What Is A Buy/Sell Redemption Life Insurance Plan?

In today’s fast-paced and very busy lifestyle, one might be able to overlook insurance planning simply because there are other things that are more important. These other things that you are focused on make insurance seem like a not-so-important priority. Of course, family, work and necessities are your main concern. A little leisure for yourself and the whole bunch doesn’t hurt either. Insurance plans are often neglected by many people who think that they don’t need it. Oftentimes, they come up with excuses and come to their senses when it’s too late. At some point in your life, you will realize that insurance planning is a very important part of security. Insurance plans may also be used to fund a buy/sell redemption plan.

If you have an insurance plan, you might want to consider using it to fund a Buy/Sell Redemption Plan. It is just similar to trying to acquire and vend a cross procure plan really. You are actually making use of the earnings from your life indemnity to a subsidized plan to make some alterations of rights with a corporation, member or partnership. Think about buy and sell cross purchase plans. It would sure help to provide you with money to be able to fund the plan. The prices are determined once both parties agree on buying and selling their business interests. It’s quite hard to understand at first but there are a lot of people that can help you with that.

These purchase and trade emancipation plans toil like magic. It is quite a lot to take at first but, if you understand it fully, then you will see the beauty of it. Corporations or business owners are usually the first ones to kick off a purchase and trade redemption agreement through their attorneys and financial team consisting of some accountants and planners. Insurance policies are what the business needs to obtain through purchasing life insurance policies from individual owners. The business in turn, would receive tax free profits. The income or money comes from the bereavement assistance takings of the dead owners.

There are some advantages and some disadvantages of using these life insurance policies. Like in any business, there are some pros to it and there are some risks as well.

Advantages

  • Lump sums are created by life insurance to fund the buy/sell redemption agreement at death.
  • Life insurance proceeds are payable immediately after death. These transactions are settled quickly.
  • The life insurance proceeds are tax-free.

There are two sides to every story. Buy/sell redemption plans also has some downsides to it. These need to be taken into consideration as well. It is important that you understand how it works and understand it fully before you consider utilizing life insurance policies to fund any buy/sell redemption plans.

Disadvantages

  • Life insurance plans are not part of the tax deductible expenses of the company.
  • Premiums requirements are an ongoing expense.
  • More insurance are necessary to cover up the bigger rights interests if the proportion differ broadly. This would pilot to a high quality costs for owners who have lesser ownership interests.

Your trusty life insurance agent can help you about the signs that tell you if you should pull the trigger on the purchase and sell agreement. The mediator would be a great asset in setting up the life insurance part of the deal. They can also help you in going over the premiums and how they should be settled. Your attorney, financial team and beloved insurance agent can help you get the transaction in your good turn. You should be able to get the value of business on its potential value in the future as well as its present stage. It is noteworthy since your indemnity coverage should match the merit of your ownership interests. You should clear this up with the company on how they address any valuation differences. If you die before you retire, the amount of funds from the rule proceeds or part ways to pay your estates in full as your share of the company. However, if it isn’t affordable at the moment, it is best to give out as much as you can. The difference can be settled by increasing the insurance’s amount. Another option would be to use some additional methods in financing. In situations like these, you have to clarify how your family or estates are going to settle the amount since it is required to pay in full for your component of the trade.

Loyalty Doesn’t Pay

I had a conversation with a friend the other day that gave me inspiration for this topic. My friend, who I will call an loyalist, said “I have been with my for 52 years. When I call they jump.” We discussed this belief for a little while as I wanted to get a little more insight from his perspective. For the purpose of this week’s topic, it is coming from the perspective of being in CA, considering CA insurance law. If you are from another state, your laws may be different, and I am not an attorney so this is not legal advice.

