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Buy-Sell Agreements: The Importance Of Transition Planning

The 24-year old actor James Dean was the iconic Rebel Without a Cause, the image of teenage angst, who already had three blockbuster movies under his belt before a misplaced 1950 Ford Tudor blocked the intersection on US Route 466 that would serve as a premature end to the meteoric rise of the young star. It is reported that “Humphrey Bogart, who also knew a thing or two about image making, once said: ‘Dean died at just the right time. He left behind a legend. If he had lived, he’d never have been able to live up to his publicity.’” Sometimes in the entertainment world death is a good career move.
 
And we tend to view buy-sell agreements the same way. The best “move” the participants can make in triggering its fulfillment is for one of the participants to die.
 
Fund the event with life insurance that provides tax-free dollars that are used to purchase the inherited interest from the estate (with a step-up in basis, no less) and everyone goes happily on their way to a new and more cash-flushed existence.

Consequently the death of an owner is the contingency on which we focus too exclusively when planning.

The fact is that a business owner usually doesn’t die. They often leave the business for one reason or another that initiates a buy-out that usually takes the form of a down payment (maybe) and an installment sale for an agreed number of years at an agreed interest rate.
 
Even then life insurance is important.
 
Consider two instances:
  1. The remaining owners buy out a departing partner under an agreement funded with life insurance. The coverage on the departing partner can be kept in force to provide remaining owners funds to pay-off the loan balance should the seller die during its term. It also relieves the departing partner of any concern whether or not the balance will be paid to his family should he die. This arrangement may be cleaner if the policy is transferred back to the insured and a collateral assignment is given in the amount of the loan balance. If so, tax issues and premium-payment arrangements would need to be ironed out.
  2. A younger key person buys out a retiring owner-employer. The retiring seller wants to be sure of payment in the event of the death of the key person-buyer during the term of the loan. Carriers do not recognize a creditor’s insurable interest in a debtor, so they won’t allow the seller to purchase coverage on the borrower. However, the borrower can buy coverage, justifying it as personal insurance, and give a collateral assignment for the balance and term of the loan.
We recently assisted in a case similar to situation #2. We advised with regard to structuring the personally-owned coverage on the purchaser. We advised concerning the drafting of the collateral assignment. We laid a good predicate with the carrier to assure they understood the case – and then the selling owner placed the business through another agent and, consequently, another general agency. As my Mother used to say, “No good deed goes unpunished.” I say simply, “A pox on his house!”
 
Every business you represent should have in place an updated documented transition plan. If one doesn’t, then tell the owners they go to bed every night unsure of who they will be in business with the next morning! Then call us to assist you in all matters of their buy-sell planning and funding. Remember, we will get on the phone with you and talk directly to both your clients and their advisors if you think it beneficial.
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Executive Bonus – Enhanced To Show Quality

If you wanna feel better about yourself just do an Internet search on something like Celebrities Without Makeup, or Un-photo-shopped VIPs. It will do your heart good to see how plain looking or, in some cases, how down-right ugly-wuggly many icons among the “beautiful people” really are in their natural state.
 
Personalities whose reputation rests significantly on their physical attractiveness even have a critical team member responsible for the prior scouring of any pictures intended for distribution to assure that nothing un-doctored, un-enhanced, or unflattering slips through for consumption by the masses.

The Lady and Lord Mucks of the entertainment world understand that they work in a tough marketplace and things simply sell better when they look good.

Perhaps we insurance advisors could take a lesson from that when showcasing our own products and services. The difference is that a properly accoutered insurance-funded benefit plan will not only sell more easily, it will remain an ongoing thing of attractiveness and substance to those it protects.
 
A prime example is the often unadorned (and as a result the often unsold) executive bonus arrangement. The plan chassis is simply an executive-owned policy paid for by the employer. But creative use of some of its flexible features makes it the most attractive non-qualified benefit in most business situations:
 
Eliminate sticker shock.
 
The amount of premiums paid by the employer is reported on the executive’s W-2. Avoid the sting of a year-end tax increase by adjusting the bonus so that the after-tax amount covers the planned premiums and the remainder can be withheld to cover taxes on the total bonus on April 15.
 
