Business Uses of Life Insurance

quiz

Question 1 Which statement about COLI plans is NOT correct? The corporation receives the benefit at the death of an individual employee. The corporation owns the policies covering individual employees. -The policies cannot remain in place after the employee retires or quits. The corporation is the beneficiary under each policy. Under a COLI plan, the corporation owns the policies and names itself as beneficiary. At the death of an employee, the corporation receives the benefit. Question 2 Jackie Jones is the Chief Financial Officer of Delta Industries and has been instrumental in the company's growth and success over the years. Because of the significant financial loss that Delta would suffer if she died, it purchased a key person insurance policy covering Jackie. Which of the following statements regarding this scenario is NOT correct? If Jackie ends her employment, Delta can sell the policy to her for an amount equal to its cash value. -If Jackie dies, the insurer will pay most of the death benefit to Delta, with the remaining amount going to her heirs. If Jackie dies, the insurer will pay the death benefit to Delta. If Jackie dies, the death benefits can be used to pay Delta's outstanding loans. If Jackie ends her employment, Delta can sell the policy to her for an amount equal to its cash value. Question 3 What is the main purpose of key person insurance? to compensate the key employee's family when he or she dies -to compensate the business for the loss of its key employee to provide retirement benefits to key employees to add to an employee's salary at retirement Key person insurance does not pay a death benefit to the key employee's family at his or her death. Question 4 What is the main difference between a traditional deferred compensation plan and a salary continuation plan? -The employer funds the future benefit under a salary continuation plan. The employee funds the future benefit under a salary continuation plan. The employer cannot deduct benefits that are paid under a salary continuation plan. Term life insurance is often used to fund a deferred compensation plan. With a salary continuation plan, the employer funds, or pays for, the future benefit. In contrast, in a traditional deferred compensation plan, the employee funds the benefit by deferring a portion of current compensation. Question 1 Which one of the following is the most appropriate use of life insurance? -Buying life insurance to insure all the parties to a business buy-sell agreement. Buying life insurance to obtain workers' compensation protection. Buying life insurance on an unrelated person as an investment. Buying life insurance to save for a big vacation in several years. Workers' compensation is funded by the employer (amounts vary according to state law), but this is social insurance program, not a life insurance policy. Question 2 Which one of the following statements about insured executive bonus plans is most correct? -The executive must include the employer's premium payment as income. The employer must pay all of the premiums for the life insurance policy. The employer is the beneficiary under the policy. The employer owns the life insurance policy. Under an executive bonus plan, the employer's premium payments are taxable income to the executive. Question 3 Which one of the following statements about non-qualified deferred compensation plans is most correct? Life insurance is never used with deferred compensation plans. -When an executive receives the deferred compensation, he or she will generally be in a lower tax bracket and will pay lower taxes. The executive will typically receive the deferred compensation when he or she changes jobs. If the executive dies before retirement, his or her heirs will not receive any of the deferred compensation. A non-qualified deferred compensation plan lets an employee delay receiving current compensation until a future date, usually retirement. At retirement, he or she will generally be in a reduced tax bracket and will pay lower taxes. Question 4 Which statement about key person insurance coverage is NOT correct? The business applies for and owns the policy. The amount of coverage typically reflects the financial loss that the business would suffer if the key employee died. The key employee has no ownership rights in the policy. -The key person's family receives the death benefits. Under a key person plan, the business applies for, owns, and is the beneficiary of the policy covering the life of a key employee. Coverage compensates the employer for the loss of a key employee when he or she dies. Question 1 The four shareholders of ABC Corporation each own a $1,000,000 interest in the company and enter into a stock redemption agreement which is funded with life insurance. One of the shareholders dies six months later. All the following statements regarding this scenario are correct EXCEPT The insurer will pay the $1,000,000 death benefit from the deceased owner's policy to ABC Corporation. -The three remaining shareholders will buy the deceased owner's interest from his estate. ABC Corporation will use the death benefit to buy the deceased owner's interest from his estate. Each of the surviving shareholders will then own a one-third share of ABC Corporation. If a shareholder dies, the insurer will pay the death benefit to ABC Corporation. The company then will use the funds to buy the $1,000,000 interest from the deceased owner's heirs. Question 2 Which statement is true under a split-dollar life insurance plan? The employee receives the entire death benefit. -The employer and employee split the premiums. The employee gets temporary insurance protection. The employee pays all of the premiums. Under a split-dollar life insurance plan, a permanent life insurance policy is bought on the life of a key executive. The premiums for the policy and the death benefits provided under it are split between the employer and the executive. Question 3 Four business partners each agree to buy the others' business interests in case a partner dies or leaves the partnership. What is the total number of life insurance policies needed to fund this cross-purchase buy-sell agreement? 6 16 -12 4 In a cross-purchase buy-sell agreement, the four partners can fund the agreement by buying life insurance on the lives of the others. However, they will not need a total of six policies. Question 4 When an employee retires, what is the general tax treatment of the payments he or she receives under a deferred compensation plan? partially tax free -taxable to the employee as he or she receives benefits taxable to the employee as a lump-sum benefit entirely tax free Under a non-qualified deferred compensation plan, an employee delays receiving current compensation until a future time. However, benefits are not received partially tax-free.

