529 Plans: Helping Employees Save for Education

Most employers recognize that for many of their employees, saving for a child’s education is a top priority. With the cost of a private four-year college education ranging upwards of $80,000 (National Center for Education Statistics, 2001), saving early has become paramount in helping to ensure a child’s schooling and, for many employees, their own continuing education. In particular, 529 college savings plans (named for Internal Revenue Code 529) are a popular way to set money aside for college and graduate school.

In response to the warm reception these tax-advantaged savings vehicles are receiving, particularly after favorable changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (Tax Relief Act), employers seeking innovative ways to attract and retain a qualified workforce have begun offering the 529 plan as an incentive in their benefits packages. Furthermore, to ease the process for employees and to encourage a disciplined approach to saving, many companies allow contributions to be easily made through payroll deduction.

Tax Advantages

529 college savings plans (not to be confused with pre-paid tuition plans) are state-sponsored investment accounts that offer two distinct tax advantages: 1) the potential for earnings to grow free of federal income tax; and 2) the opportunity for withdrawals to be made free of federal income tax, if funds are used for qualified education expenses, such as tuition, fees, room, and board. Certain state taxes may apply. Nonqualified withdrawals may be subject to a 10% federal income tax penalty. Prior to the Tax Relief Act, beneficiaries of a 529 plan had to pay federal income tax on any earnings. However, on December 31, 2010 this provision is scheduled to “sunset” and, if Congress does not act in the interim, then regulations regarding 529 plans revert back to tax year 2001.

Contribution limits vary by state, and in most states exceed $200,000. As an employer-sponsored payroll deduction, employees contribute a percentage of their pay (similar to a 401(k) plan) to a 529 account. While contributors are not eligible for any federal income tax deductions, some states allow for certain state income tax deductions. A person’s residency status in the state sponsoring the plan generally affects his or her state tax benefits, which may affect employees of companies with offices in different regions. For example, suppose a company has an east coast office and a west coast office. The main office, which is on the east coast, offers a 529 college savings plan from that east coast state. This would allow east coast employees to reap state tax benefits, as well as federal tax benefits. However, employees from the west coast office, while sharing the potential for earnings free of federal income tax, would not qualify for any state tax benefits.

For contributors in all states, federal gift taxes may also apply, but a special provision applies to 529 plans. In 2004, any individual may gift to another $11,000 per year ($22,000 for married couples) without incurring gift taxes. However, individuals contributing to a 529 plan are allowed to make a lump sum contribution of $55,000 ($110,000 for married couples), using five years’ worth of gifting. While this method limits tax-free gifting for the next five years, it may allow funds a longer time for potential compound earnings.

Investment Options
Investment options vary by plan, but often include a selection of mutual funds. Generally, the diversification (a strategy used to manage risk and maximize potential earnings) of the portfolio’s assets is based on the beneficiary’s age, or years until the beneficiary begins college. Remember that mutual funds are subject to market risk, and shares, when redeemed, may be worth more or less than the original investment. The portfolio’s investment strategy may be changed once (during a calendar year) without incurring any federal income tax penalties. Also, the account holder may change the designated beneficiary at any time without incurring federal income tax penalties.

Before Beginning
In addition to understanding the federal and state tax issues affecting 529 plans, it is also important to understand the associated fees and expenses. These vary by state and plan, but often include enrollment fees, maintenance fees, sales charges, management fees, and fund expenses. For many employees, sending children to college or continuing their own education is a significant life goal. Offering a 529 plan with payroll deduction as part of a benefits package may boost employee satisfaction, which may help the business owner retain a valuable workforce.

Don’t Let a Disability Derail Your Company

Many business owners, who don’t question the need for life insurance coverage, often tend to overlook the potentially greater risk from a serious disability. According to the Insurance Information Institute (III, 2002), an individual age 40 has a greater chance of missing at least three months of work due to an accident or illness than of suffering an untimely death.

How long would you be able to cover your personal and business overhead expenses if your income and revenues were to stop today? As a business owner, you could find yourself in a dire situation.

Consider the following hypothetical example. Dave Harrison learned this the hard way. At age 48, he was the president and co-founder of a small but growing electronic components company. He thought he was in excellent health. However, one day, without warning, he suffered a minor cardiac incident. Although it left no lasting damage, the follow-up surgery resulted in complications that sidelined Dave for the next two years. By the time he was finally able to return to work, he had narrowly missed declaring personal bankruptcy and losing his business. Unfortunately, his retirement savings had been depleted in the process.

According to the National Center for Chronic Disease Prevention and Health Promotion (2002) chronic conditions, such as heart disease, diabetes, and cancer, are leading causes of disability and limit the dail activities of 25 million Americans. What can you if such a situation prevents you from fully performing the duties of your job? There are two important types of insurance protection that can help safeguard a portion of both your income and your business.