Forget about recovering costs.
 
Too many employers worry about getting premiums back if the executive leaves after a couple annual bonuses. If recovery is a serious issue than use a split dollar plan. Otherwise provisions requiring reimbursement are burdensome and reduce the attractiveness of the plan to the executive. An employer can reduce risk by funding a policy at lower premium levels in the early years, then increasing the bonus amount as the service period lengthens.
 
Make it a “gold watch” as well.
 
A policy that must be maintained by the executive beyond retirement can be seen as an anticipated burden that takes some of the luster off the current benefit of the coverage. Fund the policy in a manner that will achieve paid-up status and allow the executive to carry the self-sustaining policy into his or her non-working years.
 
Make it a “living benefit” as well.
 
Adding a long-term care rider gives the executive lifetime protection as well by assisting with costs of care using tax-free accelerated benefits. Funding the policy to paid-up status at retirement gives the executive this protection through his or her entire life.
 
Economize using a “two-policy solution”.
 
A paid-up permanent policy, especially with an LTC rider, can get costly. Recognizing that death protection needs are higher during the working years, structure the plan so that the bulk of the coverage is provided with a level-premium term policy for the duration of the anticipated working life. This can be dropped at retirement when no longer needed.
 
In addition, carry a smaller permanent policy whose death benefit will cover a significant portion of costs if long-term care expenses arise, but will still provide adequate estate liquidity if long-term care needs don’t arise.
 
The ultimate futility of cosmetic or techno-treatment to shore up current or deteriorating beauty was summed up best by comedian Moms Mabley when she said, “Beauty is only skin deep, but ugly is to the bone!” But there is no decline in the beauty of a well-designed benefit plan that will keep good executives in the company fold through the provision of employer-provided lifelong protection.
 
Call Tom Virkler, JD, Director of Advanced Markets, with questions on your next case at 706-354-0401 or tom@cpsadvancedmarkets.com.
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Policy Valuation: How Much Are You Worth?

A bidder at an auction purchased a Stradivarius and a Rembrandt for what he felt was an unbelievably low price. He took them to an appraiser to see if they were authentic. The appraiser informed him, “Yes, they are authentic. It’s just a shame that Stradivarius couldn’t paint and that Rembrandt didn’t know beans about making a violin.”
 
The common legal definition for fair market value of an asset is the price on which a seller and a buyer can agree, neither being under any constraint and both being aware of all the circumstances. Simple enough. So why is there so much confusion with regard to valuation of an inforce life insurance policy?

The need for a reliable value occurs often in the business, estate and financial planning process.

And by “reliable” we mean one that the IRS will find acceptable, because usually the value is needed to calculate the tax consequences at the time of an ownership change.
 
The reason the IRS takes such an interest with life policies is, probably, because most transactions don’t involve parties whose opposing interests are characterized by a level of dynamic tension that will necessarily result in a fair and final value.
 
Consider This:
  • An employer distributing a business-owned contract to an employee-insured (e.g. distribution of a key person policy at retirement) may appreciate the corresponding business deduction, but probably would be happy to undervalue it to augment the benefit to a long-time employee by decreasing the amount he or she must recognize as income.
  • When a policy is distributed from a qualified plan, the stated value matters not at all to the plan trustee. But to the participant who must recognize the value as income (perhaps even with a 10% tax penalty) the lower the valuation, unrealistically or not, the better.
  • In a gifting situation the transferor of a policy is of a donative mindset anyway, so a lower value doesn’t reduce anything he or she might have received in return, except the size of a gift tax bill. So the lower the better, again realistically or not.
The difficulty is that neither Congress nor the IRS nor the courts have put together a reliable set of laws, regulations and rulings that allow for easy or certain valuation of a policy. Taxpayers must deal with a hodge-podge of criteria that vary with circumstances and with interpretation of the facts.
 
The good news for the insurance advisor is – it is not your responsibility to determine value, nor should you try. Rendering an opinion is outside the scope of your legitimate professional activity. The best you can, and should, do is offer to request from the carrier their “Form 712” valuations used by an executor in determining a policy’s value in an owner’s estate. You will get back one or more numbers.
 