In 1988 California voters passed Prop 103, which was a insurance reform proposition. It is my understanding that this law, while primarily focused on regulating rates, protects insurance consumers by preventing the use of discriminatory tactics by insurance companies. What this means is that insurance companies have to treat a 1 day customer, with the same service as a 52 year customer. If the gives preferential service to the older customer over the newer customer they are subject to penalties and fines if the Department of Insurance were to investigate complaints of this nature. Typically the penalties far exceed the value of any client, so insurance companies do not waiver in their treatment of their customers regardless of tenure. So for my friend, while the company may listen a little more politely, their policy for him is the same as a new customer. If they jump for him, they jump for everyone. As an insurance shopper, just know that your treatment is the same no matter how long you are with a specific company.I am not privy to the world of corporate leaders, but I would bet in the boardrooms, and executive meetings, the opposite of ‘jumping’ is the case. Given how much insurance companies study the business for profit, I would bet loyalist customers are the most profitable customers for insurance companies. Once the insurance loyalist is set in their comfort zone, they can be taken advantage of with changes in policies or direction. These corporate leaders don’t talk about special privileges for loyalists, but rather take the insurance loyalist for granted, assuming that no matter what they do as a company, or how they treat their customers, the loyalists will stay. Similar to some sports teams, where no matter how bad the product is, the fans stick around in faith for their team. In the meantime the executives get healthy bonus payment and the company makes healthy profits on the back of these consumers. Since my goal is to give good tips or advice on insurance shopping, it makes sense to get you to think about these things.

What I did tell my friend was he, like any insurance consumer, should shop his insurance regularly or talk to his agent about pricing other companies, to could confirm his pricing is the best. Why throw money away over a brand? I told him the primary factors in determining his best rate are: his driving record (tickets and accidents), the number of years of driving experience he has, and how far he drives each year.

There are other factors that insurance companies may use in determining rates and those are the important ones for insurance shoppers and finding the best price. Did his company offer a loyalty discount of some type? Yes. I asked him, what his 52 years of loyalty was worth to his company. We did some math and his loyalty discount was worth about 7%. Moving forward, knowing that your 52 years of brand loyalty to an was worth about 7%, would you stick around especially if there were greater discounts elsewhere?

In the category of these other factors, there are companies with discounts for college degrees or targeted professions worth 15% or more. Did his company have something like that? No, he said. From the perspective of being an insurance shopper over a company loyalist, in just this one discount he potentially was sacrificing an additional savings of 8%. This is only one example of potential savings for insurance shoppers. Companies advertise discounts for alumni associations or organizations you belong to, or extra discounts for having an ‘extra’ clean driving record. The key for insurance shoppers is to be willing to look around. It doesn’t take much to shop for comparison quotes, and the insurance shopper and the insurance loyalist both may save some money.My take on the matter, you don’t have to shop your insurance every year, but I would look for the triggers indicating you should. Did your rate change from one policy period to another but your primary rating factors did not? Is there a change that your company or agent pass off as simply ‘new rates’? Does the explanation you hear not make a lot of sense? Not every company raises their rates at the same time, or changes discounts that you qualify for, so if that happens to you, use your triggers to be a new insurance shopper.

A Brief Introduction to Captive Insurance

Over the past 20 years, many small businesses have begun to insure their own risks through a product called “Captive Insurance.” Small captives (also known as single-parent captives) are insurance companies established by the owners of closely held businesses looking to insure risks that are either too costly or too difficult to insure through the traditional insurance marketplace. Brad Barros, an expert in the field of captive insurance, explains how “all captives are treated as corporations and must be managed in a method consistent with rules established with both the IRS and the appropriate insurance regulator.”

According to Barros, often single parent captives are owned by a trust, partnership or other structure established by the premium payer or his family. When properly designed and administered, a business can make tax-deductible premium payments to their related-party insurance company. Depending on circumstances, underwriting profits, if any, can be paid out to the owners as dividends, and profits from liquidation of the company may be taxed at capital gains.

Premium payers and their captives may garner tax benefits only when the captive operates as a real insurance company. Alternatively, advisers and business owners who use captives as estate planning tools, asset protection vehicles, tax deferral or other benefits not related to the true business purpose of an insurance company may face grave regulatory and tax consequences.

