deduct the plan’s administration costs too, but not the premium amount.
Key Person Life Insurance
Insurers created key person life insurance to cover a business in case a vital employee passes away. The face amount should hold the company over until a person to fill the critical role can be hired.
Companies consider anyone whose passing would have an adverse economic impact on your company.
Because the business owns the insurance policy, you (as the business owner) can take advantage of the cash value accumulation feature.
How They Work
The business is both the owner and the beneficiary of the policy. The insured employee must be notified and give their consent to the key person policy.
Small, family-run companies use key person life insurance to create succession plans for the business. Larger companies use key person on their executive team to create their own bank through the use of an IUL cash value accumulation. They can borrow money from the cash value to fund new ventures or help them through rough patches.
Best Type of Life Insurance for Key Person
This will depend on whether you’re strategically using the cash value or purchasing a life insurance policy as a “just in case” strategy.
For the advantages created by cash value accumulation, indexed universal life policies have some of the fastest growth with a 0% floor – so your policy never loses money. These can be tricky to set up, so make sure to speak with an experienced insurance agent.
To cover a key person, your business will pay less in premiums on a term insurance policy. Whole life is an excellent alternative to IUL for a lower premium permanent policy.
In most cases, you will not pay any taxes for the death benefit on a key person claim. Double-check with a tax professional to ensure you’re doing everything correctly.
The loans from the cash value of the policy are not taxable as long as they do not exceed the amount of premium paid.
Buy-sell agreements are contracts between owners of a business to ensure operations continue when an owner leaves or passes away. They avoid the mess of a spouse or child taking over that owner’s share.
Funding your buy-sell with life insurance offers additional protection for your business. It transfers the ownership of the company at an agreed-upon price, so there is no haggling with a spouse or heirs over purchase price for their share. They also create flexibility in how you want the transition of ownership to work.
How They Work
First, the insurance company will want a rough value of your business to make sure they do not over-insure any of the owners. You will also want to combine this with a business attorney to draw up the buy-sell agreement.
If one owner passes away, the life insurance pays for that owner’s share of the business – as agreed upon in the buy-sell contract.
Best Type of Life Insurance for Buy-Sell Agreements
Permanent life insurance works best. Whole life will have the lowest premiums out of all of the permanent options. Still, it doesn’t offer the added benefits of fast cash value accumulation growth.
If you’re looking to take advantage of the cash value accumulation for your business, it may be less fraught with legal pitfalls to look at the other types of business insurance since they won’t affect the other owners.
You cannot deduct the premiums used to purchase life insurance for a buy-sell on your taxes. Because the types of life insurance you use for buy-sells have cash value, there are also tax considerations for the cash value portion. It’s best to speak with an experienced agent and your tax advisor on the specifics of your situation.
Stock-Redemption Plans Funded With Life Insurance
A stock-redemption plan is similar to a buy-sell agreement funded by life insurance. The only difference is it simplifies the insurance when there are more than two partners.
How They Work
In this type of buy-out strategy, the company is the owner, beneficiary, and premium payor on the life insurance. If one of the owners passes on, retires, or becomes disabled, the buy-out gets triggered. The company receives the death benefit at the agreed-upon amount to buy out that owner’s share. The business then pays the spouse, heir, or estate with the death benefit.
Best Type of Life Insurance for Stock-Redemption Plans
Choose a type of permanent life insurance. Typically, whole life insurance is the simplest if you aren’t using the cash value accumulation feature for anything.
While the premiums on this are technically deductible, it’s not a good decision. If you deduct the premiums, the death benefit becomes taxable. If you do not deduct the premium payments, then the death benefit is tax-free to the business.
Group life insurance is something you can offer as part of a benefits package. It’s almost always term life insurance, but there is little underwriting and rates are lower because the insurance company gets the business of a group of people rather than an individual.
How It Works
The details here go beyond the scope of our overview. There are many types you can offer. You also have options to provide it to all of your employees or only specific groups, such as your executives.
Keep in mind that there are several anti-discrimination laws in place regulating what groups you can and cannot exclude from group insurance. For example, you can offer group life insurance to executives, but you cannot offer it only to the men who work for you.
When you have a group policy as part of your benefits package, you can choose whether your business will cover all of the premiums, the premiums up to a point, or a percent. You can also select the requirements for qualifying for these benefits – usually a length of employment.
Best Type of Life Insurance for Group Benefits
The majority of businesses go with term insurance. You could choose a permanent policy, but then there is more HR paperwork involved with that happens to the policy if an employee leaves.
Any premiums paid beyond $50,000 in benefits is considered taxable income for the employee. You can write off premiums in most cases for non-exclusionary group life insurance plans. It would be smart to consult with your tax advisor for more information on the plan you’d like to implement.
There are many ways to strategically use life insurance to minimize your tax liability, as well as potentially reduce taxes for your key employees as well.
It would be wise before setting up any of these options to consult a tax advisor or attorney for guidance on your specific situation.
How Abrams Insurance Solutions Can Help
We’re a small group of independent agents looking to help people create stable financial foundations in their lives. Life insurance is just one pillar for family stability, and it has even more advantages for businesses.
Give us a call today at (858) 703-6178 to see which of these will benefit your company.