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Inflating Asset Value? Indexing During Financial Underwriting

What’s good for the goose is good for the gander; or so we are told. But adages aren’t always truisms, so unfortunately the conventional wisdom behind them must be applied categorically and with ginger – especially when building financial justification for a case. The coverage guideline a carrier uses for one insurance need may not be applicable to another.
 
When buying insurance, a thoughtful purchaser and advisor always struggle with whether or not sufficient coverage now will do the job down the road – especially where there is a reasonable anticipation of increasing need. A good example is insuring against future estate tax liabilities.
 
Most successful clients know that they are going to be worth considerably more later.
 
So they would rather go ahead and over-insure against the possibility of a higher tax bill, rather than risk less favorable medical underwriting if they were to wait and try to purchase more at an older age.
 
Most carriers will accommodate this concern by allowing clients to index their estimated taxable estate (usually an amount resembling their net worth) for inflation. A common formula allows application of a reasonable rate of interest (currently 3-4% unless compelling circumstances justify more) for a period equivalent to 75% of the insured’s life expectancy not to exceed 15 years.

The parameters differ from company to company, so the issue of indexing can influence the choice of carrier.

Future increase in asset value is also important when buying coverage to fund buy-sell arrangements.
 
Co-owners set a current purchase price knowing that the business value will increase as the enterprise prospers. Soooo . . . one would think that the estate tax indexing guideline should apply here as well. But if you went to an underwriter back in the 16th century and argued, “Deeply drinketh the goose as does the gander” (that’s how they said it back then), he or she would tell you that it ain’t necessarily so.
 
Carriers will not allow anticipated increases in business value as financial justification for more coverage. Perhaps the concern is rooted in the fact that someone other than heirs could benefit if the insured’s goose is cooked at too early an age. Advisors should suggest that otherwise unneeded key person coverage may be a justifiable source for the additional insurance sought.
 
Indexing, as well as many other issues related to financial underwriting, can create fewer problems when addressed early in the planning process.
 
Call us and talk about situations you have that may require some foresight when insurance is needed for estate or business situations.
 
Speaking of “honkers” – have you ever noticed that when a gaggle flies over in V-formation one side is always longer than the other. There is a good practical reason for this. It’s because there are more geese on that side.
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Unlock More Key-Person Coverage

Real old-timers remember the days of one of comedy’s iconic duos, the husband and wife team of George Burns and Gracie Allen. Any younger connoisseurs of good humor would do well to spend some online-time calling up at least some of their radio, television, and cinema work-product on YouTube or some other source. But search engines didn’t help me uncover one famous routine, so I will paraphrase:
 
Gracie: Did you hear that my friend got hit by a car that didn’t have its headlights on? George: That’s awful! Why didn’t the driver bother to use the headlights? Gracie: Because it wasn’t dark yet!

Knowing all the facts can certainly change the response to circumstances.

And so it is when talking to a business owner about how much company-owned coverage he or she can get on an important executive. Consider:
 
The standard key-person formula.
 
Most carriers will allow a business to own coverage on an important executive in the amount of ten times his or her compensation package. This includes not just W-2 salary, but also bonuses, cost of perks (e.g. club memberships), fringe benefit costs (e.g. health insurance, etc.), qualified retirement plan contributions, deferred compensation, as well as the use of a company car or other business assets.
 
Stretching the limits a bit.
 
Some carriers will allow a larger multiple for financial justification. But some might impose a lower multiple as well if it appears unlikely the executive will work for ten more years. When owner-executives are involved a carrier may allow for part of the proposed insured’s Schedule K income to be taken into consideration. If the proposed insured is being awarded ownership interests, the value of those interests might be treated as compensation.
 
Debt can help.
 
Some carriers will allow additional coverage based on a percentage of the company’s longer-term obligations to financial institutions if it can be shown that loss of the executive will curtail the company’s ability to repay. Sometimes the policy is initiated by a lender’s requirement, in which case the financial institution is secured through a collateral assignment.
 
Redemption obligations.
 
A major reason a business may be economically burdened by the death of an executive is the existence of an agreement to buy his or her ownership interest in the company from the surviving family. The agreed purchase price can be added to the amount of coverage sought. If no agreement exists this might open up a discussion of that planning need with the client.
 
Company-owned policies are often more easily placed because the limited time for which coverage is needed (till the insured’s anticipated retirement or for the expected period of service) make economical term insurance a good product choice.
 