Many captive insurance companies are often formed by US businesses in jurisdictions outside of the United States. The reason for this is that foreign jurisdictions offer lower costs and greater flexibility than their US counterparts. As a rule, US businesses can use foreign-based insurance companies so long as the jurisdiction meets the insurance regulatory standards required by the Internal Revenue Service (IRS).

There are several notable foreign jurisdictions whose insurance regulations are recognized as safe and effective. These include Bermuda and St. Lucia. Bermuda, while more expensive than other jurisdictions, is home to many of the largest insurance companies in the world. St. Lucia, a more reasonably priced location for smaller captives, is noteworthy for statutes that are both progressive and compliant. St. Lucia is also acclaimed for recently passing “Incorporated Cell” legislation, modeled after similar statutes in Washington, DC.

Common Captive Insurance Abuses; While captives remain highly beneficial to many businesses, some industry professionals have begun to improperly market and misuse these structures for purposes other than those intended by Congress. The abuses include the following:

1. Improper risk shifting and risk distribution, aka “Bogus Risk Pools”

2. High deductibles in captive-pooled arrangements; Re insuring captives through private placement variable life insurance schemes

3. Improper marketing

4. Inappropriate life insurance integration

Meeting the high standards imposed by the IRS and local insurance regulators can be a complex and expensive proposition and should only be done with the assistance of competent and experienced counsel. The ramifications of failing to be an insurance company can be devastating and may include the following penalties:

1. Loss of all deductions on premiums received by the insurance company

2. Loss of all deductions from the premium payer

3. Forced distribution or liquidation of all assets from the insurance company effectuating additional taxes for capital gains or dividends

4. Potential adverse tax treatment as a Controlled Foreign Corporation

5. Potential adverse tax treatment as a Personal Foreign Holding Company (PFHC)

6. Potential regulatory penalties imposed by the insuring jurisdiction

7. Potential penalties and interest imposed by the IRS.

All in all, the tax consequences may be greater than 100% of the premiums paid to the captive. In addition, attorneys, CPA’s wealth advisors and their clients may be treated as tax shelter promoters by the IRS, causing fines as great as $100,000 or more per transaction.

Clearly, establishing a captive insurance company is not something that should be taken lightly. It is critical that businesses seeking to establish a captive work with competent attorneys and accountants who have the requisite knowledge and experience necessary to avoid the pitfalls associated with abusive or poorly designed insurance structures. A general rule of thumb is that a captive insurance product should have a legal opinion covering the essential elements of the program. It is well recognized that the opinion should be provided by an independent, regional or national law firm.

Risk Shifting and Risk Distribution Abuses; Two key elements of insurance are those of shifting risk from the insured party to others (risk shifting) and subsequently allocating risk amongst a large pool of insured’s (risk distribution). After many years of litigation, in 2005 the IRS released a Revenue Ruling (2005-40) describing the essential elements required in order to meet risk shifting and distribution requirements.

For those who are self-insured, the use of the captive structure approved in Rev. Ruling 2005-40 has two advantages. First, the parent does not have to share risks with any other parties. In Ruling 2005-40, the IRS announced that the risks can be shared within the same economic family as long as the separate subsidiary companies ( a minimum of 7 are required) are formed for non-tax business reasons, and that the separateness of these subsidiaries also has a business reason. Furthermore, “risk distribution” is afforded so long as no insured subsidiary has provided more than 15% or less than 5% of the premiums held by the captive. Second, the special provisions of insurance law allowing captives to take a current deduction for an estimate of future losses, and in some circumstances shelter the income earned on the investment of the reserves, reduces the cash flow needed to fund future claims from about 25% to nearly 50%. In other words, a well-designed captive that meets the requirements of 2005-40 can bring about a cost savings of 25% or more.

While some businesses can meet the requirements of 2005-40 within their own pool of related entities, most privately held companies cannot. Therefore, it is common for captives to purchase “third party risk” from other insurance companies, often spending 4% to 8% per year on the amount of coverage necessary to meet the IRS requirements.