First, disability income insurance helps replace a portion of your lost income while you are disabled. Most employer-sponsored plans replace salary for only a minimum period of time, typically 26 weeks or less. However, you can extend coverage either by purchasing an individual disability policy or by participating in a group plan through a business or professional association. When purchasing a policy, carefully examine the definition of disability. Some policies protect against loss if you are unable to work in your own occupation, while others cover you only if you are unable to engage in any work at all.

Second, a business overhead policy helps pay for a variety of overhead expenses once you become disabled under the terms of the policy. Thus, if you are temporarily unable to generate revenue, you can rest assured the bills will continue to be paid without interruption.

If your disability becomes permanent, there still is one glaring issue that will need to be addressed—what will happen to your company? Will you be forced to sell it below fair market value? If you have co-owners, they may agree to continue your salary on a temporary basis, but they may be unwilling to do so indefinitely. With a disability buy-out agreement, your salary would continue for a specified period of time. If it appears that you are permanently unable to return to work, your co-owners would be able to use the proceeds from a disability buy-out policy to purchase your share of the business.

Don’t let a disability derail your business. Disability income insurance, a business overhead policy, and a disability buy-out agreement are tools that can help keep your future—and that of your business—on track. A qualified insurance professional can assist you in creating a business disability protection plan that is appropriate for your needs

Estate Strategies Can Present Challenges for S Corporations

With advice from counsel and their CPAs, many small business owners choose Subchapter S as a business entity primarily due to liability and income tax considerations. However, such an election may often result in business continuation challenges in later years, when estate planning becomes a more crucial issue. Thus, estate planning for S corporation shareholders is essential because the improper transfer of shares could potentially terminate the corporation’s S status. Therefore, a carefully drafted buy-sell agreement is of utmost importance to all shareholders.

Buy-Sell Agreement Considerations
A buy-sell agreement must address several key issues to ensure the proper transfer of shares and to maintain the integrity of the S corporation status. The agreement should detail who can and cannot be the recipient of shares. This may include prohibiting the transfer of shares to partnerships, corporations, nonqualifying trusts, and individuals other than nonresident aliens. A sound agreement should also contain a provision ensuring that the number of shareholders will not increase beyond 75. Otherwise, the S corporation status could be terminated.

Another important issue that resulted in closer scrutiny from the Internal Revenue Service (IRS) was the possibility that a buy-sell agreement could create a second class of stock. However, regulations have been enacted stating that as long as there is a bona fide agreement to redeem or purchase stock upon a specified triggering event (i.e., death, disability, divorce, or separation of service), such redemption or purchase would not constitute the creation of a second class of stock.

Additional planning considerations arise with respect to the valuation of shares. In order for the valuation of shares under a buy-sell agreement to be recognized for estate valuation purposes, the buy-sell agreement must: 1) not serve as a mechanism for transferring shares to family members for less than full and adequate consideration; 2) be a bona fide business agreement; and 3) have terms and provisions similar to an "arm’s-length transaction." Also, the share price that is set must apply both during life and at death.

Finally, a determination must be made as to the type of buy-sell agreement that will be utilized and how the agreement will be funded. Although various hybrid arrangements exist, there are essentially two types of buy-sell agreements: a cross purchase and an entity purchase. In brief, with a cross purchase, the individual owners buy out the deceased or disabled owner’s shares. On the other hand, with an entity purchase, the business entity buys out the deceased or disabled owner’s shares.

Both arrangements have various advantages depending on the type of entity and the goals of the shareholders. For instance, under a cross purchase arrangement, a key advantage to the surviving S corporation shareholders is that their basis will increase by the amount of interest each shareholder purchases, respectively. An entity purchase does not afford shareholders this benefit. However, because a cross purchase requires arrangements between shareholders, the demographics of the shareholders (e.g., significant age disparity or disproportionate ownership interests) may be detrimental to the overall success of such a plan. In this respect, an entity purchase may be more appropriate in some situations.

Funding a Buy-Sell Agreement
Generally, one of the best methods for funding a buy-sell agreement is with life insurance. Life insurance offers some distinct advantages: 1) the only costs to the shareholders (or corporation) are for the premium payments and 2) the policy’s death benefit proceeds are usually not income-taxable to S corporation shareholders. With a cross purchase arrangement, the individual owners purchase a policy on each individual. With an entity purchase arrangement, the corporation purchases a life insurance policy on each individual owner.

Parting Thought Estate and business continuation planning for S corporation shareholders can be exceedingly complex. Often, such planning becomes a delicate balance between meeting the organizational goals of the S corporation and the personal goals of the shareholders. Thus, it is essential that all affected parties consult with qualified legal, tax, and insurance professionals.

Factors to Consider When Selling Your Business

Successful business executives have most likely devoted years to building their companies. Yet, at some point, they may contemplate retiring or changing direction. If selling your business is an option on the horizon, there are a number of important factors to consider in ensuring a successful and profitable sale.

