Contractor Tax Planning: Why Life Insurance Should Be Part of the Strategy
Every contractor knows the goal of business ownership is to be profitable. Yet every year contractors face unexpected financial challenges can end up severely affecting their businesses’ bottom line.
One thing that contractors can do to mitigate their risks is to seek tools that help shift financial and tax hazards to external parties or institutions. For this reason, tax planning is important for contractors at every stage of the business process.
While it might not be the first thing that comes to mind when looking to lower tax liability, life insurance is a tax planning tool that can help to reduce a contractor’s financial and tax perils, while providing additional financial security.
Life insurance is a contract between an insurer who promises to pay a premium (a specified amount of money) to an insurance company who promises to provide a financial benefit to the insurer should there be the loss of the life of the beneficiary.
Some of the most common types of Life Insurance Policies are:
• Term insurance: Provides coverage for a specified period and pays a benefit only if the insured dies during that term.
• Permanent insurance: Offers lifetime coverage with a fixed death benefit and a cash value component.
• Variable life insurance: Allows the policy owner to allocate cash values among investment options. This adds an additional risk factor due to the ability to increase the cash value because of greater earning opportunities.
• Universal life insurance: Features flexible premiums and adjustable death benefits, with cash values subject to current interest rates and charges.
Here are a few situations where contractors can benefit from life insurance policies:
Key Person Insurance
In this type of insurance policy this business obtains a policy on an employee who is key to the operation and success of the business. The insured must prove that the death of this employee will have a significantly negative effect on the business. While the premium for this policy is not deductible, the death benefits are completely tax-free to the business; the benefits are intended to replace income lost as a result of the key person’s passing, as well as to help recruit and train a replacement for that key role.
Buy – Sell Agreements
Life insurance can be used to fund buy-sell agreements. A buy-sell agreement is a contract among business owners that controls the ownership of the business by allowing remaining owners to purchase an owner’s interest when a triggering event such as death, divorce, or retirement occurs.
Simply put, these benefits will:
• Ensure continuity of ownership and management
• Prevent unwanted individuals from acquiring an interest in the business
• Provide liquidity for a departing owner or their estate
Attract and Retain Employees
When a business seeks to attract and retain employees, life insurance can provide an effective employee tax benefit. This option is attractive to the employee because it provides the death benefits for the employee’s beneficiaries as well as accumulating cash value (in the case of whole, variable and universal life insurance policies) which the employee will have access to, if needed, through loans.
In an executive bonus plan, the business pays the top-level employee a bonus equal to the amount of the life insurance premium. The employee owns the policy and names the beneficiaries. A bonus/premium is taxable to the employee and deductible by the business.
The typical structure involves:
• The top-level employee applies for and owns the life insurance policy.
• The employer pays the premium (as a bonus) directly to the insurance company or reimburses the top-level employee.
• The premium payment is included in the top-level employee’s taxable income.
• The employer deducts the bonus as a compensation expense
• Sometimes, a “double bonus” is used, where the employer also pays an additional bonus to cover the top-level employee’s income tax liability on the premium payment.
Deferred Compensation Plans
Life insurance can also be used to fund deferred compensation plans for owners or employees. In these arrangements, the business provides a life insurance policy as part of a supplemental retirement benefit. The employer typically owns the policy and pays the premiums, while the employee or owner is the insured and names their beneficiaries.
The cash value in the policy grows tax-deferred, offering a future source of retirement income. When structured properly, the business may receive a tax deduction for payments made to the employee or owner at retirement, and the death benefit is generally tax-free to the beneficiaries. This strategy can help reduce current tax liability by deferring compensation and provide valuable retirement and survivor benefits.
A Flexible Financial Planning Tool
These examples have only touched the surface in terms of the opportunities that life insurance policies can provide. They range from simple to highly complex policies that provide a financial and tax haven for contractors. Consider engaging a tax or financial professional who is well-versed in the nuances of tax and financial planning before attempting to implement any of the suggestions mentioned above.
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