What good is a strategy if it doesn’t make economic sense?
In this post, we’re going to review the economic benefits of the Business Owner Benefit Plan versus a taxable investment.
For those who are unfamiliar with the Business Owner Benefit Plan, it allows for a business to make a 100- percent deductible contribution to the BOBP. The participant typically recognizes 30-percent of the total contribution on their individual tax return in the form of an 83(b) election.
Once the contribution is made to the Business Owner Benefit Plan, the trust purchases a whole life insurance policy. The whole life insurance policy is necessary to recognize the deduction. There must be a business purpose for the life insurance death benefit to qualify.
A whole life insurance policy is a conservative, fixed asset class. It is comparable to a Certificate of Deposit (CD), bond portfolio, etc.
“When we compare the BOBP to a taxable investment it is important to keep in mind the taxable investment must earn an equivalent rate of return using a conservative, underlying asset class like the abovementioned.”
The whole life insurance policy provides several benefits:
- It allows the plan to recognize the deduction
- Provides tax-deferred growth and tax-advantaged withdrawals
- The death benefit self-completes funding of the plan if death occurs
- Works well in conjunction with buy/sell agreements and key man coverage Includes a residual death benefit after all distributions have been made
In general, a unique component of any permanent life insurance policy is its tax efficiency. Permanent life insurance allows for tax-deferred growth, and the ability to access cash flow tax-free. And, in most scenarios, the death benefit is income tax-free.
Business Owner Benefit Plan versus a Taxable Investment
To analyze a Business Owner Benefit Plan versus a taxable investment we need to make a few assumptions:
- 45-year old, male business owner
- Wants to contribute $100,000 per year for 10-years
- 45-percent tax rate
NOTE: The Business Owner Benefit Plan can only be set up by an established business entity: S-Corp, C- Corp, LLC, or LLP (sole proprietors or LLCs taxed as a sole proprietor are not eligible). In addition, in order to establish a plan, the business entity must commit to a minimum annual contribution of $50,000 or more for a period of at least 5-years.
To understand the economics of a Business Owner Benefit Plan versus a Taxable Investment we’re going to break it down into the following three phases:
Phase 1 – Funding Period
Phase 2 – Policy Distribution and Deferral
Phase 3 – Withdrawal Period
Phase 1 – Contribution Period
During Phase 1 the participant is going to contribute $100,000 per year for 10-years to the Business Owner Benefit Plan.
Since the “business owner/participant” is going to recognize $30,000 of income on their personal return it is important to take this into consideration for purposes of our comparison. In order to net the $30,000 taxable amount, the participant will owe taxes of $24,545. Therefore, to net a $100,000 contribution to the Business Owner Benefit Plan, the participant will need to gross $124,545.
Now that this has been established, if the participant makes the decision to not participate in the Business Owner Benefit Plan, and instead chose to pay taxes on $124,545 they would recognize net income of $68,500.
The result is a contribution to the Business Owner Benefit Plan of $100,000 and $68,500 into a taxable investment. The goal of completing this analysis is to determine what rate of return the taxable investment would have to earn to equal the cash flow performance of the Business Owner Benefit Plan.
Here you will see the $100,000 being contributed to the Business Owner Benefit Plan, and $68,500 being contributed to the Taxable Investment Comparison. We have assumed an 8-percent rate of return for the taxable investment comparison.
You will notice the cash value of the Business Owner Benefit Plan whole life insurance policy has
$1,006,413 versus the $861,323 in the Taxable Investment Comparison at the end of Year 10. In addition, the Business Owner Benefit Plan provided an initial death benefit of $3,876,218 that grew to $4,783,776 by year 10.
Phase 2 – Policy Distribution and Deferral
In Phase 2 the whole life insurance policy is distributed from the Business Owner Benefit Plan to the participant. At distribution, the participant will recognize income taxes on a portion of the cash value.
We are going to assume taxes owed on the distribution are going to be paid in the form of a distribution from the policy. We are also assuming the participant chooses to defer any additional income from the policy for ten more years until they turn age 66.
First, you’ll notice the distribution from the policy in Year 11 for $187,549. This amount represents the taxes that will be owed on the distribution of the policy from the Business Owner Benefit Plan assuming a 45-percent tax rate. This amount is withdrawn from the policy tax-free to the participant.
Second, we have reduced the death benefit of the policy from $4,783,776 in Year 10 to $1,799,032 in Year 11. This allows the cash value of the policy to grow at a faster rate. Cash value growth in a life insurance policy is tax-deferred. You will also notice that as the cash surrender value grows so too does the policy death benefit.
Phase 3 – Withdrawal Period
During the withdrawal period, the participant receives tax-free distributions from the policy. In this example, we have assumed the participant begins withdrawals at age 66. Nothing says the participant must take withdrawals at age 66.
When the policy is distributed from the Business Owner Benefit Plan the participant can choose when they would like to receive distributions. And, unlike a qualified plan, the participant is not required to begin minimum distributions beginning at age 72.
In this example, beginning at age 66, the participant receives net income of $99,095 per year for 20- years from the Business Owner Benefit Plan for a total of $1,981,900.
Under the taxable investment, assuming an 7.5-percent rate of return, the participant receives net income of $88,903 for 17 years and $93,782 in year 18. The total net income distributed from the taxable investment is $1,778,397.
Each time income is taken from the policy the death benefit is reduced. But, in addition to the income received, the policy still has a $443,182 death benefit. The remaining death benefit will be paid to the insured’s beneficiary at their death income tax-free. It is important to keep the life insurance coverage in force after all the withdrawals have been taken to avoid a large portion of the distributions from the policy from becoming taxable.
For participants in states with high-income taxes, the rate of return needed to keep up with the Business Owner Benefit Plan is much higher. In some cases. The higher the tax rate the larger the rate of return required for a taxable investment to match the performance of the Business Owner Benefit Plan.
Again, it is also important to remember we are using a conservative, fixed asset class. If your fixed asset portfolio is earning more than 8-percent, then it probably makes sense to not participate in a Business Owner Benefit Plan.
But, you should also remember the Business Owner Benefit Plan provides a rather significant death benefit. The value of this should not be overlooked.
What Did the Business Owner Benefit Plan Accomplish that the Taxable Investment did not?
The Business Owner Benefit Plan reduced the participant’s tax rate on plan contributions from 45-percent to 15-percent. It also provided a $100,000 annual deduction for the business. In the event death was to occur, BOBP provided a death benefit to the participant’s beneficiary.
Lastly, the Business Owner Benefit Plan provided $1,981,900 of tax-free income to the participant.