Creating Market Value
One of the first questions to ask is, "Who are the potential prospects for my business?" Likely candidates may include larger companies or competitors. However, too often, private businesses are sold through business contacts or as a result of direct approaches made by potential buyers. While an unsolicited proposal is flattering to receive, such chance opportunities may not yield the highest value.

Another possibility is to sell the company to employees through an employee stock ownership plan (ESOP). ESOPs are defined contribution plans and are subject to the same guidelines imposed on 401(k) and profit-sharing plans.

Although ESOPs give all employees a vested interest in the company's profitability, they can also function as a private marketplace, enabling a retiring business executive (or employee) to recognize a retirement benefit by selling his or her shares back to the ESOP. In some circumstances, the executive may also be able to defer gain on the sale of stock to the ESOP.

When actively seeking a buyer, it is also important to keep in mind that there are some actions you can take to increase the value of your company. Just as banks lend more readily when business prospects are good, buyers are more receptive to companies just ending prosperous years.

By planning to sell when your company's performance is good, you can greatly influence buyer interest and the value generated in the marketplace. This can ultimately help you negotiate the highest sale price and draw the right buyer from among the parties bidding on your business. Only by meeting with a host of potential buyers can you weigh the relative merits of each proposed offer.

Consider Tax Effects
Review the net after-tax effect of any proposed transaction with care. The tax consequences of an asset sale are quite different from those of a stock sale. The accompanying chart illustrates the impact of these two different scenarios, along with a "compromise" option-a stock sale at a reduced price.

Suppose Jack Flynn founded Flynn Chemical Company, a "C" corporation, in 1980 with $100,000 of personal capital. Today, Flynn Chemical Company is worth $1,000,000 and Jack has decided to sell his business. Jack has an interested buyer, but he is unsure whether to liquidate his company's assets (Option A) or to sell his stock outright (Option B). The chart below shows the result of both methods.

Keep in mind, that it is also not uncommon for negotiations to result in a compromise. For instance, Jack may decide to sell the stock to the buyer at a reduced price (Option C). Jack's proceeds will still be substantial-more than if he had sold the assets outright-and the buyer's concerns about not receiving a step-up in basis for the acquired assets will, more than likely, be outweighed by the reduced sales price.

Note 1: With an asset sale, in addition to the $900,000 gain to Flynn Chemical Co., for the amount received over the corporation's basis in the assets, there may be a gain to Jack Flynn as an individual taxpayer upon liquidation of the business. Note 2: This example is for hypothetical purposes only. It is not intended to portray past or future investment performance for any specific investment. Your own investment may perform better or worse than this example.

Personal Planning-Front and Center
Regardless of which option you decide to pursue, your initial efforts should focus on a close examination of your personal planning needs and concerns. If you are like many business executives, you have probably had little time to devote to your personal financial and estate planning needs.

In addition, you could be holding a compensation package that contains benefits that are not portable. Other benefits, such as deferred compensation, may not be available for your current use, while some benefits may become available only upon retirement or death.

Because much of your worth may be tied up in your company's stock, it is important to review the proper tax, estate, and financial planning issues prior to the actual sale of your business.

Now may be a good time to meet with your financial service professional to minimize any tax liabilities, and to help guide you over the potential legal, tax, and accounting hurdles that may arise. Intermediaries can help you set realistic goals, sort through potential buyers, negotiate with interested parties, and select the most advantageous offer to ensure the maximum future benefit for you and your family.

Family Employees Bring Home Tax Benefits

If you are the owner of a small business, employing your children may help reduce both your family's aggregated income subject to taxation, as well as the effective rate at which that income is taxed. This fact applies whether you are running your business as a corporation, partnership, or sole proprietorship. Putting a family member on your payroll makes that person's income—and the proportional costs of his or her employee benefits— deductible business expenses.

As a result, the gross income of your business is lowered. While the total family income may remain essentially the same, the income paid to the family member (assuming he or she is not a spouse) is generally taxed at a lower rate. In addition, certain employee benefits are not taxable to the family member. Under this scenario, the family's overall tax liability is lowered.

Good News-Now and Later
Suppose that you have a teenage daughter, Susan, who has good computer skills. If you directly pay Susan the going rate for maintaining your database, and keep a record of her hours and the work performed, her salary is tax deductible as a business expense. As long as her wages are less than the standard deduction ($4,850 for 2004), her income will be nontaxable. Income above that amount will be taxed at Susan's presumably lower tax rate. Remember, however, that by putting her on your payroll you may be unable to claim Susan as a dependent.

Alternatively, imagine that daughter Susan is still an infant. If Jane, your spouse, works in your business, the cost of paying for childcare while she works will be lessened through the allowable childcare tax credit for such expenses.

