|Life Insurance Policies in a Medical Corporation
Common errors exposed.
December 15, 2011
My October and November columns have focused on the importance of careful succession planning for the continuation of a closely-held businesses – particularly for those with no ready market for the transference of ownership and those that don’t have non-owner managers.
But sometimes businesses can plan too much. That was the case with Jonesville Orthopedic Clinic. Life insurance agents led these physician shareholders so astray and caused them to be so over planned that they were nearly ready to tear apart their practice.
Common Errors Exposed
Jonesville Orthopedic Clinic (JOC) is a corporation with four senior orthopedic surgeons who are shareholders. For a decade, life insurance issues have been a constant source of irritation and confusion among the doctors because each was insured with three separate policies.
One set was purchased to informally fund a deferred-compensation plan. Another set was purchased as key-man insurance (coverage that protects the company in the case of an untimely death or disability of a top salesperson, executive or business owner), so the clinic had the funds to retain another orthopedic surgeon if one of the doctors died. The final set of policies were purchased to redeem a deceased doctor’s stock, but were never able to agree upon a price for the repurchase of their stock. Annual JOC business meetings became chaotic once the office manager opened up the life insurance file for discussion. It is now time to clean up this mess.
The planning that justified purchasing life-insurance policies to informally fund a deferred compensation plan was seriously flawed. The promise made when the plan was set up 10 years ago — to provide a $75,000 annual benefit for 15 years starting when doctors reach age 62 — is not going to be met because the cash values are much less than had been projected. In fact, the current projection is that only about half of the $75,000 of annual deferred benefits will be possible without huge increases in premiums. This is because the benefits were defined 10 years ago with the payment of fixed premiums. As interest rates fell since 2000 (from six percent to four percent) and several premiums were missed, the policies have become increasingly underfunded without anyone noticing. What the doctors did not understand at the time is that this program never could have worked without periodic adjustments to the funding levels in order to meet the defined benefits (DB) established by the plan. Since JOC didn’t have the funds to make up this funding shortfall, dramatic adjustments had to be made to the plan.
Deferred compensation plans were used to motivate and reward employees — not employers. Each participant in the clinic’s deferred compensation plan was a shareholder or employer. There has typically been a narrow spread between corporate and individual tax rates, so there hadn’t been any rational justification for putting together a collective company retirement=income scheme funded with life insurance for employers, at least when each doctor could have taken the amount of after-tax corporate earnings as income, paid their own taxes and used the net to set up their own retirement fund. Purchasing a collective plan when individual action would have worked much better has been a constant problem as three times in the past 10 years new life insurance salesmen have come forward to criticize the policies funding deferred compensation plan in order to recommend their replacement with new ones. Fortunately, nothing had been done because the doctors could never agree on new collective action.
The doctors decided to rid themselves of this deferred compensation problem through life insurance policy transfers and funding it informally to each insured and terminating the plan. Now they can individually continue their policy or reinvest as they choose without convincing the other three doctors.
The clinic had $100,000 universal life (UL) insurance policies insuring each shareholder to indemnify the doctors for the cost of replacing a deceased surgeon. I doubt that key-man policy was ever needed in this situation. The clinic now employs two non-shareholder surgeons, so the need is definitely absent now. These key-man policies will be transferred to the insured doctors to do with as they wish.
The last set of policies had been used to fund a buy-sell agreement. They were overpriced ULs. Each shareholder was insured for $250,000, but the value of JOC stock was never been agreed upon. Shareholders have argued for per shareholder value of between $200,000 and $800,000 at various times over the years. The doctors decided that rather than attempt to find the perfect fluctuating value, they would agree on an arbitrary value of $250,000, transfer the ULs to the insured doctor and purchase cheap level-term policies to fund this agreed-upon amount. This would end the potential for a pitched legal battle between JOC and a deceased shareholder’s family as each tried to argue a value for the stock to be redeemed. What had been a confusing life insurance mess is now cleaned up.
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Peter Katt, CFP, LIC, is a fee-only life insurance advisor since 1983, he has written insurance columns for AAII Journal and Journal of Financial Planning since 1991.
* DISCLOSURE: Readers should assume that all insurance advice mentioned in this column are the author’s and/or his firm’s unless otherwise noted and does not necessarily reflect the views of the AICPA or the AICPA Wealth Management Insider.