Key points

-While a buy-sell agreement creates an obligation for the sale and purchase of a deceased owner's share of the business, it does not provide the funding. That is done separately, and life insurance is the ideal product for that. -When life insurance is used to fund a cross-purchase agreement, each partner or shareholder buys life insurance on the lives of the other partners or shareholders and names himself or herself the policies' beneficiary. -Because of the number of life insurance policies involved, the cross-purchase approach makes more sense when there are just a few partners or owners involved. -An entity plan is one in which the business itself is a party to the agreement. One policy, owned by the business, is purchased for each partner or owner. -Under a key person (or key employee) insurance plan, a business applies for, owns, and is the beneficiary of the policy covering the life of a key employee. -A nonqualified retirement plan is any arrangement in which an employer offers a benefit to a select employee (or group of employees), usually executives, that is not offered to all employees. -The two most common types of nonqualified plans are the deferred compensation plan and the Supplemental Executive Retirement Plan (SERP). -Unlike deferred compensation plans, in which executives defer the receipt of income to a future date, a SERP is funded entirely by the employer. That is, a SERP does not involve deferred compensation. -A split-dollar plan is an arrangement under which a permanent life insurance policy is bought on the life of an employee—often a key executive—and the policy premiums and death benefit are split between the employer and the executive (or another third party). -Life insurance is the ideal means by which funds can be made available, precisely at the time they are needed, to pay off the company's debt and help it continue in business upon the owner's death. -A COLI is any type of individual life insurance taken out by a company on the lives of its employees for the exclusive benefit of the company.

Deferred Compensation Plan

A deferred compensation plan is a nonqualified benefit plan under which an employee, normally a senior executive, agrees to defer a portion of his or her salary or some element of his or her compensation until a future date (typically retirement). Life insurance is commonly used as the funding instrument. The business owns the life insurance that is used to informally fund the plan and may use the policy's cash value as the source of funds to pay the executive's deferred compensation. Or, if the executive dies before retirement, the employer receives the death benefit and may pay compensation to the deceased executive's survivors (in accordance with the plan) by using the policy's death benefit.

Business Continuation

Life insurance is often used for business continuation purposes. Businesses must often incur debt to expand or to invest in new products or new markets. Often, creditors who extend loans to businesses rely on the special abilities of a single business owner. These special abilities help ensure that the business prospers. Moreover, they help ensure that the business can repay the borrowed funds when due. The death of a business owner might easily result in the dissolution of the business if funds are not available to retire the business debt taken on while the owner was alive. Life insurance is the ideal means by which funds can be made available, precisely at the time they are needed, to pay off the company's debt and help it continue in business. When an insured business owner dies, the new owner can continue the business uninterrupted.