Looking forward 20 years into the future, having Jane on the payroll could help out with retirement planning. Your company's pension, or defined benefit plan, which qualifies under the Employee Retirement Income Security Act (ERISA, amended in 1974), allows Jane to receive an annual minimum distribution of $10,000, regardless of whether her annual salary ever got that high. Most importantly, during Jane's 20 years of service, your business was able to deduct contributions to the plan on her behalf from gross income.

Perhaps your business offers a 401(k), a type of profit sharing plan. If so, the contributions made by your business to Jane's account, up to a certain amount, also qualify as a tax-deductible business expense.

IRAs are Family-Friendly
If your business does not offer a qualified retirement plan, or family members like Jane and Susan do not participate in such a plan, then Individual Retirement Accounts (IRAs)—available only to employed individuals or their spouses—are an option. IRA contributions, under current law, $3,000 per year*, are tax deductible subject to certain income limits for the employee (but not to the business) and allow for tax deferral on earnings until withdrawal. SIMPLE IRAs allow annual tax-deductible contributions up to $9,000 in 2004.** Contributions that are matched by the employer are deductible as a business expense.

In Sickness and In Health
As employees, Jane and Susan are eligible for other employee benefits your company may elect to provide, such as accident and health coverage, group term life insurance, and tuition assistance. The costs of these benefits, assuming they are reasonable, are also deductible business expenses.

You should keep in mind that employing family memebers means they must actually work in the business for compensation that is reasonable for the type of work they are performing. Also, be aware that the tax status of any retirement account or plan vehicle (and there are many types) is strictly governed by statutes and regulations that cover both employer and employee. Nonetheless, putting family members on the payroll can often clear financial and tax benefits.

*The $3,000 IRA contribution limit will be increased to $4,000 in 2005, and $5,000 in 2008 and later years. The IRA contribution limit would be indexed for inflation, in $500 increments, after 2008. Catch-up contributions will also be allowed for taxpayers who are age 50 and older. In calendar years 2002-2005, the catch-up contribution limit will be $500. For 2006, and later years, the contribution limit will be $1,000.

**As of 2002, the salary deferral contribution limit was increased from $6,500 as follows: $7,000 in 2002; $8,000 in 2003; $9,000 in 2004; and $10,000 in 2005 and later years. Thereafter, the SIMPLE IRA limit will be indexed in $500 increments. Also, taxpayers age 50 or older will be permitted to make catch-up contributions. The amounts are as follows: $500 in 2002; $1,000 in 2003; $1,500 in 2004; $2,000 in 2005; and $2,500 in 2006 (indexed in $500 increments).

Intrafamily Transfers Using a Private Annuity

In many closely-held businesses, the goals of a succession plan often include providing the owner with lifetime income, minimizing estate taxes, and transferring ownership to children under terms which they can afford.

Consider Joseph Wyatt, a 100% shareholder in Wyatt, Inc., a real estate property management company. He has two children active in the business, and since he is nearing retirement, he would like them to succeed him as officers and owners. Furthermore, since the closely-held stock makes up the bulk of his estate, he is looking to the business to provide most of his retirement income.

Joseph and his children could structure a private annuity which would provide periodic fixed payments to Joseph over his lifetime, in return for transferred ownership of the business. A private annuity is an arrangement whereby one person (the transferee or obligor) who is not in the business of writing annuities agrees to make periodic payments to another person (the transferor or obligee), usually for the obligee`s life, in exchange for a property transfer.

If the value of the property transferred and the value of the annuity (actuarially determined using IRS tables) were equal, there would be no gift. If the property transferred was worth more than the promised annuity, the excess would be deemed a gift and could have gift tax consequences. Upon Joseph’s death, the obligation of his children would end, and nothing relating to the value of the business would be included in his gross estate.

Potential Advantages

	Estate Tax Savings--The property is immediately removed from Joseph`s estate; future appreciation of the business is shifted to his children.
	Lifetime Income-- Joseph receives an economic benefit (i.e., lifetime income) as if the transferred property had been retained
	Income Taxes--The income from the annuity is partially a tax-free return of basis and partially a long-term capital gain; there are no payroll taxes associated with the annuity income.

No "Deferred Gain" Consequences at Death--Any deferred gain at Joseph`s death is not "income with respect to a decedent" in his estate; in contrast, had an installment sale been used, any "notes" not yet paid at Joseph`s death would be included in his gross estate.