The most common is the interpolated terminal reserve, but many will also include: accumulated cash value, PERC value, premiums paid, cash surrender value, tax reserve, statutory reserve, etc. Provide it to the attorney, CPA or appraiser to assist in their valuation. You’ve done all you can and more than most would.
 
There is another story of an auctioneer who was interrupted when his clerk handed him a note. Reading it the auctioneer announced, “A gentleman has lost a wallet containing $500 in cash. If it is returned, he will pay a reward of $100.” After a moment someone in the audience shouted, “$150!”
 
Call with any questions concerning policy valuation. We will make it worth your while.
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Multiplication Tables – Using Basic Financial Underwriting To Increase Your Sale

How much does an insurance company think that your client is worth? Many times it is much more than your client does, and you have their underwriting guidelines to prove it!
 
Insurance companies don’t want to over-insure someone. Too much coverage can often result in someone falling down a flight of stairs before their proper time. Carriers set their financial underwriting criteria to limit the amount of insurance someone can buy, not to try to increase the size of the sale. So financial guidelines are a carrier’s attempt to standardize the process for determination of the reasonable worth of an applicant based on their situation.

The most common insurance need among prospects and clients is to replace the income survivors would have anticipated had premature death not occurred.

The starting point for calculating the amount of coverage a carrier will issue for purposes of income replacement is determined by a multiple of current annual compensation based on the proposed insured’s age.
 
The multiple deceases with age, understandably, because death denies a person fewer potential income-producing years as they get older. Multiples vary from company to company.
 
Consider one of the more conservative examples:
The table can help a client to realistically focus on just how big a pool of money the survivors would need to survive over the remaining years should a wage-earner pass away. And the client can “fatten up” a little in that the compensation figure used is usually the pre-tax earnings which in the calculation process translates into an amount of untaxed death proceeds.
 
Carriers will usually only take earned income into consideration unless it can be shown that the insured’s death might have a direct affect on unearned income. Non-working spouses can usually get a minimum of one-half the coverage on a working spouse.
 
At young ages the calculation can result in a large death benefit. But it is what the client needs and if he or she is healthy the competitiveness of current term insurance rates make sufficient coverage affordable to all.
 
Call with any questions concerning financial underwriting that may arise in case planning or when dealing with carriers.
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Super-Roth-Likeness: Does it Walk Like a Duck?

Comedian Steven Wright tells of the time a burglar broke into his apartment while he was asleep, stole everything, and replaced it all with exact replicas. Later his best friend walked in, looked at Steve and said, “Do I know you?”

Americans have never been averse to imitations when the original was unavailable, especially when the substitute still did the job and was more economical as well.

This passion for the more commonplace might help you make sales to clients who have maxed out their qualified retirement options and are looking for an effective way to accumulate more for supplemental income when they no longer work. In this case there is an “imitation” that may be better than the original.
 
Consider a Roth IRA, best described as “a reverse traditional IRA.” Contributions are after-tax and distributions are tax-free. But consider, too, an over-funded universal life policy that builds significant cash value in later years.
 
Compare the features and uses of the two vehicles:
 
The perceived value of an executive bonus plan is greatly enhanced when the policy is designed as an over-funded contract and the possibility of withdrawals to supplement retirement income is highlighted at the time of implementation. But any client is more inclined to consider use of an insurance contract for retirement purposes when the similarities to a Roth IRA, or any qualified plan, are explained.
 
Speaking of similarities, there is the story of a citrus farmer in the Central Valley who has developed a grapefruit that looks exactly like an orange, except that it is bigger and it is yellow.
 
Get in touch to discuss how a client’s retirement can be better, or with any other planning questions that arise in your casework, at either 706.614.3796 or tom@cpsadvancedmarkets.com.
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The Problem With LTC Riders In The Third Person

Climatologists can argue all day about which hurricane was the worst. The fact of the matter is the “baddest” is the one that destroyed your home, the number of millibars notwithstanding. And back in the old days they all were the baddest because you didn’t have any warning.
 
Nowadays, sophisticated stuff starts measuring a storm as soon as some breeze off North Africa throws a few straws into the wind, allowing homeowners in the “cone” to take proper measures, and all the ships at sea.

