Case Scenario
Meet Michele. She is the owner of a small but thriving awning manufacturing company, Canopy, Inc. (Canopy), which employs 20 full-time people. She realizes that the success of the business is due to two key people — David and Ernie. Michele doesn’t want them to leave and go to work for the competition, so she is looking for a strategy that will entice them to stay at Canopy. She is hesitant to just pay them a higher salary or to give them a cash bonus because, although she likes the income tax deduction for Canopy, she knows that as soon as she pays them, she will lose control, and they may spend the money.
Both David and Ernie have families, and Michele wants to help these key people save for retirement and protect their families if one of them should die prematurely. Additionally, Michele wants to retain some element of control over whatever strategy she chooses. So, she is looking for an approach that will get an income tax deduction for Canopy but also allow it to maintain some control over any money spent on the strategy.
Goals
- Entice David and Ernie to stay at Canopy.
- Provide a death benefit for their families.
- Help supplement their retirement income.
- Create a current income tax deduction for Canopy.
- Maintain control over any strategy that is put in place.
the employees you rely on most
is essential to the success of your
business. There are many ways to
incentivize these key people.
A Possible Solution
Michele contacted her financial professional, who suggested an executive bonus arrangement. This arrangement provides that David and Ernie must be insurable, and then purchase personally owned permanent life insurance policies on their lives and name the beneficiaries. Canopy pays both of them annual bonuses of $10,000, which is equal to the premiums. The bonuses are tax-deductible to Canopy and currently taxable to David and Ernie. Assuming David and Ernie are both in the 30% income tax bracket, they would each pay $3,000 of tax on the bonus. Under an executive bonus arrangement, both of them will also own any potential policy cash value and be able to access1 the cash value at retirement through loans and withdrawals. However, they can also surrender the policy at any time, which conflicts with Canopy’s interest in having some control over any strategy that is put into place — in this instance, the cash value.
That is where a leveraged bonus arrangement can help. It is set up the same way as an executive bonus arrangement except that instead of David and Ernie paying the $3,000 of income tax on the bonuses, Canopy agrees to lend to them the amount of income tax on the premium bonuses, or $3,000. Interest is paid on the loan based on a rate equal to or greater than the appropriate applicable federal rate. Each year, Canopy will loan $3,000 to David and Ernie so they can pay the income tax associated with the premium. Therefore, each year, the loan balance (plus interest) will grow. To protect against David or Ernie not repaying the loan, the loan is secured by a collateral assignment of the policy cash values. This provides the control that Canopy wants. It will prevent David and Ernie from accessing1 the cash value through loans and withdrawals without permission from Canopy. Additionally, if either of them does end up leaving Canopy and doesn’t voluntarily repay the loan, Canopy can contact the issuing insurance company and request repayment of the loan from the cash value of the life insurance policy. If David or Ernie dies, the loan is first repaid from the death benefit, with the balance going to the named beneficiaries.