Potential Disadvantages and Concerns

	Income Taxes-- Joseph`s children must make the annuity payments with after-tax dollars; there is no interest deduction for any portion of the payments as there would be in an installment sale.
	Characterization as Retained Life Estate--In order to avoid potential retained life estate problems under Sec. 2036, there must be no strings attached (e.g., retained voting rights by Joseph) to the transferred property.
	Security--The private annuity contract must be an unsecured promise to pay in order to achieve the benefits of the annuity tax rules and avoid immediate tax on the gain.
	Valuation and Gift Taxes--Any excess of the property`s value over the present value of the annuity will generally constitute an immediate gift. With closely-held stock, and other types of property where exact valuation may be difficult, the IRS may challenge the valuation used in creating the annuity contract.
	No Basis Step-up--The children do not get the stepped-up basis which would apply if the stock were inherited. Rather, their basis is equal to all the payments made up to Joseph’s death.
	Estate Taxes--By transferring the property in exchange for the annuity, the property is removed from Joseph’s estate. However, if Joseph allows the payments received to accumulate, and he exceeds his life expectancy, the estate tax savings may be illusory unless such income is consumed or otherwise disposed.

In appropriate circumstances, the private annuity has been a valuable intrafamily estate planning tool, enabling the transfer of appreciated property to younger family members in exchange for lifetime payments to an older generation transferor. However, because the private annuity is typically a transaction between related parties, its use may come under more careful scrutiny by the IRS. Familiarity with Chapter 14 of the IRC (particularly Sec. 2703) will be helpful for anyone considering the use of this transfer technique.

Issues Facing Today

An individual who is an owner of a family business is in a rather unique estate planning situation. Often, their business interest makes up a majority of their estate. Thus, on one hand lies the issue of estate taxes and the future of the business, while on the other hand, there is the complex issue of determining the value of a family-owned business for estate tax and/or business continuation purposes.

First Steps
Typically, a number of personal, business, and tax-related issues need to be addressed. For instance, are there any family members interested in taking over the business? Will the business owner's estate have adequate liquidity to pay estate taxes? Is the business marketable if it must be sold? What types of financial contingencies are in place to provide for a spouse or for family members after the owner's death? These are just a few of the many questions facing a family business owner.

Because an owner's business interest is an asset, and will be included in the owner's estate, initial planning often focuses on the maximization of the applicable exclusion amount. The owner of a qualified family-owned business (QFOB) is given a deduction which, when added to the applicable credit amount, totals $1,300,000.

This deduction raises several interesting planning points. First, any combined use of the deduction and the applicable credit amount cannot exceed $1,300,000 in any year. Therefore, as the applicable exclusion amount gradually increases over the next several years (thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001) from $1,000,000 in 2002 to $3,500,000 in 2009, the deduction for a QFOB actually decreases from $300,000 in 2002 to its complete elimination in 2004.* Second, in order to qualify for the deduction:

1. the decedent's interest must be greater than 50% of his or her estate;
2. family members must have participated in the business for at least 5 of 8 years within a 10-year period prior to the decedent's death; and
3. if any interest is sold to a nonfamily member within 10 years after the decedent's death, the tax savings will be recaptured.

As a result, if a family business qualifies for the exclusion at the time of the decedent's death, family members participating in the business should be made aware of the potential tax ramifications if any business interest is sold in the future.

Gaining Perspective with Business Valuations
Once the applicable credit amount and special estate tax exclusion for qualified family-owned businesses are analyzed, an owner can turn his or her attention to the family business itself, and how it fits into their overall estate plan. Generally, the owner will have three choices for the future of the business:

1. keep the business in the family;
2. sell the business; or
3. liquidate the business.

Although each option requires different planning strategies and has its own set of potential problems and concerns, there is a similarity among each choice. Upon the owner's death, the business must be accurately valued for estate tax purposes to help ensure the proper and timely disposition of business interests.

Generally, there is no readily available means for determining the fair market value of a family-owned business. Consequently, alternative valuation methods must be used before the value of the business can be determined.

One important factor the business valuation process reviews is the nature and history of the business. For the Internal Revenue Service (IRS), the key to this factor is the identification of risk. While disregarding past events that are unlikely to recur in the future, the IRS believes capital structure, sales records, growth, and diversity of operations can speak volumes about past business performance and how the business will fare in the future.

Next, the economic outlook for the country, as well as the geographic location of the business, must be factored into the appraisal. The key to this element is the future potential for business profits; the greater the expectation of profits, the greater the value of the business. Where a particular business stands in relation to its competitors is often a good indicator of future business profits. The appraiser is required to evaluate the industry, as well as the position of the particular business within the industry.

Taken together, the book value and financial condition of the business form the third factor that must be weighed. Book value, defined as assets minus liabilities, is readily obtained from the balance sheet. In most cases, however, balance sheet adjustments will have to be made to book value in order to accurately reflect economic versus tax depreciation.

The IRS often finds this fourth factor, earnings, to be the most important criteria in service-based businesses. It is often common for appraisers to "capitalize" earnings as a means of reducing future income to a single number, otherwise referred to as present value. Capitalizing earnings is nothing more than a fancy method used to answer the question of how much an individual will pay for a business given the level of risk involved.