Call with questions on or assistance with your next key person or other personal or business planning case at 706-614-3796 or tom@cpsadvancedmarkets.com.
 
George Burns lost his show-biz and life partner in 1964. His career continued after Gracie until he passed away 32 years later, just 49 days after his 100th birthday. So we will end with the signature closing of Burns & Allen:
 
George: Say good-night, Gracie.
Gracie: Good-night, Gracie!
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162 Executive Bonus – Making It “Seem Kinda Tax-Free” Up Front

When discussing and designing executive bonus plans, too much time is lost talking about and describing “single bonus” and “double bonus” methods, and too many cases may be lost because they haven’t been discussed at all.
 
Just a quick study of vanilla executive bonus:
 
The employer (ER) agrees to pay the cost of a selected employee’s (EE’s) life insurance plan (or any other asset for that matter – but that’s another topic). The ER gets to deduct the amount paid to the carrier and then reports it on the EE’s W-2. Boom! At the end of the year the EE realizes an increase in his or her tax bill for what has been, in effect, a non-cash benefit.

Even with proper forewarning, the effect under the “single bonus” method can result in the plan losing its luster in the eyes of the participant when tax time rolls around.

So, then you explain that the ER can avoid this delayed sticker shock by “grossing up” the bonus so that the amount committed to the plan each year equals the anticipated cost of coverage, and the tax that will be due on the total “double bonus.” But if the double bonus method is explained to the ER in response to this concern, it can leave him or her feeling that he or she must commit more than anticipated in order for the plan to keep its sizzle.
 
The psychologically sound sales solution:
 
Don’t mention double or single bonus at all. Once you have determined that an ER wants to assist an EE with the cost of insurance, focus on the amount they are willing to commit. Then, back into the coverage that can be purchased with what would be the after-tax portion. Once the breakdown is established and the plan is in place, it is easy for the ER to send the premium amount to the carrier and withhold the remainder.
 
The ER is still within the original budget, and the benefit is presented to the EE with the assurance that there will be no out-of-pocket tax due at the end of the year as a result of the coverage. The transaction is not a non-recognizable event to the EE, but when explained and implemented correctly, it will have that sensation on April 15.
 
Don’t forget the participation possibilities:
 
If the after-tax amount of the bonus is less than what the participant to the plan might need to achieve an overall risk management goal, emphasize that the policy belongs to the EE and it can be designed so that it provides the total coverage needed with the commitment of additional personal premium payments, either through payroll deduction, if the ER agrees, or by direct payment.
 
A properly designed executive bonus plan doesn’t solve every non-qualified benefit need, but almost. Call for assistance on any case design work you have.
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Idioms & Grantor Trusts: Having It Both Ways (For Now)

You can’t eat your cake and have it, too!
 
We’ve all said it many times and in every case we were talking about more than just desserts. Layered within the phrase is the more subtle and intended message that you can’t have it both ways; or that to get something you’ve got to give up something else.
 
Our conversations are peppered with idioms, those oft-used little word-packages whose literal meaning have nothing to do with what they actually communicate. For the outsider struggling to learn the language, idioms can cause more roadblocks to understanding that all the other irregularities of grammar and spelling that attend the King’s English. And it gets more confusing when an idiomatic truth proves unreliable; as in the case of grantor trusts.

These grantor/intentionally-defective/irrevocable/lay in the house that Jack built/life insurance trusts turn the idiom on its head by allowing, from at least a tax perspective, a taxpayer to have it both ways.

Consider the advantages a grantor trust can provide if all is properly done:
 
  • For estate tax purposes: All property in the trust is not included in the trust-maker’s taxable estate, offering significant tax savings on both the original principal and on appreciation after transfer to the trust.
  • For income tax purposes: The consequences of all that takes place in the trust flow back to the personal return of the trust-maker. This a) allows more control over the severity of the tax – especially if the maker has certain tax advantages in play, and b) avoids depletion of assets in the trust to make tax payments and, by paying the trust’s tax, allows for a gift tax-free benefit to the trust by the maker.
Let’s keep the ball rolling. While the maker is enjoying the best of both tax worlds, he or she also benefits in that:
  • Assets in the trust are protected from the claims of the maker’s creditors.
  • If the maker is married, he or she can maintain remarkable degrees of vicarious control over and access to property in the trust by establishing a life estate in the spouse.
If you want to hide a barn you shouldn’t paint it red. It’s no surprise that a planning device with this many advantages has caught the attention of the lawmakers.
 
If lack of familiarity with common idioms is hampering you then it’s time you pulled yourself up by your own bootstraps, put your nose to the grindstone, and began to get the lay of the land on such things. Or simply contact me with questions that come up in your casework concerning grantor trusts, at 706-614-3796 or tom@cpsadvancedmarkets.com. When we are done you will know your noodles.
 
By the way, my Mother never quite got the hang of making cakes from scratch. Her marble cakes were always so hard we just took them for granite.
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Is Insurance In A Qualified Plan Beneficial?

Whenever life insurance is proposed the first two client-questions that inevitably follow are: first, how much will it cost and then, are the premiums deductible (especially if the client is a business-person). Let’s deal with the second.
 
In a business situation life insurance premiums are never deductible. Even in an executive bonus arrangement the employer can write off amounts paid only because, in fact, the amounts are W-2 compensation, not because they are eventually spent on life insurance.

In the personal context there hovers about the discussion of tax-deductible costs for coverage the possibility of holding life insurance in a qualified plan.

It sounds good at first blush. Contribute to the plan and use the untaxed dollars to buy a policy. But take a closer look.
 
Permanent insurance outside a plan can be broken down into three parts.
 
On the bottom is basis, the after-tax dollars used to pay premiums (it can be a little more complicated than that, but let’s keep in simple). Above that is the potentially taxable, but currently tax-deferred gain in the policy, i.e. the reserves in excess of the basis. On top is the risk portion, the amount of death benefit over the policy values.
 
Two tax advantages to keep in mind with non-plan coverage are:
  • So long as the policy stays in force prior to death, the gain in the policy can be protected from taxation
  • In the event of death the whole kit and caboodle (basis, gain and risk) is paid to the beneficiary income tax-free
Now compare to the taxation of a policy in a qualified plan.
 
Untaxed dollars inside the plan are used to buy the life insurance. So far so good. But next the plan administrator must report each year as taxable income to the insured plan participant the “economic benefit” realized by the coverage. This is often calculated using the carrier’s one-year term rates acceptable to the IRS.
 
The result is an amount usually lower than the actual premiums paid. On balance the participant comes out ahead, but not with as much sizzle as they may have anticipated.
 
What will follow from there is one of two unavoidable tax disadvantages that are avoided with insurance outside the plan.
 
If the participant retires or otherwise separates from service most plans do not allow the policy to remain in the plan. If the policy is distributed its FMV (usually the account value) must be recognized to the extent of the FMV exceeds the accumulated economic benefits recognized over the years of participation, i.e. the gain is taxed, a result that would not have happened with coverage outside the plan. The participant can buy the policy out of the plan, but the result is the same. The heretofore untaxed gain in the contract is not purchased with after-tax dollars.
 
If the participant dies while the policy is in the plan the beneficiary receives the death benefit tax-free only to the extent that it exceeds the policy value minus the accumulated economic benefits. Again, the gain in the policy is taxed, unlike when a death benefit is received for coverage outside the plan.
 
There will always be taxation of the policy gain. In addition, if the insured anticipates death tax liability, either federal or state or both, the proceeds from a plan-owned policy cannot be kept out of the taxable estate. Both are things to consider before hastily buying coverage inside a qualified plan with the hope of, at least, part of its cost being paid for with untaxed dollars.
 
Call with any question concerning coverage inside or outside a plan.
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Properly Documenting Your Clients Intentions

In the most important episode of his life Paul Revere did not fire a shot. But his willingness to spread the alarm averted what could have been an early military disaster for the revolutionists of Massachusetts Bay.
 
Planners, too, in addition to fulfillment of their usual responsibilities must fill the role of an alarmist if they are to keep their clientele financially whole.

The sad truth is that if your clients do not take the time to plan correctly the government is poised to do it for them poorly when the need arises.

State laws allows for a citizens to assure that their affairs are handled according to their wishes, but they must takes steps to document their intentions properly.
 
Proper documentation can be achieved through the execution of these three basic planning documents:
  • A durable Power of Attorney that permits an appointed agent (attorney-in-fact) to conduct financial transactions for your client under the terms expressed.
  • A Health Care Directive (a/k/a – healthcare proxy, living will, durable power of attorney for health care) that appoints an agent to make health care decisions if the client becomes unable to do so.
  • A Last Will & Testament that, upon death, allows the client to a) decide who will receive the assets owned by the client, b) appoint who will manage those assets, c) state preferences for the guardian of the client’s minor children, and d) appoint trustees of trusts created by the Will.
If these are not in place a client must understand that there is legislation in every state that will make these decisions for them.
 
