nsurance isn’t only the purview of public practice CPAs. Companies use insurance to meet a wide variety of business needs. For example, in most corporations, proper risk management for the company’s property and employees is the responsibility of the CFO. And more than 70% of Fortune 500 companies have deferred compensation arrangements funded by insurance. Since these plans typically involve the enterprise’s most senior executives, making sure the company has the right coverage is similarly an important responsibility.
In most companies there generally are three insurance-related areas that almost always have some room for improvement:
Deferred compensation funding.
Corporate risk management.
This article describes some of the basics CPAs need to know to make a bottom line contribution in these areas.
FUNDING DEFERRED COMP
Businesses use life insurance in a number of different aspects of deferred compensation agreements.
Executive deferred compensation. Corporations typically use life insurance to fund deferred compensation arrangements for highly paid executives. Created properly, a plan is virtually cost-free to the company.
Here’s how it works: A company buys a life policy on each of its highly compensated executives. The company makes aftertax premium payments on the policies and waits for the cash values to build up. When it comes time to pay the employees their deferred compensation, the employer takes out a loan against the policy. Under current law, policy loans are not taxable. The payment to the employee is a tax deduction for the company as a payroll expense. The company can recoup a material portion of the plan costs. Such plans often fall under the heading of a SERP—a supplemental executive retirement plan. Selecting a policy from a major carrier that has a history of performance allowing for cash value build-up will ensure that funds are available to pay deferred compensation and can save the company money on premiums.
Funding retirement plans. Companies can use insurance to provide retirement income for employees while managing the tax consequences of the obligation. For example, a typical retirement plan may work like this: The plan guarantees annual retirement payments beginning at age 65 of $10,000 for 10 years. The company purchases an insurance policy on the executive’s life. The policy’s cash value provides the employer with the funds it needs to meet its obligation. The death benefit provides an additional way for the employer to recover plan costs or pay survivor’s benefits. Using policies with increasing death benefits can actually produce a profit for the company.
Advantages of cash value build-up. Companies that employ an insurance policy funding strategy for deferred compensation programs can make good use of the policies’ cash value features. Since the owner can delegate investment management to the insurance company’s professionals, both the company and the employee profit. Additional features of cash value policies include
Tax-advantaged investment appreciation.
Owners can withdraw part of the cash value build-up.
Owners can borrow against the accumulated cash value.
There are some disadvantages to depending on cash value build-up to pay deferred compensation. The most important is the return on the insurance company’s portfolio—it may or may not be competitive with top Wall Street money managers. The second is the carrier’s loss experience, which not only affects the insurance company’s stability but also can change the terms of the policy as they relate to the speed of cash value build-up. Last, when the employer borrows funds from the cash value account, any unpaid accrued interest has an adverse effect on policy performance and reduces benefits if not repaid by the employee’s death.
Split-dollar purchase plans. Even though the rules governing split-dollar life insurance policy purchases may soon change (see JofA , July01, page 54 ), properly created policies can still benefit employees. Split-dollar means the company and the employee “split” the cost of the insurance policy premium. The company’s premium payment is not tax deductible. On the death of the employee, the company receives an amount equal to its premium outlays and the employee’s beneficiary gets the remainder of the insurance death benefit. Split-dollar plans offer a cost-effective way for companies to provide survivor benefits to key employees.
Regardless of a company’s form of ownership, it’s important to pay attention to what happens when a key owner dies. Without proper planning, the value of the company may plummet as heirs seek to raise the funds needed to pay estate taxes and other obligations. If other stakeholders don’t have the money to buy out the decedent’s interest in the company, its survivability can come into question.
Many buy/sell agreements use insurance to fund acquisition of the deceased owner’s interest in the company. One of three instruments used in stock redemption is the cross purchase agreement, which allows the owner to provide for the purchase of his or her interest in the company on death. The agreement establishes either a set purchase price or a method of determining one. It is binding on all parties and obligates the heirs to sell and the remaining owners to buy the deceased owner’s share when he or she dies.
Since purchasing the company—especially a large, successful enterprise—may be financially impossible for the surviving owners, they obtain insurance on each other’s lives to fund the acquisition. Each is an owner and beneficiary of the policy on his or her partner’s life. When one owner dies, the insurance policy benefits enable the other owners to buy the deceased partner’s interest. There’s a tax break to this arrangement since life insurance death benefit proceeds are tax free to the beneficiaries. Cross-purchase agreements ensure an orderly transfer of the enterprise to the surviving owners at a fair price to the deceased’s estate.
However, most cross-purchase agreements fail to provide for purchasing the owners’ shares on anything short of death—such as disability or retirement. One improvement CPAs can suggest is that the agreement be broadened to include either eventuality. To cover disability, the company can acquire disability insurance to fund regular payments to the disabled owner to purchase his or her interest. As noted above, the company or other partners can borrow against cash value life insurance policies to buy out a partner at retirement.
MANAGING CORPORATE RISK
If a CPA suddenly finds him- or herself with overall responsibility for a company’s risk management, it’s important to be aware of how to use insurance to mitigate risk. Insurance can be helpful in a wide variety of circumstances.
Certain executives, engineers and product design people may hold the company’s future profitability in their heads. Life insurance on these key people compensates the company in the event of their deaths. Think of it as profit replacement.
Some lenders may insist on life insurance to protect the company against the loss of key people. Some loan covenants contain acceleration clauses in the event of specified executives’ deaths. Insurance proceeds fund repayment of such loans immediately.
Restricted stock (also called rule 144 stock) cannot be sold immediately. Nevertheless, heirs receiving it after the owner’s death may have to pay estate taxes and other liabilities. Life insurance can help provide them with the liquidity they need to meet this obligation.
Business risk management also includes insurance on the company’s property—plant, equipment, vehicles—as well as insurance to protect the company in the event of product liability or other lawsuits. At some companies it might also include health and disability insurance on employees. Protecting these “assets” is also important to a company’s continued success. CPAs without the proper expertise in this complicated area of insurance should consult a qualified expert to make certain the company has the coverage it needs.
Insurance can definitely be a creative way for many CFOs to solve certain business problems. As a result, corporations are becoming increasingly sophisticated in the use of tax-advantaged ways to limit risk, pay employees and manage a change of control. For example, when creating cross-purchase agreements, CPAs should look into new ways to use trusts to gain even more tax advantages. The reverse stock redemption features under IRC section 303 can provide more attractive ways to pay estate costs by having an entity other than the corporation purchase the insurance needed to fund the estate’s stock redemption.
Neil Alexander, CFP, is founder and president of Alexander Capital Consulting, LLC, in Los Angeles. His e-mail address is firstname.lastname@example.org .