Several years ago, James expanded his business, CDC Technology, to attract more higher-end projects, and hired Sarah, a business development executive with a great reputation. The move paid off — Sarah brought in new clients and landed projects that had a big impact on profits. She is now a key factor in CDC’s success. But if she were gone, it would be difficult and expensive for James to replace her.
James purchases Key Person insurance to protect his business from financial loss if Sarah leaves. James estimates the dollar value of Sarah’s contribution and the cost of replacing her, including:
- Lost profits;
- Costs of recruiting and retaining a replacement; and
- Protecting the company’s position in the marketplace.
Next, CDC Technology purchases life insurance on Sarah’s life, pays the premiums, and is owner and beneficiary of the life insurance policy.
- The policy cash value is an asset of CDC.
- Sarah and her family have no interest in the policy.
Now James Has Options to Protect CDC’s Future
- If Sarah dies, the business receives the policy death benefit tax-free, ensuring that CDC will have working capital and funds to survive any financial loss and to recruit a successor.
- If Sarah stays until retirement, the life insurance cash values can be used to:
- Provide cash flow;
- Provide executive benefits to Sarah; and/or
- Cover expenses, including the cost of recruiting for Sarah’s replacement.
Business-owned life insurance purchased on a key employee issued after August 17, 2006 is subject to the Pension Protection Act (PPA) of 2006. This allows tax-free death benefits to an employer provided the employer gives written notice to the key employee, prior to issuance of the policy, of the intent to purchase a life insurance policy insuring the key employee, and the key employee gives written consent to be insured and for the coverage to continue after the employee ceases employment. The employer is required, under IRC §6039I, to annually report all employer-owned life insurance contracts on IRS Form 8925.Receipt of the death benefit by the business may also result in Alternative Minimum Tax (AMT) for C Corporations. This is not a problem for S Corporations, partnerships or LLCs. If policy values are accessed to pay executive benefits, they are subject to income tax when paid to the employee.
Guest Article Provided by: Cornerstone Wealth Management – A YPP Client