Broaden the influence you have with and the comprehensiveness of the service you provide to your clients by asking them if they have taken the time have drafted at least the three fundamental planning documents listed above.
 
We do not practice law or offer legal advice (nor do you), but will look at a client’s planning documents to direct them better when they have them reviewed by legal counsel. Give us a call.
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Sweat Equity, Without The Equity

The business world abounds with stories of the entrepreneurs who managed success building an undercapitalized venture largely because they made little or nothing in the early years, choosing rather to channel revenues back into the growth of the business.
 
But there are often unsung heroes in these stories of delayed gratification: those talented and enterprising key employees who, captured by the vision and its opportunities, also sacrificed, giving up other more “sensible” opportunities, committing to onerous work schedules, and settling for less salary during their “salad days” so they might share in the bounty down the road.

The difference is that they have no ownership interest; and therein lies the sales opportunity.

Business owners with a conscience will be sure to reward such sacrifice among loyal employees when company fortunes turn.
 
Unfortunately there are some things over which the they have no control, like their unexpected premature death, or the level of obligation that successor owners might feel for those employees who played a role in getting the company to the dance.
 
There is an easy and economical way business owners can protect loyal employees, and the concept should be a club in the bag of every agent working the small to mid-sized business market, or who wants to be a player there.
 
Contact us to discusses how you can increase business sales using the concept of “loyal employee insurance.”
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Buy-Sell Planning While Generation Straddling

Two of the top ten reasons that younger women say that they marry older men are, first, they have a better read on those with a more promising future, even if it is shorter; and second, if they sprain their ankle they can use their husband’s cane.
 
Pretty funny, but not unlike a couple of the underlying reasons it might make sense for a young entrepreneur to associate with an older colleague in a business venture.
 
The “kid” has the track record of the potential partner to serve as a good indicator how much the codger will bring to the table in the time remaining in his or her active work life. And the older businessperson has picked up things along the way that may come in handy to overcome unexpected hurdles (the cane, just in case you aren’t following the analogy).

But a disparity in age always seems to create a fly in the ointment when it comes time to do some business transition planning.

When insurance ledgers are run in anticipation of insuring for a buy-out in the event of death there is often sticker shock over the difference in cost between coverage for the young ‘un and the old fogie.
 
Clients expect some spread in cost due to age, but not that much – and it doesn’t help that the older proposed insured’s medical history isn’t as positive as it used to be (after all, you generally don’t use a cane because there has been an improvement in health).
 
If properly addressed this bump in the road shouldn’t be a problem. Assume a case where the partners will buy each other out with policies they own on each other on which each will pay the premium.
 
Consider:
 
  • Because the need for coverage is a measurable period of time that is less than life expectancy, term insurance can be used to considerably lower cost up front. And it is usually eligible for conversion if the policy is needed longer for any reason.
  • The higher premium burden of the younger partner can be neutralized by double-bonusing the cost of coverage to both. This equalizes the expense by creating a zero after-tax outlay and the business is now seen bearing the overall cost of the transition plan.
  • After that, focus on the benefits each is to derive from the agreement: either a) the assurance that their heirs will receive a fair price in the form of cash for the business interest, or b) the assurance of funds to buy out a deceased partner and future full ownership of the business. What each partner derives from the buy-sell is exactly the same, exactly what they want, and exactly what they need.
An uninsurable partner creates different problems, but policy cost due to mere differences in age or insurable health should not be an objection.
 
Two other reasons in younger women’s top ten are that an older husband will introduce them to a whole previous generation of chick flicks (Thelma and Louise, Steel Magnolias and Breakfast at Tiffany’s), and he can help with homework.
 
Contact us with any and all questions that come up in buy-sell planning for clients of any age.
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Executive Bonus With Cost Recovery!

Okay, let’s start with a few premises and see where it leads: Love is blind/ Marriage is an institution/ Love and marriage go together/ Therefore, marriage is an institution for the blind.
 
I don’t know if Aristotle would approve of the structure of that syllogism, but it does illustrate that when you put two things together you can sometimes get surprising results, for better or for worse.
 