One of the essential elements of the purchased risk is that there is a reasonable likelihood of loss. Because of this exposure, some promoters have attempted to circumvent the intention of Revenue Ruling 2005-40 by directing their clients into “bogus risk pools.” In this somewhat common scenario, an attorney or other promoter will have 10 or more of their clients’ captives enter into a collective risk-sharing agreement. Included in the agreement is a written or unwritten agreement not to make claims on the pool. The clients like this arrangement because they get all of the tax benefits of owning a captive insurance company without the risk associated with insurance. Unfortunately for these businesses, the IRS views these types of arrangements as something other than insurance.

Risk sharing agreements such as these are considered without merit and should be avoided at all costs. They amount to nothing more than a glorified pretax savings account. If it can be shown that a risk pool is bogus, the protective tax status of the captive can be denied and the severe tax ramifications described above will be enforced.

It is well known that the IRS looks at arrangements between owners of captives with great suspicion. The gold standard in the industry is to purchase third party risk from an insurance company. Anything less opens the door to potentially catastrophic consequences.

Abusively High Deductibles; Some promoters sell captives, and then have their captives participate in a large risk pool with a high deductible. Most losses fall within the deductible and are paid by the captive, not the risk pool.

These promoters may advise their clients that since the deductible is so high, there is no real likelihood of third party claims. The problem with this type of arrangement is that the deductible is so high that the captive fails to meet the standards set forth by the IRS. The captive looks more like a sophisticated pre tax savings account: not an insurance company.

A separate concern is that the clients may be advised that they can deduct all their premiums paid into the risk pool. In the case where the risk pool has few or no claims (compared to the losses retained by the participating captives using a high deductible), the premiums allocated to the risk pool are simply too high. If claims don’t occur, then premiums should be reduced. In this scenario, if challenged, the IRS will disallow the deduction made by the captive for unnecessary premiums ceded to the risk pool. The IRS may also treat the captive as something other than an insurance company because it did not meet the standards set forth in 2005-40 and previous related rulings.

Private Placement Variable Life Reinsurance Schemes; Over the years promoters have attempted to create captive solutions designed to provide abusive tax free benefits or “exit strategies” from captives. One of the more popular schemes is where a business establishes or works with a captive insurance company, and then remits to a Reinsurance Company that portion of the premium commensurate with the portion of the risk re-insured.

Typically, the Reinsurance Company is wholly-owned by a foreign life insurance company. The legal owner of the reinsurance cell is a foreign property and casualty insurance company that is not subject to U.S. income taxation. Practically, ownership of the Reinsurance Company can be traced to the cash value of a life insurance policy a foreign life insurance company issued to the principal owner of the Business, or a related party, and which insures the principle owner or a related party.

1. The IRS may apply the sham-transaction doctrine.

2. The IRS may challenge the use of a reinsurance agreement as an improper attempt to divert income from a taxable entity to a tax-exempt entity and will reallocate income.

3. The life insurance policy issued to the Company may not qualify as life insurance for U.S. Federal income tax purposes because it violates the investor control restrictions.

Investor Control; The IRS has reiterated in its published revenue rulings, its private letter rulings, and its other administrative pronouncements, that the owner of a life insurance policy will be considered the income tax owner of the assets legally owned by the life insurance policy if the policy owner possesses “incidents of ownership” in those assets. Generally, in order for the life insurance company to be considered the owner of the assets in a separate account, control over individual investment decisions must not be in the hands of the policy owner.

The IRS prohibits the policy owner, or a party related to the policy holder, from having any right, either directly or indirectly, to require the insurance company, or the separate account, to acquire any particular asset with the funds in the separate account. In effect, the policy owner cannot tell the life insurance company what particular assets to invest in. And, the IRS has announced that there cannot be any prearranged plan or oral understanding as to what specific assets can be invested in by the separate account (commonly referred to as “indirect investor control”). And, in a continuing series of private letter rulings, the IRS consistently applies a look-through approach with respect to investments made by separate accounts of life insurance policies to find indirect investor control. Recently, the IRS issued published guidelines on when the investor control restriction is violated. This guidance discusses reasonable and unreasonable levels of policy owner participation, thereby establishing safe harbors and impermissible levels of investor control.

