For some companies self insurance was a popular idea a few years ago. There is a similar idea that allows business owners to become their own banker. In today's business environment, this may be an alternative to consider. As described in the book "Becoming Your Own Banker" written by R. Nelson Nash, business owners are using a form of self-banking for their business. There are several alternatives you can use to finance your bank; however, Nash determined the most effective method is to use dividend-paying whole life insurance.
With a life policy properly designed towards banking, cash values that accumulate tax-deferred in your policy can be accessed to fund your business' working capital needs or equipment financing. In this plan, you are lending to your business, and it is paying you back principal and interest. You can begin immediately to borrow against your insurance policy as long as the policy has built up sufficient cash value. The cash values in the life policy will continue to grow through the guaranteed rates of interest paid, tax-free dividends and the business' repayment of their loans.
These types of dividend-paying life insurance policies are designed to utilize paid-up additions to make cash values available to the policy owner as quickly as possible. In order to preserve the favorable tax treatment of life insurance, the policy (bank) needs to be set up to avoid the trap of qualifying as a Modified Endowment Contract (MEC). To do this, the policy must be designed with sufficient death benefit, for a given age of the applicant, to allow for the amount of premiums planned to be paid into the life contract. The MEC limits are calculated by the insurance companies, and are monitored during the life of the policy to help the policy owner keep his policy MEC-compliant. MEC policies lose many of the tax advantages of a life insurance policy, and are taxed more like an annuity product.
This self-banking strategy is designed for business owners who have the discipline to pay back the loans at market rates on a timely basis. In effect, instead of paying large amounts of interest to financial institutions, you are building your own bank and cash value as long as you pay the loans back in a timely manner. With these funds growing annually, your bank has the potential to be a significant portion of your net worth and of your estate, and even enjoy some creditor protection under current Nevada state law!
Let's review the income tax and estate planning benefits:
Self-banking should be set up so that you take a loan from your policy and, in turn, prepare a promissory note from your company to you. The company then makes payments; principal and interest to you, the lender, on a monthly basis and you repay the money into your policy. Your business pays the policy loan back to you over a reasonable time, as set in your loan agreement. The interest portion is a deductible business expense. The interest income you earn as an individual and deduct by your business offset each other. The net effect is a zero taxable impact to you, as long as your business is a pass-through entity for tax purposes.
Self-banking has estate planning benefits too. The annual increases in cash value are not subject to current taxation, and the policy death benefit is passed income-tax-free to your beneficiary(ies). As the values of the policy increase, the tax-free death benefit is designed to increase as well.
Also, if the loan to the business from the policy holder is outstanding at death, the loan is forgiven and is not subject to estate tax. Here is an example: A business owner takes $50,000 loan from his $500,000 individual life insurance policy and lends to his business for equipment financing. If, at his death, there is a loan balance of $25,000, the policy loan of $25,000 is paid off at death, and the net death payment to the business owner's beneficiary is $475,000 income tax free. Wow! Your wealth building opportunities and tax benefits are extraordinary.
Is it time for you to self-bank for your business needs? For some business owners, this is a great strategy for their lending, building net worth, and tax planning. It will even provide a compelling alternative to your traditional retirement funding plans. For further information on your particular situation and circumstances, seek advice from your tax advisor.
Scott T. Wait, CPA, is a shareholder in RS Wait of Reno and is an affiliate office of the McLean Group, a merger and acquisitions firm serving the middle market nationwide. Contact him at scott@rswait.com or through www.rswait.com.
Nick Stosic of Stosic Wealth Strategies also contributed to the article. Contact him at 853-5533 or nick@insurancereno.com.
