By Dan Cotter

What is the most common error business owners make in regard to life insurance?

In a word: Titling. The most common mistakes are in ownership and beneficiary designations. A business might own a life insurance policy on the life of the owner or major shareowner, for example, and name another shareowner or the owner’s spouse as beneficiary. Third party ownership can be tricky, and it is almost always a mistake to have a beneficiary someone or some entity other than the owner.

Here’s a real life example. A Michigan corporation purchases a policy on the life of the president of the company. The corporation is the owner and pays the premium. As a benefit, they allow the president to name his spouse and children as beneficiaries. What are the potential tax pitfalls? At death, the corporation has effectively made a gift equal to the death benefit to the beneficiary. Gift taxes could be owed by the company and the life insurance proceeds taxable to the beneficiaries. Further, the premiums could be considered dividends and taxed to the president’s estate. As a rule of thumb, life insurance policies with owners other than the insured should have the beneficiary designation match the ownership designation. Too often, executive benefits or buy sell arrangements can cause major tax traps when policy titling is poorly done.

What is the most important thing business owners should know about their life insurance?

This period of sustained low interest rates is toxic for life insurance policies. Life insurance is a dynamic instrument, susceptible and vulnerable to interest rate conditions. In business, life insurance is purchased to fund promises to key people, to provide capital for stock redemption and buy sell arrangements, and even to provide cash injections if key people die. All of these noble purposes could go unmet if your policies waste away while no one is paying attention. Business owners must review their policies.

Are all policies wasting away?

Some are just fine. Others are actually over funded. But the point is that these are dynamic instruments with moving parts and periodic reviews are prudent exercises.  Corporate owned policies — so-called COLI (corporate owned life insurance) plans provide another good example. Lots of COLI plans are for promises like deferred compensation or supplemental retirement plans for executive classes. COLI plans are typically funded with variable life insurance, meaning the cash values change up or down with stock and bond markets. What a wild ride these products have had these past few years! On the other hand, we recently looked at a corporate-owned group of policies purchased to fund stock redemptions to keep company stock closely held. These policies were very conservative whole life plans with very robust cash values. You look at these on the surface and your first reaction is these are high cash value products with no exposure to stock market or interest rate volatility. The problem was these very were very expensive, rather outmoded policies that were safe, but could be transitioned into more modern products that are just as safe but with more efficient cost benefits.

What other mistakes do business owners make with business life insurance?

Probably the next big thing is with key person life insurance. Lots of small businesses have a big life insurance policy on the person who owns and runs the company. The business is the owner and the beneficiary. Sounds fine, right? Key person is a terrific idea, but you need to be careful when the key person is a stockowner. Let’s suppose you have a company and your estate will pay federal estate taxes upon your death. Upon your death, your estate includes all your assets, inclusive of the stock in your company valued at date of death. The value of your stock will now increase because your company will receive $5 million (or whatever your policy was worth), inflating your stock value and your estate tax bill. The net effect of key person life insurance: a higher estate tax bill.