As a partner or co-owner (private shareholder) of a business, you’ve spent years building a valuable financial interest in your company. You may have considered setting up a buy-sell agreement to ensure your surviving family a smooth sale of your business interest and are looking into funding methods. One of the first methods you should consider is life insurance. The life insurance that funds your buy-sell agreement will create a sum of money at your death that will be used to pay your family or your estate the full value of your ownership interest.
When using life insurance with a buy-sell agreement, either the company or the individual co-owners buy life insurance policies on the lives of each co-owner (but not on themselves). If you were to die, the policyowners (the company or co-owners) receive the death benefits from the policies on your life. That money is paid to your surviving family members as payment for your interest in the business. If all goes well, your family gets a sum of cash they can use to help sustain them after your death, and the company has ensured its continuity.
Section 162 of the Internal Revenue Code is the section that states that an employer may deduct certain expenses - including salary and other compensation - that are ordinary and necessary business expenses. It is in reference to this Code section that certain nonqualified plans, known as executive bonus plans, are sometimes referred to as Section 162 Plans. In its simplest form, an executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee.
Employers often seek additional incentives to motivate their executives, and an executive bonus plan provides that facility. In addition, the life insurance policy that provides the vehicle for the plan enables executives to make additional premium contributions.
In addition to providing the death benefits, the cash value in the policy may provide supplemental income at retirement. While the supplemental retirement income may be in addition to a qualified retirement plan, it may also be the only retirement plan that the employer offers - at least at the current stage of its development. As in all nonqualified plans, the executive bonus plan may simply be used by the employer to provide special treatment to a key executive in compensation for his or her contribution to the success of the company.
Key person insurance is simply life insurance on the key person in a business. In a small business, this is usually the owner, the founders or perhaps a key employee or two. These are the people who are crucial to a business - the ones whose absence would sink the company. You definitely need to consider key person insurance on those people.
Here’s how key person insurance works: A company purchases a life insurance policy on its key employee(s), pays the premiums and is the beneficiary of the policy. If that person unexpectedly dies, the company receives the insurance payoff. The reason this coverage is important is because the death of a key person in a small company can cause the death of that company. The purpose of key person insurance is to help the company survive the blow of losing the person who makes the business work.
The company can use the insurance proceeds for expenses until it can find a replacement person, or, if necessary, pay off debts, distribute money to investors, pay severance to employees and close the business down in an orderly manner. In a tragic situation, key person insurance gives the company some options other than immediate bankruptcy.
Let’s say you want to reward a few key executives with low-cost life insurance. Can you do so without providng the same benefit to your other employees? You can with a split dollar life insurance plan. In fact, such an arrangement can provide your business with several benefits. It can help you attract and retain employees, reward key executives, and fund severance packages and certain other benefit plans.
Split dollar life insurance is an arrangement between an employer and an employee to share the costs and benefits of a life insurance policy. Specifically, the parties join together to purchase an insurance policy on the life of the employee and agree, in writing, to split the cost of the insurance premiums, as well as the policy’s death proceeds, cash value, and other benefits. The actual life insurance policy used can be whole life, universal life, second-to-die (survivorship), or any other cash value policy.
Split dollar arrangements usually take one of two forms. Under the endorsement form, the employer is formally designated as the owner of the life insurance contract and endorses the contract to specify the portion of the death proceeds payable to the employee’s beneficiary. Under the collateral assignment form, the employee is formally designated as the owner of the contract, and the emplyer premium advances are secured by a collateral assignment of the policy.
Split dollar life insurance is widely used in gift and estate planning and can be an important part of the compensation package of many key employees. You don’t have to cover all of your employees - the coverage, amounts, and terms of the split dollar arrangement are generally not subject to Employee Retirement Income Security Act (ERISA) nondiscrimination rules. Split dollar plans can be used to: