Module 04

Module 4
Considerations for
Business Owners
Craig Kinnunen, MS, CFP®
Kristen MacKenzie, MBA, CFP®, CRPC®
David Mannaioni, CFP®, MPASSM
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Table of Contents
Introduction ............................................................................ 1
Chapter 1: The Legal Forms of Doing Business..................... 4
Types of Businesses, Their Characteristics, Advantages,
and Disadvantages .............................................................. 4
Chapter 1 Review ............................................................. 17
Chapter 2: Retirement Plans ................................................ 18
Types of Plans .................................................................. 18
Chapter 2 Review ............................................................. 34
Chapter 3: Property and Liability Risk Issues for
High Net Worth Clients .................................................... 35
Client Profiles ................................................................... 35
Risk Management Techniques ........................................... 39
Property Risks for the High Net Worth Client ................... 41
International Risks ............................................................ 50
Chapter 3 Review ............................................................. 52
Chapter 4: Personal, Security, and Professional Risks ........ 53
Entertaining Guests ........................................................... 53
Serving on a Board ........................................................... 54
Personal Security Risks..................................................... 55
Professional and Employer Risks ...................................... 57
Chapter 4 Review ............................................................. 60
Chapter 5: Life and Disability Insurance for the
Wealthy Client .................................................................. 61
Life Insurance ................................................................... 61
Annuities ........................................................................... 67
Disability Insurance ........................................................... 68
Finding and Using the Right Tools .................................... 69
Chapter 5 Review .............................................................. 69
Chapter 6: Exit Planning for the Small Business Owner ..... 70
A Primer on Exit Planning ................................................. 71
The Steps in the Exit Planning Process .............................. 74
Potential Exit Planning Paths ............................................. 76
Valuing an Unlisted Business ............................................ 83
Buy-Sell Agreements Between Existing Shareholders ........ 84
Chapter 6 Review .............................................................. 89
Summary ................................................................................ 90
Chapter Review Answers ...................................................... 91
Chapter 1 ........................................................................... 91
Chapter 2 ........................................................................... 93
Chapter 3 ........................................................................... 95
Chapter 4 ........................................................................... 97
Chapter 5 ........................................................................... 98
Chapter 6 ......................................................................... 100
References ............................................................................ 104
About the Authors ............................................................... 105
Index .................................................................................... 106
Introduction
H
ave you ever asked yourself what type(s) of people are your best
clients? If you have not, skim through your list of clients and make a
note of those with whom you are actively engaged and who are
decisive in the way they conduct their business with you. Chances are that a great
number of these clients are small-business owners, partners in professional
groups, or retired individuals from either of these groups. Now ask yourself what
the special needs are of this group, and how you can effectively serve those
needs.
This module focuses on one of the most important classes of clients for the
investment professional: small-business owners and professionals in their own
practices. As a group, these clients tend to have a high net worth and a variety of
financial needs that the investment professional can effectively serve.
The majority of business owners are small-business owners, and because of their
impact on employment, innovation, and wealth creation, they have been the
subject of academic study for several decades. As distinct from other workers,
these individuals are found to have:
 a greater need for achievement,
 a greater need for control of their activities,
 greater risk-taking propensities,
 a higher level of interest in wealth and material gain, and
 a greater tolerance for ambiguity.
Unlike salaried managers in large corporations, business owners do not act as

agents, but as principals, and their decisions affect their personal fortunes
directly. Every experienced investment professional will recognize the greater
comfort level that the typical business owner has in making personal investment
Introduction  1
decisions when compared to the typical salaried employee. Salaried employees
making decisions with their employer’s money may take far less risk when
investing their own money. For the small-business owner, every decision
involves his or her own money.
In addition to investment planning, small-business owners often require

assistance with their liquidity, retirement planning, risk management, and general
financial planning needs. Being well-versed in more than just one of these areas
can open up considerable opportunities for serving the client. The eventual
transfer of the business likewise provides ample opportunities for the investment
professional, not only with regard to investment of any funds generated, but also
for tax planning, retirement planning, and estate planning related to any of the
exit planning strategies the business owner may utilize.
The chapters in this module are:
The Legal Forms of Doing Business
Retirement Plans
Property and Liability Risk Issues for High Net Worth Clients
Personal, Security, and Professional Risks
Life and Disability Insurance for the Wealthy Client
Exit Planning for the Small Business Owner
Upon completion of this module, you should be able to understand certain

financial planning and exit planning issues for the small-business owner.
2  Considerations for Business Owners

To enable you to reach the goal of this module, material is structured around the
following learning objectives:
4–1 Explain important tax and non-tax characteristics, advantages, and

disadvantages of the various forms of business entities.
4–2 Explain how various retirement plans may be utilized to reduce

taxable income while providing an important benefit to owners and
employees.
4–3 Analyze the risk management process and the property and liability
risks for high net worth individuals and make appropriate
recommendations.
4–4 Analyze the personal, security, and professional risks for high net
worth individuals and make appropriate recommendations.
4–5 Analyze the need for life and disability insurance for the high net
worth client and make appropriate recommendations.
4–6 Explain the characteristics, advantages, and disadvantages to the

various exit planning methods available to business owners.
Look for the boxed objectives throughout this module to guide your studies.
Introduction  3
Chapter 1: The Legal Forms of
Doing Business
H
ow are small businesses organized? From the standpoint of financial
planning and the rendering of investment advice, does it matter if a
client is a sole proprietor, partner, or owner of a closely held
corporation? What are the tax and other aspects of these legal forms of
organization that matter to the investment professional whose client is a small-
business owner?
Reading this chapter will enable you to:

Types of Businesses, Their Characteristics,

Advantages, and Disadvantages
Sole Proprietorship
A sole proprietorship is a business owned by one person that is not operated (or
organized) as a corporation, partnership, or trust. An owner of a sole
proprietorship is called a sole proprietor. A sole proprietor is personally liable for
the debts and obligations of a sole proprietorship.
According to the Small Business Association (SBA), over 70% of businesses in

the U.S. are sole proprietors/sole traders, many of which will be in service
industries such as a consultant or a freelance writer.

Advantages of Sole Proprietorships
 It is simple to set up. The sole proprietorship requires no legal charter and no
formal declaration or filing. Depending on the location, a local permit may
be required to set up shop. If business is not conducted in the proprietor’s
name, a trade name affidavit may need to be filed with some county or state
office. Of course, a sole proprietor must keep records for business and tax
purposes and pay self-employment taxes for Social Security and Medicare.
 Decision making and control are easier. Since one person is the owner,
there are no management committees, boards of directors, and so forth
needed to approve activities or review results.
 The sole proprietor owns it all. All the wealth, in excess of expenses,
generated as cash flow or as operating assets belongs to the owner.
 Profits of the business are taxed only once. Sole proprietorships are pass-
through entities for tax purposes. Business earnings are the owner’s personal
earnings and are taxed as personal income. There is no corporate level of
taxation between the earnings of the business and what the owner receives.
Disadvantages of Sole Proprietorships
 The sole proprietor typically lacks checks against his or her business
judgment. The committees, staffs, and boards of large corporations may
complicate decision making, but they act as filters, identifying risks and
suggesting alternative courses of action. The sole proprietor goes it alone.
 The sole proprietor has “unlimited personal liability”—that is, legal

responsibility—for all debts of the business. This means that the entire
accumulated wealth of the owner is at risk for any and all liabilities that
develop in the business. There is no wall between the financial estate of the
business and that of the owner. If the business cannot pay its debts, the
personal property of the business owner can be claimed by creditors.
Chapter 1: The Legal Forms of Doing Business  5

 Capital is generally difficult to obtain and tends to be more expensive for
the sole proprietor. Unlike some corporations that can tap larger pools of
capital in return for shares of ownership, the only pools for the sole
proprietor are the owner’s own pockets. Banks are cautious about lending to
proprietorships, and that caution is expressed in the form of higher interest
rates and the requirement of a personal guarantee by the owner to repay the
debt.
 The tax advantages on employee benefits available to corporations are less

available to sole proprietors. For example, the full deduction for group term
life insurance available to corporations is not available to the sole proprietor.
(although, in certain situations, a self-employed individual may be allowed to
deduct 100% of the cost of health insurance and a limited amount of long-
term care insurance as an adjustment to income.)
 The business does not outlive the owner. The entity folds when the owner
quits, retires, or dies. Compared with a corporation or partnership, estate
planning for a sole proprietorship may be difficult. For example, it may be
difficult to gift away assets held by a sole proprietorship.
This problem with capital ultimately limits the growth potential of the sole
proprietorship. Thus, the sole proprietor business owner may be very successful
and grow wealthy over time, but the inability to finance expansion almost always
confines the operation to the category of “small” business.
Partnerships
A partnership is an association of two or more persons to carry on a business as
co-owners for profit. By tradition, many of the skilled professions such as
accounting, architecture, law, and medicine are organized as partnerships. The
fields of finance, real estate, and insurance also use this business form. Compared
to the other legal forms of doing business, partnerships are rare; again according
to the SBA, approximately 7% of all U.S. businesses operated as partnerships.
(Source: Internal Revenue Service.)

Advantages of Partnerships
 They are easily formed, requiring only a partnership agreement between

the two or more owners. This agreement may or may not be in writing.
 Decision making is relatively simple, as the number of parties involved is

generally less than a handful.
 Like the proprietorship, the partnership is a pass-through entity and

earnings of the partnership are treated as the personal earnings of the
partners, and thus are not subject to double taxation, although an
informational partnership tax return (Form 1065) must be filed.
 The enterprise can survive the death or withdrawal of one or more

partners. The departing partner can withdraw his or her interests in a manner
spelled out in the partnership agreement. (From a strictly legal standpoint, a
partnership cannot survive the death of any one partner, but various
agreements can assure the partnership’s continuation.)
Because partnerships have more “pockets” from which to draw to fund capital
and operations needs, they have the potential to grow larger than sole
proprietorships. A law firm of 10 partners, for example, can tap the financial
resources of 10 professionals instead of one if they agree to expand operations.
Disadvantages of Partnerships
 Each partner is fully liable for the debts of the partnership—a condition
known as “joint and several liability”—and that liability extends to the entire
net worth of each partner. Thus, the actions of partner A can create a
situation for which partners B, C, and D are fully liable.
 Disagreements between partners can lead to dysfunctional business
operations.
 The withdrawal of any single partner can put the enterprise into financial
distress.

 Access to capital is a problem. Like the sole proprietorship, partnerships
must look to their owners’ personal funds and borrowing capabilities to raise
money. The fact that the pockets of two or more people are available
generally puts the partnership in a better position than the sole proprietor, but
the money-raising potential of the partnership remains small relative to the
corporation.
 The tax advantages on employee benefits available to corporations are less
available to partnerships. For example, the full deduction for group term life
insurance available to corporations is not available to a partnership.
However, a partner may be entitled to a self-employed health insurance
deduction equal to 100% of the cost of health insurance and a limited amount
of long-term care insurance as an adjustment to income on his or her
individual income tax return. (Note: By law, a partner is a self-employed
individual. Therefore, the income tax rules for self-employed individuals
apply to partners.)
The Limited Partnership

A hybrid form of partnership is the limited partnership, which has two
different classes of partners.
1. General partner(s). There can be one or more of these. Their liability is

unlimited, and their responsibilities extend to the day-to-day operations of
the enterprise.
2. Limited partners. This class of partner plays a passive role—primarily that

of supplying capital. As the name implies, the liability of this class of
partners is limited to the extent of their individual investments, plus any
requirement for later contributions.
Limited Liability Partnerships

The registered limited liability partnership (RLLP), or LLP, is a type of general
partnership that protects the owners’ personal assets when another partner is sued

for malpractice. In case of a malpractice suit, the assets of the derelict partner, the
partner supervising the work of a culpable employee, and the partnership’s assets
are at risk. An LLP will not diminish the ability of plaintiffs to recover damages
from the partnership or firm itself or from the individual or individuals who
directly caused the loss, nor will it reduce legal or insurance expenses. The key
distinction here from the general partnership is that the personal assets of the
other partners are not exposed, which is a tremendous advantage of LLPs.
The Corporation
A corporation is a business owned by one or more parties. Ownership is
evidenced by shares of stock, each of which represents a fractional interest in the
business. Some corporations are small and privately held—their shares are
bought and sold by mutual agreement between two people and they do not trade
over-the-counter or on exchanges. Other corporations, of course, are huge,
publicly held entities. The shareholders are the residual claimants of the business.
With respect to tax status, there are two important categories of corporations: “C”
and “S” corporations. Generally, the term “S corporation” is used where the tax
distinction is involved, whereas the word “corporation” typically means C
corporation. (When a company incorporates, it does so as a C corporation unless
a special tax election is made to become an S corporation. The market-traded
companies familiar to the investment professional are C corporations.)
Approximately 20% of businesses are corporations, and while this is a relatively

small percentage, the great majority of business income reported is generated by
corporations.
Advantages of Corporations
 The owners (shareholders) have “limited liability.” The debts of the

corporation are settled out of its own assets and not out of the personal assets
of the owners. Thus, the liabilities of the shareholders are limited to the
amount of their investments. In practice, however, small-business owners

