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Succession planning insights – Part II

Part 2

Expensive (and common) mistakes with life insurance.

Almost all successful business owners have acquired what is perceived by too many of them as a rather routine, basic asset—life insurance.

Life insurance is utilized for good reason by wealthy individuals for a number of purposes including, but not limited to, estate tax planning, business succession funding, deferred compensation programs for key executives and estate equalization.

The major concern with life insurance is a massive lack of understanding by business owners of how their policies actually function. Most business owners typically know nothing more than the name of the company, how much death benefit they have and how much it costs. Oftentimes, they don’t even know this minimal information.

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Why is this a serious problem? There are many reasons. The first is that the death benefits that business owners hold on their lives are often the second largest asset in their portfolios only behind the value of their companies. Yet rarely, if ever, do business owners conduct necessary independent and thorough due diligence before acquiring this asset, which is usually in the millions of dollars. Most business owners, frankly, cannot accurately describe how their life insurance contracts function. This lack of understanding can ultimately lead to huge financial mistakes including the loss of entire death benefits and millions of dollars of taxes that could have been legally avoided.

There are hugely successful business owners who are almost dismissive of their life insurance because it is viewed in their minds as something simplistic, which it is not. Life insurance is a complex asset that, if it doesn’t perform as intended, can virtually destroy a business succession and estate plan regardless of how good the attorney and CPA were who constructed the planning.

Assumption No. 1: Life insurance is all the same, right? Wrong. Very wrong.

A life insurance policy is a legal contract between a policy owner and an insurance company that may be intended to last decades. Too many business owners incorrectly think that they are positioned well because they have “XYZ Insurance Company” and they believe it to be a safe company. Yes, the financial safety of an insurance company is critical, but it is only one component of proper due diligence. How many business owners are aware that even if they have a policy with a life insurance company that is among the highest rated that their policy can still blow up with no value and they’ll lose every dollar that was contributed even though they diligently paid their premiums year in and year out? Have you read your life insurance contract cover-to-cover? Even if you’re among the rare few that actually have read your policy, do you actually understand what you’re reading? Many types of insurance contracts are written in language that consumers, including highly successful and wealthy business owners, don’t understand.

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Traditional universal life insurance and variable life insurance are among the types of policies that do not have contractually guaranteed premiums, cash values or even death benefits. Too often, these policies are sold to business owners through the use of sales illustrations that include values that look good on paper, but aren’t worth any more than the pages on which they’re printed. There are a number of assumptions that must take place for these policies to outlive the insured. However, individuals acquiring insurance incorrectly too often consider these assumptions as fact.

Assumption No. 2: Life insurance payouts are tax-free. Thin

A misconception of many successful business owners is that life insurance payouts are tax free. They should be, but many times the death benefit can become taxable both on an income- and estate-tax level. Are you absolutely positive your life insurance benefits will be tax-free? How do you know, and what are you basing that on?

There are various reasons that cause the eventual taxability of life insurance benefits. Because of space restraints I will only mention one. It is directly tied into the Pension Protection Act of 2006. Specifically, if an entity (corporation, LLC, partnership, etc.) owns life insurance on an employee (even the business owner) and an acknowledgement and consent was not signed prior to issue of the policy, the entire death benefit will become income taxable.

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A recent example is a new client of mine. While reviewing various legal documents and insurance contracts, I came across corporate-owned insurance policies that were acquired for business buyout purposes. The total insurance amount was $125 million. An acknowledgement and consent form wasn’t signed by any of the insureds, which means every dollar of the $125 million will ultimately be taxed. The only options to avoid unnecessarily paying legally avoidable taxes in the tens of millions of dollars is for the clients to scrap the insurance and start new. This problem cannot be corrected any other way.

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