Split-Dollar Critical Illness Insurance allows you to reduce risk and optimize tax in your company.
How it Works
Critical Illness insurance pays you a lump sum of cash when you are diagnosed with a life-threatening illness. Like other insurance contracts, you pay for the premiums each year (or, monthly). With Critical Illness Insurance, you can add a “Return of Premium” benefit to the contract. This benefit pays back 100% the insurance premium and the return of premium costs if you don’t get sick.
This strategy works by “splitting” these premiums (both the insurance and the return of premiums) between the corporation and the owner(s). The corporation pays for a majority of the cost (the insurance), while the owner personally pays for the Return of Premium. As you will see in the scenarios below, this helps reduce risk and taxes.
Reducing Both Taxes and Risk
There are three scenarios where we use this strategy with clients:
1. Single Shareholder of the Business
If there is a single owner/operator of the business, we want to protect this “key person”. While most people want to believe nothing bad will ever happen to them, that’s not what the statistics prove. For those who do have coverage, the business will receive a lump sum of cash so it can continue to operate.
To get the insurance benefit out of their company, the owner must pay personal tax. However, most clients are willing to pay the corporate insurance premium to hedge this risk. Fast forward 15 years, we can compare this strategy to paying yourself a salary. For example, to receive $90,000 after-tax, you need to pay yourself a salary of $120,000 to pay $30,000 in tax. Whereas you could cancel the Critical Illness contract to receive the return of premium benefit and save yourself $30,000 in taxes.
The premiums act as a “forced savings plan”. Relatively inexpensive, you are will likely forget about them. What you won’t forget is walking away with a lump-sum of cash personally in 15 years. You can’t thank your future self-enough for this. You have also benefitted from free insurance coverage for the past 15 years.
2. Two or More Shareholders of the Business
It is also common for a business to have multiple owners. For example, there may be one partner focused on operations while the other focuses on engineering. The risk is that the business cannot run effectively without both of them. This is a common use-case critical illness contract, in which it protects the company should a key person be unable to work.
Again, the company pays for the insurance benefit. If either partner makes a claim during the 15-year contract, the company receives the insurance benefit tax-free. The owners pay for the return of premium component of the contract. If neither partner makes a claim during the term they get 100% of the contract premiums back. The owner-paid premiums become trivial once you consider the amount of risk you are taking off the table and the future tax-benefits.
3. Optimizing the Sale of Your Business
Another application of this strategy is when you sell your business.
For example, a client recently sold their operating company. There is an earn-out provision included in the deal for the next few years. To optimize investment planning and tax reductions, we implemented an investment life contract with a fixed deposit schedule (to learn more about this strategy click here). We also structured a 100% Return of Premium Critical Illness contract to protect these scheduled deposits. If they get diagnosed, the Critical Illness contract will pay for the remaining deposit schedule, and not put them in financial risk. Think of it as the insurance for your investment insurance contract.
The client is depositing $100,000 for the next 5 years of the investment life contract. The Split Dollar strategy helps them mitigate the financial impact of a life-threatening illness. They are now positioned that if they were diagnosed, they would receive a lump-sum injection of cash, allowing them to spend It as they choose. They no longer need to worry about using their savings or future income to pay for the scheduled deposits of the investment life contract, or other financial commitments. This allows them to focus on getting better.
In this scenario, the strategy works whether you get sick or not:
- If you do get diagnosed, the contract ensures you are financially secure.
- If you do not get diagnosed, this is another clever way to get tax-preferred money out of your company.
We see this as an under-utilized strategy that is essential for protecting your finances, business, and health. Your greatest asset health, followed by your businesses ability to earn future income. This dual-purposed strategy allows you to protect both, and use this to optimize tax.
How do I know if this strategy is for me?
Give us a call. The correct design will vary based on your age, income, and needs. Please speak with us to see if this strategy is right for you.
We look forward to chatting.
By the way, we recently wrote this article on Bomb Shelter Investing. You should definitely check it out.