Where appropriate, the dividend-paying capacity of the company will be examined, as well. The IRS believes that dividends are not a reliable criteria of market value in the closely-held company, however, since the controlling stockholders have the discretion to pay deductible salary and bonuses as opposed to nondeductible dividends.

Finally, goodwill, or the ability of a business to earn a return over and above what it could on its fixed assets, represents the sixth, and possibly most difficult, factor to value. Intangible goodwill value can come from such things as the location of the business, the reputation of the business, or a specific list of customers. Goodwill is usually most difficult to value in those businesses that have no intangible assets.

Family business owners are in a truly unique estate planning situation. As a result, already complex planning can easily become more involved when one figures in the qualifications for the new small business exclusion and the rigors of a small business valuation. As with all advance planning, it is important to review and solidify the business owner's goals and objectives before proceeding with any course of action. In addition, business valuations should be performed by a licensed professional business appraiser.

Keeping Sight of Personal Priorities

Key Person Insurance Protecting Your Most Valuable Assets

As a business executive, suppose you were to arrive at your desk one morning only to be informed that your key sales manager had died unexpectedly during the night. Have you ever considered how such a turn of events might affect your company? Along with losing a valued member of your management team, you would also be losing the manager’s skill, “know-how,” and, perhaps, the important business relationships he or she had cultivated over the years.

Navigating the Shoals
Although you can’t prevent the sudden and unexpected loss of a critical employee, you can receive compensation through key person insurance. A key person policy covers or “indemnifies” a company against the loss of a valued team member’s skill and experience. The proceeds can help: provide funds to recruit, hire, and train a replacement; restore lost profits; and reassure customers and lenders that business operations will continue and funds will be available to help repay business loans.

Generally, the company owns the policy, the premiums are not deductible, and the death proceeds are received by the company free of income taxes [although there may be alternative minimum tax (AMT) consequences for businesses organized as C corporations].

Charting a Course
Needless to say, it is not easy placing a value on a key employee. Generally, there are three different approaches to determine the amount of insurance that is necessary.

One of the most common methods is called the “multiple” approach. This method uses a multiple of the key person’s total annual compensation, including bonuses and deferred compensation. The disadvantage to this approach is that the estimate, typically for five or more years’ annual compensation, may or may not relate to actual needs. The popularity of this method may simply be a reflection of the difficulty business executives have in quantifying a key employee’s value.

A more sophisticated method is the business profits approach. This method tries to quantify the portion of the business’s net profit that is directly attributable to the efforts of the key person and then multiplies that amount by the number of years it is expected to take for a replacement to become as productive as the insured. For example, if the estimate of net profit attributable to the key employee is $250,000 annually, and it is estimated that it would take five years to hire and train a replacement, then, the policy’s face amount would be $1.25 million under this method.

A third method determines the present value of the profit contributions of the key employee over a specified number of years. This quantity is then used as the face amount of the policy. For a simplified example, with anticipated profit contributions of $250,000 per year for the next five years and a discount rate of 8 percent, the policy’s face value would be about $1 million. This method assumes the insurance proceeds can be invested at some rate of return and will be expended over a period of years. Business executives should consult with their insurer regarding the company’s specific “rule of thumb” approach.

Regardless of which method is best suited for your business, key person insurance is a vital component to consider in protecting your business from the loss of your most valuable assets—the people who help it grow and prosper. In addition to providing cash to recruit, hire, and train replacements, the proceeds can also be used to help restore lost profits, maintain customer satisfaction, and lender obligations.

Nonqualified Plans—Baiting the Benefit Hook

Attracting and retaining qualified employees and managers is a constant challenge, especially in today’s tight labor market. Most employers realize competitive salaries are not enough to win over the best workers. Sought-after employees also expect compensation packages to include desirable benefits.

Qualified retirement plans are a traditional component of many employee benefit packages. As a business owner, you’re likely to appreciate their advantages: your contributions are tax deductible and accumulate on a tax-deferred basis. Unfortunately, these plans are difficult to administer and contain many regulations restricting employee eligibility, participation, vesting, and employee contributions.

What’s the alternative? Nonqualified plans offer the flexibility to selectively choose whom you’ll cover and how much you’ll contribute for each individual. Many companies use them to supplement or replace their qualified plans. Although there is a wide range of nonqualified plans from which to choose, executive bonus plans and deferred compensation plans are among the most popular.

Executive Bonus Plans
If you’re looking for a plan that provides a current tax deduction, consider the executive bonus plan. This strategy makes sense when your company’s tax bracket exceeds your personal tax bracket. Here’s how it works: you choose which workers you wish to reward with a bonus. The bonus comes in the form of a life insurance policy on the selected employee with premiums paid by your company.

This approach will likely appeal to you for its simplicity. And, it benefits your employee as well, since his or her family receives additional protection over what the company’s group life insurance plan offers. The employee can also look forward to having access to the policy’s cash value, which can be used to help supplement future college costs or retirement income.