The ultimate factual determination is straight-forward. Any court will ask whether there was an understanding, be it orally communicated or tacitly understood, that the separate account of the life insurance policy will invest its funds in a reinsurance company that issued reinsurance for a property and casualty policy that insured the risks of a business where the life insurance policy owner and the person insured under the life insurance policy are related to or are the same person as the owner of the business deducting the payment of the property and casualty insurance premiums?

If this can be answered in the affirmative, then the IRS should be able to successfully convince the Tax Court that the investor control restriction is violated. It then follows that the income earned by the life insurance policy is taxable to the life insurance policy owner as it is earned.

The investor control restriction is violated in the structure described above as these schemes generally provide that the Reinsurance Company will be owned by the segregated account of a life insurance policy insuring the life of the owner of the Business of a person related to the owner of the Business. If one draws a circle, all of the monies paid as premiums by the Business cannot become available for unrelated, third-parties. Therefore, any court looking at this structure could easily conclude that each step in the structure was prearranged, and that the investor control restriction is violated.

Suffice it to say that the IRS announced in Notice 2002-70, 2002-2 C.B. 765, that it would apply both the sham transaction doctrine and ยงยง 482 or 845 to reallocate income from a non-taxable entity to a taxable entity to situations involving property and casualty reinsurance arrangements similar to the described reinsurance structure.

Even if the property and casualty premiums are reasonable and satisfy the risk sharing and risk distribution requirements so that the payment of these premiums is deductible in full for U.S. income tax purposes, the ability of the Business to currently deduct its premium payments on its U.S. income tax returns is entirely separate from the question of whether the life insurance policy qualifies as life insurance for U.S. income tax purposes.

Inappropriate Marketing; One of the ways in which captives are sold is through aggressive marketing designed to highlight benefits other than real business purpose. Captives are corporations. As such, they can offer valuable planning opportunities to shareholders. However, any potential benefits, including asset protection, estate planning, tax advantaged investing, etc., must be secondary to the real business purpose of the insurance company.

Recently, a large regional bank began offering “business and estate planning captives” to customers of their trust department. Again, a rule of thumb with captives is that they must operate as real insurance companies. Real insurance companies sell insurance, not “estate planning” benefits. The IRS may use abusive sales promotion materials from a promoter to deny the compliance and subsequent deductions related to a captive. Given the substantial risks associated with improper promotion, a safe bet is to only work with captive promoters whose sales materials focus on captive insurance company ownership; not estate, asset protection and investment planning benefits. Better still would be for a promoter to have a large and independent regional or national law firm review their materials for compliance and confirm in writing that the materials meet the standards set forth by the IRS.

The IRS can look back several years to abusive materials, and then suspecting that a promoter is marketing an abusive tax shelter, begin a costly and potentially devastating examination of the insured’s and marketers.

Abusive Life Insurance Arrangements; A recent concern is the integration of small captives with life insurance policies. Small captives treated under section 831(b) have no statutory authority to deduct life premiums. Also, if a small captive uses life insurance as an investment, the cash value of the life policy can be taxable to the captive, and then be taxable again when distributed to the ultimate beneficial owner. The consequence of this double taxation is to devastate the efficacy of the life insurance and, it extends serious levels of liability to any accountant recommends the plan or even signs the tax return of the business that pays premiums to the captive.

The IRS is aware that several large insurance companies are promoting their life insurance policies as investments with small captives. The outcome looks eerily like that of the thousands of 419 and 412(I) plans that are currently under audit.

All in all Captive insurance arrangements can be tremendously beneficial. Unlike in the past, there are now clear rules and case histories defining what constitutes a properly designed, marketed and managed insurance company. Unfortunately, some promoters abuse, bend and twist the rules in order to sell more captives. Often, the business owner who is purchasing a captive is unaware of the enormous risk he or she faces because the promoter acted improperly. Sadly, it is the insured and the beneficial owner of the captive who face painful consequences when their insurance company is deemed to be abusive or non-compliant. The captive industry has skilled professionals providing compliant services. Better to use an expert supported by a major law firm than a slick promoter who sells something that sounds too good to be true.