And so it is with tax laws, the worst is the one that costs you – made worse by the fact that you didn’t see it coming.

And both may be true depending on how you structure third-person ownership of a life insurance policy with a chronic illness or LTC rider.
 
The most common planning question involves estate taxation.
 
Insureds want to keep the death benefits out of their taxable estate, but still want access to the rider benefits should the need arise. Policies with indemnity-type riders are commonly put in irrevocable trusts with the understanding that care costs can be paid out-of-pocket by the insured to reduce the taxable estate. If the cash payments under the rider are needed by the insured, the trust can provide for loans to the insured.
 
Reimbursement-type riders present a problem.
 
Because expenses are paid directly to the care provider the trustee is bound by the terms of the policy to benefit the creditors of the grantor/insured. This could constitute either an incident-of-ownership in the policy or a retained interest in the trust, either of which would have the effect of pulling death benefits back into the taxable estate.
 
But there may be another tax problem lurking in the weeds for trust-owned life policies, even those with indemnity-type riders, and this time it is an income tax issue. IRC 101 is the section allowing for income tax-free receipt of proceeds from a policy by reason of death.
 
Regarding treatment of accelerated death benefits subsection (g)(1)(B) says:
 
For purposes of this section, the following amounts shall be treated as an amount paid by reason of the death of an insured . . . Any amount received under a life insurance contract on the life of an insured who is a chronically ill individual.
 
But then the Code goes on to say in subsection (g)(3)(A):
 
In the case of an insured who is a chronically ill individual . . . [tax-free treatment as an accelerated death benefit] shall not apply to any payment received for any period unless— such payment is for costs incurred by the payee [the person getting paid the benefit, i.e. the policy owner] for qualified long-term care services provided for the insured for such period.
 
This raises the possibility that benefits paid to a third-party policyowner will not get income tax-free treatment under the rider because the third-party owner (the payee) did not incur the medical costs resulting in the claim. Material on the topic warns, “. . . there is no specific guidance from the Internal Revenue Service as to the tax effects of such third-party ownership . . . there is the risk that such ownership structure could cause adverse income, estate and/or gift tax consequences.”
 
The responsibility of the insurance advisor is clear.
 
When helping a client implement third-party ownership of a life policy with an LTC or chronic illness rider the client must be pressed to get the advice of a tax advisor.
 
To sow the wind by not doing so it to risk eventually reaping the whirlwind. For help in addressing this concern with you client, contact your LTC Sales & Marketing Manager.
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Who Qualifies For Non-Qualified?

In 1826 the German author Joseph Freiherr von Eichendorff (Jo-Eich for short) published a novella titled (in English) Memoirs of a Good-for-Nothing. Both he and it are unimportant except for a Latin phrase from the book: Quod licet Iovi, non licet bovi, translated, “What is permissible for Jove, is not permissible for the bull.” It describes the common double standard when, “what is permitted to one important person or group, is not permitted to everyone.”
 
Seems a bit unfair, but the expression can be turned on its head: “What is permissible to the bull, is not permissible to Jove.”

The visibility and responsibilities of those in high places often deny them the flexibility and lack of restraint enjoyed by the common folks in the seclusion and simplicity of their more private lives and smaller worlds.

A good example is in the matter of non-qualified benefits and owners of businesses; but the reversed double standard is caused by the tax law, not because of anyone’s high or low position or estate.
 
Consider the following assuming a 100% company owner with full-time employees.
 
Qualified Plans
 
These include benefits whose cost is immediately deductible to the employer, but for which taxation of those costs is deferred and not recognizable to the plan participants until benefits are actually received. The most common examples are qualified retirement plans. The limitations for the owner are, first, that there is a ceiling on how much can be contributed on his/her behalf. In addition, contributions must be made for qualifying employees, reducing the attractiveness of the plan for owner-retirement.
 
Non-Qualified Plans
 
These most commonly take the form of Deferred Compensation (DC) or Executive Bonus (EB) plans. Here the employer has broad latitude to discriminate regarding participation and the amount of benefits under the plan, but any employer deduction for a contribution must take place and only takes place when that amount is recognizable as income to the benefiting employee.
 