Entity Buy-Sell Agreement

In contrast to a cross-purchase plan, an entity plan is one in which the business itself is a party to the agreement. In this plan, the business buys the deceased partner's or shareholder's interest in the business. The business can be a partnership or a close corporation. (If the business is a close corporation, the buy-out agreement is also called a stock redemption agreement.) -- stock redemption agreement= Name of the agreement when a close corporation buys the interest or shares of a deceased partner or shareholder. If life insurance funds an entity plan, then the business buys, owns, and pays the premiums for life insurance policies on the life of each owner. One policy, owned by the business, is purchased for each partner or owner. If there are five partners, then five policies are purchased. The amount of each life insurance policy is the amount of interest each owner has in the business. When an owner dies, the policy's proceeds are paid to the business. The business then uses this money to buy the deceased's ownership share from the deceased's heirs or estate.

for test

-Business life insurance is a USE for life insurance, not a TYPE of life insurance. --Term life or permant can be used

Business Uses of Life Insurance

Some ways they use it: -buy-sell agreement (keeps business open if owners die.) -key person (compensates employer if key employee dies) -deferred compensation (employee deferrers some type of compensation until retirement) -salary continuation plan (emplyer pays part of salary after retirement and non of it is deffered) -split-dollar (employee and employer split death benefit and premiums if employee dies) -retire business debt(used to payoff outstanding business debt)

Executive Bonus Plan

Under an insured executive bonus plan, an employer agrees to pay some or all of the premiums on a life insurance policy purchased for a company executive, who is designated the policyowner. The employer can deduct the premium payments as compensation paid to an employee. The executive must include the employer's premium payment as income to him or her. Because the executive owns the life insurance policy, he or she can choose the beneficiary. In addition, he or she can enjoy all of the other policy ownership rights.

Cross-Purchase Buy-Sell Agreements

A cross-purchase buy-sell agreement is a contract between individual partners or shareholders. In this agreement, the partners or shareholders agree to buy the interest of the other(s) in the event the individual(s) dies or withdraws from the business. -Insurance Purchased by Every Partner or Shareholder The business itself is not involved in the cross-purchase agreement. When life insurance is used to fund a cross-purchase agreement, each partner or shareholder buys life insurance on the lives of the other partners or shareholders and names himself or herself the policies' beneficiary. Upon the death of a partner (or shareholder), the death proceeds are payable to the survivors through the policy each holds on the deceased owner. The survivors use the money to buy the deceased's interest in the business. The number of life insurance policies needed to fund a cross-purchase agreement is determined by the formula N × (N -1). In this formula N = the number of partners or shareholders For example, if four partners or stockholders are parties to the agreement, then the number of policies needed is 4 × (4 - 1) = 12 Because of the number of life insurance policies involved, the cross-purchase approach makes more sense when there are just a few partners or owners involved. When there are more than a few parties involved, an entity plan may be more appropriate

Split-Dollar Plan

A split-dollar plan is an arrangement under which a permanent life insurance policy is bought on the life of an employee—often a key executive—and the policy premiums and death benefit are split between the employer and the executive (or another third party). Either the executive or the employer may own the policy. With a traditional split-dollar arrangement, the employer's portion of the annual premium equals the amount by which the policy's cash value increases that year. The employee pays the balance. As time goes by, the sum of premiums paid by the employer equals the cash value. At the insured's death, the proceeds are split between the employer and the employee's beneficiary. An amount equal to the cash value (the amount the employer paid into the policy) is paid to the employer. The balance is paid to the employee's beneficiary. If the insured owns the life insurance policy under the split-dollar plan, the portion of the premium the employer pays may be considered taxable income to the employee.

Insured Buy-Sell Agreements

A buy-sell agreement is one in which a person, group of people, or entity agrees to buy a business owner's interest in the business upon the owner's death or permanent disability. These agreements are common with small businesses such as partnerships or close corporations. (A close corporation is one that is privately held; its stock is not openly traded.) The intent is to enable the business to continue to operate after an owner's death or total disability. (Disability buy-sell agreements are reviewed in the health Insurance course.) The entity who buys this interest is usually a partner, a co-stockholder, or the business itself. While a buy-sell agreement creates an obligation for the sale and purchase of a deceased owner's share of the business, it does not provide the funding. That is done separately, and life insurance is the ideal product for that. When life insurance is bought to provide the funds to support a buy-sell agreement, the arrangement is called an insured buy-sell agreement. There are two types of buy-sell agreements. The type of agreement chosen dictates who buys and owns the life insurance. The two types of buy-sell agreements are: -cross-purchase plans -entity plans Under either type of buy-sell agreement, the deceased's business interest is bought from his or her heirs. The difference between the plans lies in who actually buys the deceased's business interest. In one type of plan, the other owners buy the interest. In the other type of plan, the business buys the interest.