Restrictive Executive Bonus Plans
A twist on the preceding plan is the restrictive executive bonus plan. This resembles a regular bonus plan, except that your company retains greater control over the life insurance policy. This is accomplished by attaching a special endorsement that prohibits the employee from surrendering, loaning, or withdrawing the cash value from the policy. Control of this agreement is spelled out in a contract that defines your company’s rights and the vesting terms for the employee. Restrictive bonuses are a relatively new approach and provide an effective means for rewarding key employees—including yourself—while retaining some measure of company control over plan assets.

(Note: Using such restrictions may cause your company to be considered a beneficiary, since you exercise control over the policy and may have access to cash values. This could affect your company’s ability to take a tax deduction for your contributions to the plan. It may be best to discuss this issue with your accountant.)

Deferred Compensation Plans
With a deferred compensation arrangement, you agree to continue an employee`s salary for a specified period of time after retirement. Although the company`s contribution to the plan is not currently tax deductible, deferrals grow tax free provided the company uses a tax-deferred investment vehicle, such as life insurance. The advantage of a deferred compensation plan is that it gives your company control of the funding vehicle. However, it is up to you to decide whether you’d rather have a current tax deduction or one that’s deferred. This is another issue you may wish to discuss with your accountant.

In today’s competitive job market, highly qualified employees are not always easy to come by. When fishing for the best workers, the lure of nonqualified plans with their selective benefits can help you bait your benefit hook.

Pacing Your Company’s Growth

It’s only natural for many entrepreneurs to entertain thoughts of achieving hugely successful businesses. Perhaps they hope to follow in the footsteps of those companies that seem to spring fully-grown overnight. Yet, it’s worthwhile for business owners to ask at the outset—“What is the best measure of success?” Bigger isn’t always better. While outside observers often tend to measure a company’s success solely by its growth, progress, and sustainable profitability aren’t always reflected in the number of employees or the size of a company’s revenues.

Small companies that grow slowly may have an edge in sustaining growth over the long term. In this regard, it’s important for owners to keep sight of what motivated them to go into business in the first place. For instance, a desire to be responsive to customer needs and to be creative in meeting them may be best cultivated in a small business setting. Here are some strategies that can help a company maintain its small business edge:

Differentiate the Company
Carve out a niche with a clearly defined mission and target market. For instance, by defining itself as “a one-stop communications resource, specializing in small to midsize companies,” a company can help position itself to remain small enough to offer personalized attention to clients, while allowing for enough growth to provide expertise across a broad range of communication needs.

Build on Existing Capabilities
Actively seek new ways to use existing capabilities to serve customers. For instance, if our one-stop communications company initially focuses on developing marketing materials for customers through one-on-one verbal communications, as its clients expand their operations into cyberspace, it might also consider developing its own website to reach its customer base

Experiment with New Ideas
Make it a practice to cultivate creative approaches to meeting customers’ needs. For example, services can be developed on a trial basis with one or two clients. If a problem develops, or there is little interest among customers, the service can simply be discontinued.

Small companies often benefit from many advantages large businesses may lack. For instance, they may find it easier to remain close to their customer base by responding more quickly to customer needs. This kind of personalized attention can help build customer loyalty and may lead to referrals and new customers.

Many successful small businesses fail when they attempt to expand too rapidly. Slow, steady growth can help a company retain its uniqueness, responsiveness, and creative approach over the long run. By cultivating its small business edge, a company can not only generate the potential for growth, it can also help build a solid foundation for sustaining it.

Raising Capital for Your Business Needs

Raising capital for your business can be an extremely complex process. What should you use- debt (borrowed funds), equity (capital that does not need to be repaid), or a combination of the two? Whether your business is a start-up venture or an established enterprise, these financing decisions will directly affect the potential growth and profitability of your business.

Debt Financing

Like many business owners, you may favor debt financing because creditors and lenders have no direct claim on the future earnings or value of your company. Your obligation to creditors ends when you repay the debt. Another benefit of debt financing is the interest paid on loans can be deducted on your company’s tax return, lowering your real cost of capital.

Despite these advantages, debt can put a considerable strain on your business, especially if cash flow is weak. Regardless of your business’s financial position, both principal and interest must be repaid in a timely manner, and usually within a relatively short time period. In addition, interest is a fixed cost that will increase your company’s “break even” point. If your business experiences financial problems, debt can drastically affect profitability.

Although your obligation to the creditor ends when you repay a loan, the creditor may include restrictive covenants (e.g., restrictions on capital expenditures) as a contingency for granting the loan. These covenants may severely limit your control over business operations.

Equity Financing

Equity financing provides capital that does not need to be repaid, making it particularly attractive to businesses without enough cash flow to service debt. In addition, equity financing has no fixed cost. Equity financing, however, can significantly dilute your ownership interest and may diminish your operating control. Due to these risks, equity providers may request a position of authority within the company, such as a seat on your board of directors. If your business is well established, this request may be an infringement. If your business is new, you may benefit from the investor’s knowledge.