may be required to personally guarantee business loans, and the so-called
“corporate veil” of liability protection may be pierced in certain tort actions.
 The corporation can theoretically tap into all existing capital. The
divisibility of ownership and its ease of transfer through stock exchanges
makes anyone with surplus funds a potential owner and contributor of capital
(except, as we will soon see, in the case of the S corporation). This ability to
raise capital gives the corporation the ability to finance growth and explains
why virtually all large, modern enterprises are corporations. Theoretically,
corporations may find it easier to borrow, and corporations may sell bonds in
order to raise additional business capital.
 Theoretically, the life of a corporation is infinite. The death of any single

owner does not automatically end the business. This is because corporate
ownership interests are transferable and because, in the case of large firms,
ownership and management are generally separate. In fact, the rise of the
corporation in America has gone hand in hand with a division between
ownership and professional management.
 Certain expenses are uniquely tax deductible for C corporations. Current

tax law affords favorable treatment to certain fringe benefits provided by the
corporation to its employees (and to the owners if they are also employees).
The corporation receives an income tax deduction for the cost of these
benefits, listed below, and the recipients need not report the value of the
benefits as taxable income:
1. an income tax exclusion for benefits received by employees under a

nondiscriminatory self-insured medical reimbursement plan;
2. an income tax exclusion for employees for amounts received from an

accident or health plan and/or paid by the corporation to an accident or
health plan;
3. an income tax exclusion for the cost of providing employees (not

nonemployee owners) with group life insurance, with no tax
consequences to the employee for the first $50,000 of coverage; and

4. an income tax deduction for meals and lodging furnished for the
convenience of the employer.
 Corporations also receive a partial exemption for income tax purposes

from dividend income received from investments in other companies’
preferred or common stock. Currently, the exemption is 70%.
Corporate Income Tax Rates
Corporations are subject to the following graduated federal income tax rates:
Table 1: Corporate Tax Rate Schedule
Taxable But Of the

Income Over Not Over The Tax Is Amount Over
0 $ 50,000 15% 0
$ 50,000 75,000 $ 7,500 + 25% $ 50,000
75,000 100,000 13,750 + 34% 75,000
100,000 335,000 22,250 + 39% 100,000
335,000 10,000,000 113,900 + 34% 335,000
10,000,000 15,000,000 3,400,000 + 35% 10,000,000
15,000,000 18,333,333 5,150,000 + 38% 15,000,000
18,333,333 — 6,416,667 + 35% 18,333,333
Note: The top corporate rate is 35%. The 39% “bracket” serves to eliminate the
benefit of the 15% and 25% rates. The 38% “bracket” serves to eliminate the
benefit of the 34% rate.
Preferential tax rates for dividends. Just as long-term capital gains are subject to
preferential tax rates, the Code also provides preferential tax treatment for most
ordinary (cash) dividends received. Ordinary dividends received by an individual
shareholder (who meets the holding period discussed below) from a domestic
corporation are taxed at the same rates that apply to long-term capital gains. This
preferential income tax treatment applies for purposes of both the regular income

tax and the alternative minimum tax. Thus, under this law, qualified dividends
are taxed at rates of 0%, 15%, or 20%, depending upon the marginal income tax
bracket into which the gains fall.
To be eligible for preferential dividend tax treatment, a shareholder must own the
underlying share of stock for at least 61 days during the 121-day period that
begins 60 days before and ends 60 days after the ex-dividend date.
Disadvantages of Corporations
The corporate form is not without its disadvantages, the primary of these being
the fact that corporations and their owners are subject to double taxation.
First, the net profits of the corporation are taxed. This tax is levied on corporate
income before payment of dividends to common and preferred shareholders.
Thus, if XY Corporation has net profits of $100,000 and distributes $50,000 as
dividends, its taxable income is still $100,000. Distribution of profits as
dividends does not reduce taxable income for a corporation. It is worth noting
here that the same double taxation characteristic of C corporations follows the
business owners up until they exit the business. The C corporation is often the
best entity to use when in the start-up and operational phase of the company, but
an S corporation (or other pass-through entity) is the best entity structure when it
comes time to sell the business.
Second, distributions of those same corporate profits to shareholders in the form

of dividends are taxed again, this time at the individual shareholder’s tax rate.
This is the double-taxation problem of corporations, and it can be an important
drawback. Likewise, when corporations incur losses, those losses cannot be taken
by the individual owner as they could in the case of sole proprietorships,
partnerships, or S corporations. However, payments to employees, including
owner-employees, in the form of salary are (within certain restrictions)
deductible to the corporation and taxed only once—at the level of the employee
or owner-employee.