Take, for example, the three most common non-qualified benefit scenarios that usually involve life insurance: deferred compensation, split dollar, and executive bonus.
 
For simplicity and ease, an employer will usually choose an executive bonus arrangement, i.e. the executive buys insurance, the employer pays for it and reports the amount each year as taxable compensation.

The problem is, the employer often wants recovery of all or part of the plan cost if the executive cuts and runs early.

It takes a little more work and costs a little bit more, but this can be accomplished by putting two things together, for the better in this case. Try treating a split dollar plan like an executive bonus arrangement that turns over control of money paid to the executive only according to the terms of an agreed upon “vesting-like” schedule.
 
Here’s how it works:
 
Employer-paid premiums in the executive-owned policy are treated as loans. Each year the executive must recognize as income only deemed interest on the loan, usually to the tune of the AFR rates. This is an additional tax cost incurred by the executive. But current rates are so low the amount is usually not significant. Besides, if the employer chooses, the extra tax cost can be “zero-ed out” with a bonus. The employer’s rights to recover company cash from the policy if the executive goes are secured by a collateral assignment.
 
As time goes on, and according to the terms of the agreement, the loan is forgiven in increments. The amount of each reduction in the loan is reported as income to the exec and deductible to the employer – the same as an executive bonus plan.
 
As the loan drops, so does the amount of imputed interest recognized by the executive. Once the loan is reduced to zero the collateral assignment is released and we are back to a plain old vanilla executive bonus arrangement.
 
Sound logical? How about this: Some philosophers have three vowels in their name/ Socrates has three vowels in his name/ Therefore, Socrates is some philosopher. If you don’t really care then try this: All human beings are different/ All apathetic people are indifferent/ Therefore, no apathetic person is a human being.
 
Call with your next executive benefit case and we’ll show your client how they can assure recovery of funds if the participant leaves, without a whole lotta fuss.
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Business Transition Planning: How To Survive The Buy-Sell Agreement

This article speaks to a ready market. Why? Because statistics suggest that 80% of all small and mid-sized businesses in the country have made no adequate plans for transition in the event of one owner’s retirement, long-term disability, or premature death. And “adequate” includes being properly reduced to writing. All the understandings and oral agreements in the world are not worth the paper they should have been written on. Tell every transition-planning resistant client that they go to bed every night not knowing who will be their business partner when they wake up!
 
In addition, and perhaps most critically, there are no arrangements regarding the rights of a co-owner if another owner decides to sell out to a third party. Again, ask every transition-planning resistant client you have how they would like to get out of bed only to find they are in bed with their competitor.

But the focus here is only about one planning concern when purchasing life insurance to fund the agreed-upon buyout of a deceased owner: avoiding an unmanageable multiplicity of policies.

It usually makes sense to structure the buy-out outside the company through a “cross-purchase” agreement among the owners.
 
This assures that the full purchase price will be reflected in the increase in basis of the surviving owners.
 
In a cross-purchase each owner must own a piece of the insurance on all the other owners to buy a proportionate share should any other die first. If there are only two owners it’s a cake-walk. Each has a policy on the other. But things get exponentially burdensome as the number of parties increase. Three owners would require 6 polices, 4 owners need 12, and on it goes.
 
If the business is a partnership or an LLC taxed as a partnership there is an easier way.
 
Simply purchase one policy on every owner and have each held by the non-insured owners jointly-with-right-of-survivorship. On the death of one of the joint policy owners the rights to the death benefit are automatically reapportioned among the survivors. And since they are “partners” the reallocation of interests in the policy does not raise transfer-for-value issues.
 
But all must understand that anytime personally owned policies are used to fund a buy-sell agreement things only go smoothly when everyone fulfills their obligations – i.e. the estate sells the interest of the deceased owner and the survivors use the death proceeds to make the purchase from the estate, all under the terms of the agreement.
 
If the parties to a buy-sell are uncomfortable with personal ownership or the business structure doesn’t lend itself to protection from possible transfers-for-value (C-Corp, S-Corp, or an LLC taxed as a C-Corp or an S-Corp) then the policies are commonly held in an LLC or a partnership created for that purpose.
 
Contact me with any questions that arise in your casework involving business transition planning, and ask for our simple 4-page summary of business planning issues including the considerations that should be addressed in a well-constructed buy-sell agreement – either call at 706-614-3796 or email at tom@cpsadvancedmarkets.com.

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