Often, when people hear business protection planning, they at once think of 401ks, group health plans, dental insurance coverage, and disability insurance plans. When considering the fundamental elements of business protection planning with a broader scope, you may realize several options are missing from the previously mentioned list. Often, the most critical business protection planning tools are either overlooked or misunderstood.
Businesses do not get advance notice when the unexpected in life happens. Without a plan of action, an organization can struggle to recover, or worse, go out of business for good. We are talking about buy/sell arrangements, key person insurance plans, personal pension plans, and transition plans. Do your clients have these types of business plans in place?
Yes, 401ks and health insurance plans are foundational to a lot of businesses. Almost everyone acknowledges these plans as a fundamental business need. However, when it comes to protecting business assets, there are shortcomings in most privately-owned companies. Why? The cost of protection is a concern. Familiarity and comfort may be lacking. A sense of urgency may not exist with the other responsibilities of the day-to-day.
Why do business owners not plan?
There are two main reasons, in my experience, that business owners do not take care of the grand scheme planning as thoroughly as they should.
The first reason is they do not understand the finer details of what is needed to protect a business, the owners, and its employees. This is not their fault. They are experts in their own business and are not financial agents or advisors.
The second reason business owners do not plan is because most insurance agents or advisors, the very people business owners rely on for advice, do not understand what is available. I happen to think this is a much bigger problem!
A business owner trusts an insurance agent to help them with fundamental planning. What happens when the agent does not understand half of what is available? How will the business survive the death of a partner or key employee? How will they survive a disability or a transition in ownership? Our goal in the industry should be to educate educators. How do we make every agent an expert?
Let us start with a breakdown of each of the four major pieces of advanced planning in the business space.
The Buy/Sell Agreement
In a nutshell, a buy/sell is an agreement between two or more owners or partners within a company that outlines the course a business will take should one or more members pass away. Alternatively, if they become unable to fulfill their role. It is not enough to only have a document that states who does what and when. A fully funded buy/sell is the result that a business needs to achieve. The end goal is that the business has some asset, ideally permanent, cash value life insurance, covering all possible scenarios. If an owner passes away, the death benefit from the life plan is used to pay the deceased’s spouse (or estate) for their share of the company. This scenario allows retained ownership by the living owner(s) rather than a spouse or family member who does not understand the business and cannot further its success.
Business Owner Transition
The second reason to have a buy/sell fully funded comes when an owner wants to retire and exit the business. The permanent life insurance plans that the company has had will have grown cash value over the years. The cash value can be used as part of a buy-out to help transition the business. In our experience, we see one or more owners want to remain and continue working while another decides to retire. The cash value in a plan can buy-out the retiring owner’s shares of a company. It may not necessarily be enough to purchase all the retiring owner’s interest in a company, but it can certainly make a substantial difference. Payments can be made either in a lump sum or as an ongoing income stream from the plan.
We suggest implementing the same type of plan when a new owner joins a company. This new owner may have intentions to buy out the senior partners at a future date. In time, the plan’s cash value grows and is applied by the newest owner for a buy-out. This scenario supplies protection for the organization’s operation and a planned pool of funds for the future transition, rather than the new member having to reach out of pocket or take a small business loan.
There are several similarities between a buy/sell agreement among ownership and a key person plan for essential employees. Primarily, the point of a key person plan is to protect the business from losing a company’s major contributor. Examples could include the chief researcher at a medical firm, a head engineer for an oil and gas company, a leading sales representative, or a chief marketing officer. If a key person passes away unexpectedly or suffers some disability that prevents them from performing their tasks, the business could be in a crisis.
You may have heard the term golden handcuffs. Golden handcuffs are incentives for employees to stay with a company for a prearranged time. Essentially, they are handcuffed together for the duration of that period. This type of business arrangement supplies a cash-value life insurance plan to a key employee. The cash built within the plan will go to the employee at a future date, as an example, ten years from creation, if they stay employed at the end of that period. If the employee leaves before the arranged date, then the company keeps the cash it has put into the plan. If something unfortunate happens to the employee, the company, or the staff member’s family receives the death benefit.
Depending on the business structure, contributions to a key person plan can be tax-deductible to the company. However, they are counted as bonus income to the employee and are taxable to that individual.
A personal pension is literal as it sounds. It is a way for a business owner to create their own pension plan throughout a business lifetime and into retirement. In the world of insurance, we can create what is called a LIRP, or Life Insurance Retirement Plan. A LIRP is designed with insurance products and may include an Indexed Universal Life plan, a Variable Life plan, or more rarely, a Whole Life plan. LIRPs can be a way to have a tax-free income stream in retirement.
The most efficient way to build a LIRPs is to use after-tax dollars into the plan for the amount the client considers proper. The face amount is minimized and set to Option B (increasing face amount) during funding years, then changed to Option A (level face amount) after funding. After funding, the face amount can decrease. This is not the only way to build a LIRP, but it is often the most successful.
The strengths of a LIRP are three-fold; market gains – some with caps and some without, depending on selections – market risk protection on the downside with the smallest guarantees, and tax-free distributions during retirement. Of course, the client has death benefit protection as well. The mitigation of market risk and the tax-free nature of the income can mean a lot over the funding years. It is critical to consider how the income and capital gains tax rates may change – i.e., go up – in the future, further lending strength to a LIRP personal pension.
The following is a textbook example of an extraordinarily successful business that grew faster than protection and income planning.
In the second quarter of 2020, we put together a combination plan for an automobile manufacturing business. This company makes specialty parts and had been successful for several years. However, they had neither a funded buy/sell, a transition plan, nor a formal income plan. With a business valuation of just over $30 million, it was necessary to protect the three owners from any unforeseen calamities.
Each of the three owners had a 33.3% stake in the company, meaning a $10 million permanent life insurance plan for each owner. Given the necessity of having cash value within said plans for transition purposes and potential future income, we recommended indexed universal life policies.
Enter the curveball. The clients had a high net worth, but low liquidity. Compounded by the fact that a pandemic was in full swing and companies were making sure to preserve capital whenever possible, it could have been a struggle to fund the plans adequately. However, the joint success of the business and the owners allowed us the option of premium finance. Premium finance is the participation of a specialty lender supplying a sizable part (or all) of the premium needed to fund a permanent plan. This participation enables the clients to buy the protection assets they need without hampering their capital.
These indexed universal life plans are in place to act as a buy/sell between the three partners, a transition plan (using the cash value within) if a buy-out happens in the following years, as well as potential personal pension plans, to supplement the income of clients when they decide to retire.
Get educated on business protection planning.
Whether a business is big or small, generations-old, or just starting, there is an abundance of tools available to protect lives, health, and assets. Unfortunately, many advisors do not have exposure to all these tools. The opportunities, information, and training to become an expert are limited. You cannot do it if you do not know it! It is not the only catch-22 in the marketplace, but it is a big one. The good news is that limited knowledge does not mean you cannot do these things. It only means you need to know who to go to for advice. You do not need to be an expert to be able to help someone. You need to know the questions to ask.
- Do you have a fully funded buy/sell?
- Do you have a transition plan for selling the business?
- Have you set up a retirement income plan(s)?
Once you have the answers to those questions, you can speak to people who do these plans regularly and learn as you go. The best advisors are the ones who are continually learning. Make sure you are one of those advisors!
Where can I find the experts on business protection planning?
There is good news! EMG Insurance Brokerage is a full-service brokerage general agency based in Houston, Texas. We know it is essential for advisors to access quality products, expert advice, and cost-effective solutions. We keep up to date of markets, trends and continually update our carrier offerings. Connect with us for guidance on how to grow your business today; we are here for you.