Personal Service Corporation
By definition, a personal service corporation (PSC) is a C corporation in which
substantially all of the corporation’s activities are engaged in performing services
for the fields of health, law, engineering, architecture, accounting, actuarial
science, performing arts, and certain types of consulting and veterinary services.
In addition, most all of the services are performed by employee-owners of the
corporation and substantially all of the stock must be owned by employees,
retired employees, or their estates. The taxable income of a personal service
corporation is subject to a fixed tax rate of 35%. Hence, the graduated income tax
rates for C corporations do not apply to a personal service corporation.
S Corporations
An S corporation is a closely held corporation governed by a distinct and
separate set of tax rules and related restrictions. The S corporation has been in the
tax law since 1958, with slight revisions over the years. Its special provisions
have made it a popular alternative for small businesses.
The S corporation is, for tax purposes, a “conduit,” that is, an entity that pays no
income taxes but merely funnels corporate earnings (or losses or credits) to its
shareholders. The individual shareholders pay taxes on these earnings at their
personal tax rates. In this respect, the S corporation has tax aspects similar to
those of the sole proprietorship and partnership forms of business.
The original and continuing intent behind the theory that created S corporations
is that small, closely held corporations should receive beneficial treatment under
the tax laws. However, in exchange for this beneficial treatment, restrictions have
been placed on the type of corporations eligible to elect S status. Those
restrictions deal primarily with the number and identity of shareholders and with
the capital structure of the business. For purposes of discussion in this module, an
S corporation may have a maximum of 100 shareholders (a shareholder, a
shareholder’s spouse, a shareholder’s family members, and a shareholder’s estate
are counted as one shareholder for purposes of determining the maximum

number of shareholders allowed). Certain types of taxable entities—such as
specified estates or trusts—may also be shareholders. Also, the actual shares
issued must be all of the same class and with the same rights with respect to
corporate earnings and assets. Voting rights, however, may be different, even if
they are of the same class.
Advantage of S Corporations
As previously discussed, taxation is the big advantage of the S corporation.

Profits and losses are distributed to each shareholder, thereby avoiding the double
taxation that occurs with income earned by a C corporation, as well as upon the
ultimate disposition of the company.
Disadvantages of S Corporations
 The big disadvantage of the S corporation is that it cannot have more than
100 shareholders (a shareholder, a shareholder’s spouse, a shareholder’s
family members, and a shareholder’s estate are counted as one shareholder
for purposes of determining the maximum number of shareholders allowed).
This reduces the potential equity capital available to the entity and indirectly
encumbers the transferability of share ownership (since share transfers
cannot inadvertently create more than 100 shareholders). Furthermore, other
corporations, nonresident aliens, partnerships, and certain forms of trusts
may not be shareholders.
 Some of the tax benefits extended to regular C corporations do not apply to

the S corporation. As a general rule, favorable tax treatment is not available
with respect to benefits (other than retirement benefits) provided by the S
corporation to an employee who owns more than 2% of its stock. By law, a
more-than-2% shareholder-employee of an S corporation is treated as a self-
employed individual for employee-benefits purposes; therefore, the income
tax deduction rules for self-employed individuals apply to employees with
more than 2% of S corporation shares. In most other respects, the S
corporation is similar to a C corporation. It has the advantage of limiting the

liability of its owners and extending potential ownership to a larger, yet still
limited, set of potential capital contributors than is possible with the
proprietorship form of business.
As a general rule, an S corporation receives a deduction for the cost of

providing fringe benefits to its employees; however, a more than 2%
shareholder-employee must report the value of such benefits as taxable
income. Even though a more-than-2% shareholder-employee must report the
value of health insurance as taxable income, he or she may deduct 100% of
the cost of health insurance, and a limited amount of long-term care
insurance, as an adjustment to income. In contrast, a more-than-2%
shareholder-employee must report the value of certain other fringe benefits
(such as group life insurance coverage, group disability insurance coverage,
medical reimbursement plan coverage, cafeteria plan benefits, etc.) as taxable
income that cannot be deducted. In summary, these benefits cannot be
offered to more-than-2% shareholder-employees on a tax-preferred basis.
Limited Liability Companies

The limited liability company (LLC) is a business entity that includes the
beneficial attributes of both S corporations and partnerships and has been
implemented in all states and the District of Columbia.
If structured properly, the LLC combines the limited liability of corporations

with partnership treatment for federal income tax purposes. As such, the pass-
through of losses for tax reasons, which is so important to the individual
entrepreneur, is preserved without having to comply with restrictive S
corporation eligibility requirements. Thus, LLCs generally have the following
features:
1. limited liability for all owners or “members” to only that amount at risk
within the business itself;
2. limited life, such as 30 years or a period stated in the operating agreement;