No Owner Advantage for a Pass-Through Entity
 
(An S-Corp, partnership, or an LLC taxed as either one) Premiums paid under an EB plan are deductible to the business, but recognizable on the owner’s W-2 that year. Any undistributed amounts held under a DC plan are still reported on the owner’s Schedule K-1 for that year.
 
No Advantage for C-Corp Owner
 
(Or an LLC taxed as a C-Corp) Here too, EB premiums are deductible to the company, but reportable on the owner’s W-2. But amounts held for a DC plan contribution fare even more poorly. The money held back is first taxed in the company’s corporate bracket. At distribution there is a business deduction, but the owner gets taxed again in his/her personal bracket.
 
Perhaps a More Advantageous Alternative
 
A personally-owned, over-funded life insurance policy acts much like a Roth IRA, but without all of the disadvantages of a Roth. Let’s talk about that next week.
 
Winston Churchill certainly understood the privileges of position. The story goes that one morning several subtle altercations had taken place between him and his long-standing personal valet, David Inches. Later in the day the following exchange took place: Churchill: You were very rude to me, Inches. Valet: You were very rude to me, sir. Churchill: Yes, but I’m a great man!
 
Get in touch to discuss how business owners can benefit themselves better or with any other planning questions that arise in your casework, at either 706-614-3796 or tom@cpsadvancedmarkets.com.
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Using Excess RMDs To Increase Your Legacy

The London Bach Choir has been around since 1876 when it debuted with a performance of Bach’s B Minor Mass. For the next ninety or so years their gig didn’t get much attention except among those with a musical preference for things like, well… the B Minor Mass.
 
But all that changed in 1969. Their exposure and listener-ship ballooned when popular singer-songwriter Michael Philip Jagger solicited their participation in a recording with his rock group, The Rolling Stones. The result was a tune that has since become a staple in The Stones’ performance repertoire and in the world of popular music.
 
Few today are unfamiliar with its iconic lyrics:
 
You can’t always get what you want. But if you try sometime, You just might find, You get what you need.
 
And so it is when older clients reach age 70-1/2 and want to use the required minimum distributions (RMDs) from qualified plans as a source of premium to buy insurance coverage, sometimes in response to carrier marketing programs encouraging the practice.

As an advisor, you should be aware of and alert your clients to several issues in this marketplace if you are to effectively manage expectations as well as make an achievable sale.

Middle-market prospects often don’t have financial justification for coverage.
 
In these days of sizeable lifetime exemptions most don’t face any anticipated estate tax and most don’t have an income replacement need because they have little or no earned income in their retirement years.
 
Carrier enthusiasm is curbed when traditional financial needs don’t exist.
 
And this despite marketing campaigns to the contrary. An underwriter on a case is like the conductor on a train. Nothing moves down the track till he or she gives the word. And sales pieces are not always run by a carrier’s “conductor” prior to distribution.
 
The percent-of-net-worth solution.
 
Many carriers are sympathetic to issuing insurance in an estate for liquidity, inheritance equalization, or the promotion of the ease of asset distribution. Consequently some will allow, even in the absence of traditional justification, an amount of coverage determined as a percent of the total estate, the number varying among receptive carriers. Existing coverage is taken into account.
 
So don’t just throw an app up against the wall.
 
You must know the sympathetic carriers and be able to state a purpose for coverage other than “to increase the legacy.” Those words were used in the title only to get your attention. If you use them on an app they will surely get the attention of an underwriter, but not with beneficial results.
 
Give us your client’s situation and let us informally financially shop your case. When submitted the stated purpose will be “see attached cover letter” which we will write for you based on prior conversations with the underwriter.
 
It is worth the time. The coverage is on an older client utilizing a permanent product, a sale that will result justifiable compensation for your extra effort.
 
Both The Rolling Stones and the Bach Choir are still with us. Jumpin’ Jack isn’t as Flashy as he once was. But the Choir rolls on even expanding its footprint in the world of popular entertainment, participating in the soundtrack of movies like Robin Hood, The Chronicles of Narnia, Shrek the Third and Jack the Giant Slayer.
 
Call us with any older-client case you have at 706-614-3796 or tom@cpsadvancedmarkets.com. You just might find that what you need is what you want.
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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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