Corporate-Owned Life Insurance (COLI)

Aside from key person insurance, the life insurance plans discussed in this lesson exist ultimately for the employee's benefit. There is one type of plan that exists solely for the employer's benefit: Corporate-Owned Life Insurance (COLI). A COLI is any type of individual life insurance taken out by a company on the lives of its employees for the exclusive benefit of the company. A COLI plan typically covers lower level employees who are insured for the benefit of the corporation. Such a plan is usually reserved for very large corporate employers or organizations. Under a COLI plan, the corporation is the owner and beneficiary of individual policies on individual employees. It names itself as the beneficiary. At the death of the individual employee, the company receives the benefit. (Small amounts are sometimes paid to the employee's family.) The policies can remain in place even after the employee quits or retires. One reason that companies purchase life insurance on their employees is to provide the company with funds to cover costs that would arise in replacing an employee. The insurance benefits can also be used to help cover the employee benefit liabilities. However, it is not necessary for companies to have a reason for buying COLI, and in fact many companies do so as a means of bringing in tax-favored revenue. In some cases, corporations with COLI plans have taken out the insurance policies without informing their employees. A number of states have outlawed COLI plans if the employee is not notified and does not consent to the coverage.

Key Person Insurance

Funding key person coverage is another common business use of life insurance. Under a key person (or key employee) insurance plan, a business applies for, owns, and is the beneficiary of the policy covering the life of a key employee. Note that key person life insurance is not a type of policy but a use for life insurance. Any type of life insurance may be used, though most businesses use some form of permanent life insurance for this purpose. Upon the key employee's death, the business receives the policy death benefit. This benefit is intended to compensate the business for the loss, through death, of its key employee. The key employee has no ownership rights to a life insurance policy that is used for key person coverage. The amount of coverage bought on a key employee usually reflects the financial loss the business would suffer if he or she died. A dollar amount is applied to the loss the business can expect, and an amount of life insurance equal to that dollar amount is bought on the life of the key person. The death benefit proceeds of the key person policy provide the business with an important financial cushion. This financial cushion is especially important during the time when a replacement is being sought and trained. Key person life insurance also serves as evidence to any creditors that the business can continue despite the key person loss. The proceeds from key person insurance can also be used to pay outstanding loans. If a key employee ends his or her employment with the employer, the employer can continue the policy in force. The employer then receives the proceeds when the former key employee dies. However, many employers choose to -sell the policy to the insured for an amount equal to its cash value; -surrender the policy and end the insurance; or -change insureds, if allowed by the insurance company and applicable state law (for this to be done, the policy must include a change of insured provision).

Nonqualified Retirement Plans

Life insurance plays an important role in funding nonqualified retirement plans. A nonqualified retirement plan is any arrangement in which an employer offers a benefit to a select employee (or group of employees), usually executives, that is not offered to all employees. Because these plans discriminate in who is covered, they do not qualify for favorable tax treatment afforded qualified retirement plans, such as 401(k) and pension plans. The two most common types of nonqualified plans are the deferred compensation plan and the Supplemental Executive Retirement Plan (SERP).

Supplemental Executive Retirement Plan (SERP)

Sometimes called a salary continuation plan, a SERP is a nonqualified plan that provides benefits to select employees above and beyond those provided through qualified retirement plans. Unlike deferred compensation plans, in which executives defer the receipt of income to a future date, a SERP is funded entirely by the employer. That is, a SERP does not involve deferred compensation. Under a SERP, the executive does not actually defer any compensation. Instead, the employer agrees to continue paying a portion of the employee's salary for a limited period after he or she retires. Both traditional deferred compensation and salary continuation plans have the following common characteristics: -A key objective is to shift some of the executive's income to retirement, when he or she will likely be in a lower marginal income tax bracket. -The employer loses the current income tax deduction it would have enjoyed if the income had been paid to the executive rather than deferred. -Benefits are forfeited if the executive fails to meet the conditions in the deferred compensation agreement. Typical conditions include remaining with the employer until retirement and agreeing not to compete for a certain period following retirement. -The employer can deduct benefits paid under the agreement to the executive at the time they are actually paid.