3. dissolution upon the death, retirement, or resignation of a member, unless the
remaining members elect by majority to continue the LLC;
4. prohibition against transfer of management or membership rights without the

majority approval of the remaining members; and
5. deferral to the LLC’s operating agreement for purposes of determining the

LLC’s management structure.
Like a corporation, an LLC is a statutory entity and must be formed under a

specific state law. Some states prohibit LLCs from conducting certain types of
business, such as banking, insurance, and professional services.
Advantages of LLCs
Like S corporations, LLCs have the advantage of avoiding double taxation, and
the liability of shareholders is limited to the extent of their investments.
However, they can have more than 100 shareholders and, unlike S corporations,
those shareholders may include corporations, partnerships, trusts, and foreign
investors. In summary, LLCs offer the tax advantages of conduit entities such as
S corporations and limited partnerships (discussed above) and the legal
protection of a corporation, without the costs and complexity associated with a
corporation. For these reasons, LLCs are the entity of choice for many new
businesses.
Tax reporting requirements for LLCs. An LLC with two or more members will
be treated as a partnership for federal income tax reporting purposes, unless the
company elects to be treated as a C corporation. An LLC with one member only
will be treated as a sole proprietorship for federal income tax reporting purposes,
unless the company elects to be treated as a C corporation.
Disadvantages of LLCs
Some states prohibit LLCs from operating in professional, banking, or insurance

services, and some put a limit on the operating life of the LLC.

The Professional Corporation (PC)
Historically, many states prohibited certain professionals—doctors, lawyers, and
accountants, for example—from practicing in a corporate form. It was deemed
inappropriate for such professionals to do business in any form other than as
individual or general partners. Currently, most states allow these professionals to
practice through a professional corporation. A professional corporation is
incorporated in the same manner as any other corporation and is subject to all of
the same procedural requirements as any other corporation. Professional
corporations are almost always C corporations for tax purposes.
The professional corporation statutes of most states provide that an individual cannot
avoid liability for his or her own malpractice. Some states hold a professional
corporation liable for the negligent acts of a shareholder. However, an individual, in
the absence of a personal guarantee, is able to limit personal liability for the ordinary
business debts of the firm. Some states permit an individual shareholder in the
professional corporation to limit his or her liability for the malpractice of a co-owner.
Chapter 1 Review
1. List the advantages and disadvantages of a sole proprietorship.
Go to answer.
2. List the advantages and disadvantages of a partnership.

Go to answer.
3. List the advantages of a corporation.

Go to answer.
4. Discuss the important tax benefits of a corporation.

Go to answer.
5. Discuss an important tax disadvantage of a corporation.

Go to answer.

Chapter 2: Retirement Plans
R
etirement plans available to small-business owners are the focus of this
chapter. The investment professional is introduced to the various types
of available plans and shown examples of how the selection of a plan
can yield differing results to the business owner.
After studying this chapter, you will be able to:

employees.
Types of Plans
Tax-Qualified Retirement Plans
With a qualified plan, the business can take a tax deduction in the amount of its
contribution, and the plan participant does not have to include that contribution
as current income. Investment returns accumulate on a tax-deferred basis. These
plans require compliance with a host of restrictions, have contribution or benefit
limits, and commit the businesses that offer them to continuation of their funding
in most instances. The maximum amount of compensation that can be considered
in calculating a qualified plan contribution or benefit is $270,000 in 2017. This
limit and most of the qualified plan limits are subject to adjustment each year
depending on inflation. Qualified plans are often thought of in two major
categories: those that provide a set benefit to the employee upon retirement
(defined benefit), and those that provide a set contribution amount to a plan while
an employee is still working (defined contribution). Let’s look first at defined
benefit plans.

