At Life Insurance Strategies Group, we are increasingly running into the use of insurance LLCs in business succession planning, replacing traditional entity-owned and cross-purchase structures. Insurance LLCs are a strategic and flexible tool that can facilitate the seamless transition of business ownership, mitigate financial risks, and ensure the financial security of both business owners and their successors.
Statistically, a minority of businesses have documented succession plans and even fewer have those plans funded. Business succession planning is a crucial aspect of any organization's long-term sustainability. It involves designing a comprehensive strategy to transfer business ownership, management control, and key assets from one generation to the next or to designated successors. Insurance LLCs have emerged as a valuable tool within the realm of business succession planning due to their unique characteristics and benefits.
What is an Insurance LLC?
An Insurance LLC is a special-purpose entity formed by a business owner to protect and manage insurance policies used for business succession planning. It acts as the owner and beneficiary of these policies, providing a centralized and structured approach to funding the succession plan. This arrangement offers several advantages to a company, such as asset protection, tax efficiency, and enhanced liquidity.
Asset Protection - By utilizing an Insurance LLC, business owners can shield valuable assets from potential creditors and legal claims. Insurance policies held within the LLC structure are often protected from creditors, providing an added layer of security during the business transition process.
Tax Efficiency - Insurance LLCs offer potential tax advantages for business owners. Depending on the jurisdiction, the premiums paid towards insurance policies may be tax-deductible, and the proceeds from the policies can be received tax-free or with favorable tax treatment.
Liquidity - One of the primary challenges in business succession planning is ensuring sufficient liquidity to facilitate a smooth transition. Insurance LLCs address this concern by creating a pool of funds that can be readily available upon the occurrence of triggering events, such as the retirement, disability, or death of a business owner. The tax-free nature of insurance policy proceeds makes them an attractive source of liquidity.
Smooth Transition – Perhaps most importantly, Insurance LLCs ensure a seamless transfer of ownership and control of the business by providing funds for the purchase of the outgoing owner's interest. This minimizes potential disputes, preserves business continuity, and maintains stakeholder confidence during the transition process.
Implementing Insurance LLCs
While it is not a technical step in establishing and implementing an Insurance LLC, communicating the succession plan to those who need to know about the plan is vital. A succession does not simply start when a current owner or owners walk out the door. It starts with accepting that a transition will happen – voluntarily or involuntarily – and it is the best interest of all parties to work to stay in control of the outcome to the extent possible. Communicating the plan lets others know of the responsibilities when it comes to a company’s succession strategy.
Next, establishing an Insurance LLC requires compliance with relevant legal and regulatory frameworks. Consultation with legal and financial professionals is essential to ensure compliance with state laws and regulations governing the formation and operation of LLCs and insurance policies.
After the advisory team is assembled, business owners must engage in comprehensive planning to determine the appropriate insurance coverage needed to fund the succession plan adequately. Factors such as the business's value, projected growth, and potential risks should be taken into account to ensure that the insurance policies held by the LLC adequately meet the future financial needs.
At this stage, it is crucial to select life insurance policies that align with the goals and objectives of the business succession plan. Considerations such as term life insurance, whole life insurance, and key person insurance should be evaluated to determine the optimal mix of coverage to address various succession scenarios.
How an Insurance LLC Works
An Insurance LLC might work like this: A holds a 35% overall percentage interest in the operating entity, and B holds a 5% overall percentage interest in the operating entity. A and B are the beneficial owners of a policy insuring C’s life, with the annual premium being $1,000. A would make an annual contribution of $875 (35% / 40% x $1,000), and B would make a contribution of $125 (5% / 40% x $1,000).
Typically, the operating entity will pay the life insurance premiums on behalf of its owners so as to ensure the premiums are paid. Provisions can be included in the operating entity’s buy-sell agreement requiring the entity to make contributions to the Insurance LLC on behalf of its members, and the entity is to treat those contributions as deemed distributions to its owners, who as noted above, are also the owners of the Insurance LLC. A separate capital account is maintained for each policy of which a member is designated as beneficial owner and credited for the contribution made to pay the insurance premium.
Assuming the policy held by the Insurance LLC is a term policy, over the course of the year the contribution expires as the policy will lapse without further payments. Each time a new contribution is made by the members to pay the premium, the ownership of the death benefit is reallocated. This accounting is done separately for the policy on each owner. Note that if a policy held by the Insurance LLC is a policy with cash value, the contributions will not expire and will remain reflected in the capital account for that policy. Separate capital account maintenance allows insurance proceeds received by the Insurance LLC to be allocated only to those surviving members who have the obligation to purchase the deceased member’s interests in the operating entity.
At the death of any of A, B or C, the Insurance LLC’s manager collects the insurance proceeds. The manager first uses those proceeds to redeem the deceased member’s Insurance LLC interest for fair market value, which is equal to the deceased member’s capital account (which at the time of redemption needs to be adjusted for any value in the policies allocated to such deceased member). When all purchase arrangements for the deceased owner’s interest in the operating entity have been finalized, the manager then distributes the remaining insurance proceeds to those surviving Insurance LLC members designated as the beneficial owners of the policy(ies), who are also the same business owners required to purchase the deceased owner’s interests under the operating entity’s buy-sell agreement. These surviving owners immediately use the proceeds to purchase the deceased owner’s interest.
Plan to Exit
Insurance LLCs are an increasingly popular tool in business succession planning, offering significant advantages in terms of asset protection, tax efficiency, liquidity, and facilitating a smooth transition. However, their implementation requires careful consideration of legal and regulatory requirements, comprehensive planning, and the selection of appropriate insurance policies. By harnessing the potential of Insurance LLCs, business owners can secure their legacy, protect their assets, and provide a solid foundation for the continued success of their enterprises.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.