The real cost of equity financing, however, is often greater than debt financing for two reasons: 1) due to generally higher risks, investors may require greater returns on investment than creditors, and 2) dividends are not tax deductible, therefore leading investors to expect sizable capital gains from business growth.

Debt/Equity Combinations

When weighing the advantages and disadvantages of debt versus equity, you may discover that neither straight debt nor straight equity adequately meets the capital needs of your business. Therefore, you may want to consider a combination of debt/equity. One option is to couple debt with equity additions, which are warrants that enable investors to purchase a portion of your company’s stock at a fixed price sometime in the future. Such an arrangement may improve your chances of securing financing because investor risks are reduced and returns are increased. This method will also minimize debt service and limit the amount of equity you must relinquish.

Finding the Right Ratio

What is the correct debt-to-equity ratio for your business? There is no right or wrong answer to this question. However, if your business has an abnormally high debt-to-equity ratio, there is some risk that your debt instruments may be re-characterized as equity for tax purposes. Also, potential investors or lenders reviewing your company’s financial statements will look for a debt/equity ratio consistent with the industry average for your particular business. Bankers have access to these industry standards.

If your business currently has a high debt-to-equity ratio compared to others in your industry, you may want to consider seeking equity financing. Lending institutions usually avoid highly leveraged companies for fear these companies will have difficulty meeting interest and principal payments. If your business has a low debt-to-equity ratio, consider pursuing debt financing. Lenders view highly capitalized businesses as stable and, consequently, may be more willing to make favorable loans.

Of course, the amount of debt or equity your business is currently carrying should not be the only factor affecting your financing decisions. In addition to ratios, factors such as level and stability of cash flow affect business continuity and should also be examined.

Assessing the type of financing that may be best suited for your company can be a difficult process. Consultation with a financial service professional can assist you in making the appropriate financing decisions for your business.

Securing a Business Loan with Term Life

As a business executive, you have probably worked long and hard to help build a successful company. In today's thriving economy, with strong demand for many products and services, you may want to take full advantage of your opportunities to expand. Yet, even when profit projections look good and a project is backed by a sound business plan, your banker may be reluctant to lend the necessary funds.

The reason for this reluctance could be the fact that the bank is concerned that, despite an excellent credit standing, the success of your venture depends too heavily on your personal involvement. If you were to suffer an untimely death, the bank could stand to lose a significant sum.

On the other hand, the bank is in the business of lending funds. If you have had a close working relationship with your bank, and your banker has confidence in your abilities, it is likely your lender will want to continue to "partner" your business as it grows and develops. What can be done to resolve the situation?

A Life Insurance Strategy
Life insurance may offer an answer. Life insurance is an important element in many business arrangements. One of its many uses is securing a business loan. If your new or expanding business requests a loan, your lender may require you to secure the loan if the company lacks collateral to back the loan, or if the lender is concerned that your company depends too heavily on the talents of a particular individual.

Term life insurance is designed to protect against financial risk for a specified period of time in the event of the insured's death. With a term policy on your life for the duration of the loan, say five years, the bank's security requirements may be satisfied. In addition, term life benefits a business owner by providing a safety net that protects his or her estate if things don't work out as anticipated.

Policy Assignments
By assigning your policy, you transfer your rights to all, or a portion, of the proceeds to the bank. The extent to which these rights are transferable depends on the assignment provisions in the policy, the intention of the parties as expressed in the assignment form, and the actual circumstances of the assignment. Two common types of insurance policy assignments are:

	Absolute assignments -These normally assign every policy right the policyholder possessed prior to the assignment. Once the transaction is complete, the policyholder will have no further financial interest in the policy.
	Collateral assignments -These are more limited types of transfers. They can protect the lender by using the policy as security for repayment. When the loan is fully repaid, the bank releases its interest in the policy.

Life insurance policies generally can be freely assigned, unless some limitation is specified in the contract. To fully protect the assignee, the insurance company must be notified that the assignment has been made. It is also important to notify the insurer if future assignments are made and/or terminated.

Benefits after the Loan is Repaid
Term life offers benefits even after the loan has been repaid. At that point, you could convert the policy to permanent coverage to be used for a number of other business purposes. These may include funding a buy-sell agreement, a disability buyout agreement, or a deferred compensation plan. If you have no further need for the insurance, you could simply decide to let the term policy lapse.

To succeed in the long run, small businesses need to take advantage of their opportunities to grow. Yet, a lender may be unwilling to share in the calculated financial risk of an entrepreneur-even one whose efforts it supports.

A term policy can be an economical method of making a business loan possible by providing a safety net that secures repayment for a lender. For more information on how life insurance can help meet your company's needs, consult a qualified insurance professional.