Defined Benefit Pension Plans
With defined benefit plans, the size of the corporate contribution is determined
by the benefits that must be paid to retired or terminated employees. The
corporation’s contribution is deductible from taxable profits, and the employee is
not currently taxed on these annual contributions.
A defined benefit pension plan provides a specific level of annual pension benefit
at retirement. Most defined benefit plans provide security for employees through
a specified benefit and backing by the Pension Benefit Guaranty Corporation
(PBGC). However, certain plans are exempt from PBGC coverage (and the cost
of coverage). For example, plans that have always covered owner-employees
only and professional service employers with fewer than 25 active participants
are excluded from PBGC coverage. Defined benefit plans are characterized by
high plan costs due to actuarial and administrative requirements. While older
employees benefit from faster funding of retirement benefits, younger employees
generally can benefit more from the long-term tax-deferred accumulation
provided in a defined contribution plan.
The retirement benefits provided by a defined benefit plan are governed by three
plan provisions: the benefit formula, the definition of the compensation, and
normal retirement age. Compensation coupled with the plan benefit formula
determines the individual participant’s retirement benefit. Usually, time of
service is addressed in the benefit formula and in the vesting schedule. In many
plans, normal retirement age will also include a service factor; e.g., the later of
age 65 or completion of five years of service.
Compensation. Compensation is the individual’s total earnings, as defined in the

plan document. Such definition must be nondiscriminatory, which means it must
satisfy Sections 414(s) and 415(c)(3) of the Internal Revenue Code. The
definition will satisfy safe harbor provisions if it includes all compensation
within the meaning of Section 415(c)(3) and excludes all other compensation.
For our purposes, wages, salaries, and fees for service and any item included in
income meets this definition requirement. The various deferrals, such as 401(k),
403(b), and those for a cafeteria plan, may or may not be included, depending on
the definition of compensation in the plan.
Chapter 2: Retirement Plans  19

Compensation, or “pay,” will be defined in the plan document as either final
average pay or career average pay. Final average pay generally considers the
high three or five years’ compensation prior to a participant’s retirement; for
most employees, this will be a more favorable provision than career average pay.
The definition of compensation must also meet the requirements of IRC Section
401(a)(17), which imposes an annual limit on the amount of compensation that
can be considered in calculating a qualified plan contribution or benefit. This
limit is indexed and is set at $270,000 in 2017.
Example. John Ingram earned $315,000 this year and earned over $300,000 the
past three years. His employer’s defined benefit plan provides a flat percentage
benefit of 36.25% of compensation, defined as the average of the final three
years’ compensation. Because John’s salary has been well above the
compensation limit for the past three years, his benefit under the defined benefit
plan will be 36.25% of the indexed compensation limit. In 2017, his employer
can only fund for a benefit of $97,875 per year at retirement (36.25% × $270,000
= $97,875).
Normal retirement age. A plan is required to define the age at which full benefits
will commence—the “normal retirement age.” Normal retirement age is used as
the target age in the plan funding calculations. It has little to do with when
employees will actually retire or when benefit accruals under the plan will cease.
Benefit accruals will not cease (assuming the employee has not attained the
maximum benefit provided by the plan) until the employee retires. Since an
employee may continue to work beyond the normal retirement age, the employee
may continue to earn accruals under the plan.
In addition to specifying a normal retirement age, the plan document must

provide for full vesting on the attainment of normal retirement age. Typically, the
normal retirement age will be 65, although it is not unusual for an earlier age to
be selected. However, the IRS may require an employer to justify a normal
retirement age under 65, particularly if the employer is a small, privately owned
business. Any lower age should approximate the age at which company
employees customarily retire.

Benefit formula. The plan benefit formula determines the level of retirement
income provided at normal retirement age. The formula may be simple or very
complex. There are no fixed guidelines for designing the formula, but complexity
and uniqueness seem to be the desired outcomes, at least for large companies. In
one survey performed by Watson Wyatt & Company, each of the 50 large
companies surveyed had a different and intricate formula.
Generally, formulas consider either years of service (unit benefit formula) or

provide a flat benefit regardless of length of service (flat benefit formula). The
plan benefit formula may provide for a unit benefit dollar amount, a unit benefit
percentage amount, a flat benefit dollar amount, or a flat benefit percentage
amount. These are not requirements; alternative designs have evolved. Examples
of several types of formulas are presented in Table 2.
Table 2: Defined Benefit Plan Formulas
Type of Formula Example of Retirement Benefit Provided

Unit benefit percentage formula 1.63% of final compensation per year of
service
Unit benefit dollar formula $150 per month per year of service, 25 years
maximum
Flat benefit or fixed benefit percentage 50% of final three-year average

formula compensation
Flat benefit or fixed benefit dollar $1,000 per month

formula
Example. The AKZ Corporation defined benefit plan provides a retirement

benefit of 2% of final average pay per year of service. Frieda Fulton retired at
age 65 with 45 years of service; her annual retirement benefit from the plan
was calculated to be 90% of final average pay (2% × 45 = 90%).
Accrued benefit. A participant’s benefit is summarized annually in a report from

the plan administrator that includes the monthly pension benefit accrued to date,
the percentage of this benefit that is vested, and the present value of this accrued
benefit.

The annual employer contribution to a defined benefit plan is determined each
year by an actuary. The actuarial assumptions used in the calculations directly
affect the amount of the employer’s required contribution. To be deductible by
the employer, the contribution to the plan may not exceed the amount necessary
to fund individual participants’ benefits of up to the annual benefit limit: the
lesser of $215,000 in 2017 or 100% of compensation. The actuary determines
this “necessary amount.”
As with any company-sponsored qualified retirement plan, all eligible employees

must be covered under a defined benefit plan. Conditions of eligibility are
generally employees 21 or older who worked at least 1,000 hours in the previous
year. Under the right conditions, a defined benefit plan is one way that older
business owners can aggressively fund their retirement. This is especially true in
the case of an older, high earning, self-employed individual with no employees.
Brokerage firms now offer turn-key solo defined benefit plans that streamline the
process of setting up and administering such a plan. Care must be taken,
however, to avoid rushing into such a plan and then later realizing the business
income cannot support the required annual contributions. One online brokerage
platform that offers solo defined benefit plans suggests that a one-person defined
benefit plan is best suited for self-employed individuals or small business owners
that generate at least $250,000 per year in earnings to make the cost of the plan
balance out against the tax savings.
Defined Contribution Plans

Defined contribution plans typically provide for an employer contribution but,
unlike defined benefit plans, do not specify the benefit that will be paid from the
plan. The amount of a participant’s retirement benefit is based on the value of the
participant’s account balance at retirement. In a defined contribution plan, each
participant’s plan funds are maintained in an individual account. Some of the
more common types of defined contribution plans follow.
Profit sharing plans. The employer contributes between 0% and 25% of covered
payroll. In addition, as with any defined contribution plan, annual additions of
employer contributions and forfeiture allocations to each participant’s account

may not exceed the lesser of 100% of the individual’s compensation or $54,000
in 2017. Compensation, as stated previously, is limited to $270,000 in 2017. The
company typically is not bound to make contributions in any subsequent year,
nor need it always contribute the same percentage; it has the flexibility to reduce
contributions during years of poor business performance. However, contributions
must be substantial and recurring, and the failure to make substantial and
recurring contributions could lead to the plan’s disqualification. Therefore, the
plan should be established with the intent of making substantial contributions at
least every few years.
Cash or deferred account (CODA) or salary reduction plans (Section 401(k)

plan). In this instance, employees may elect to contribute the lesser of $18,000 in
2017 or 100% of annual pretax salary. The employee can exclude his or her
contribution to these plans from current income, and the employer’s contribution
(if any) is not currently taxable. The law allows individuals who are age 50 or
older to make an additional $6,000 catch-up contribution in 2017.
Money purchase pension plans. Money purchase pension plans are a more formal
type of defined contribution plan. The employer is required to contribute a fixed
percentage of compensation to employee accounts. Similar to simplified employee
pensions (SEPs), profit sharing plans, and stock bonus plans, which limit the
employer contribution to 25% of covered payroll, money purchase plans also allow
employer contributions of up to 25% of covered payroll, but this contribution is a
fixed obligation each year, and, as such, it requires committing a substantial
portion of the company’s annual cash flow, whether or not it is available. This
inflexible contribution limits the use of this plan for many employers because it
requires a predictable and stable cash flow to meet the contribution requirement.
An employer that sponsors a profit sharing plan has the flexibility to contribute
less than the maximum 25% when cash flow is reduced by business conditions
and the full 25% when business conditions improve. Such flexibility augers a
quick decline in the use of the money purchase plan. Nevertheless, money
purchase pension plans will continue to be used as part of collectively bargained
(union) plans or by employers that want (or promise) to fund retirement benefits
for their employees.

Generally, the account balance at retirement is used to purchase an annuity that
provides annual income for the participant’s retirement or the proceeds are rolled
into an IRA to enable the owner to control the distribution process to a greater
extent.
Keogh (HR 10) Plans

A Keogh is a qualified plan for self-employed individuals or partners, and can be
a defined benefit plan or defined contribution plan, such as a profit sharing plan.
A number of important restrictions apply, however, with respect to participants in
the plan. Like other plans described here, Keogh contributions by the company
are fully tax deductible to the company and tax deferred to the individual(s) on
whose behalf they are made. Keogh is simply another name for a qualified plan
sponsored by a business that is not incorporated.
Although qualified plans require substantial documentation and reporting, they

have the benefit of giving the company some flexibility through the selection of
various plan options, such as the availability of plan loans and determining when
distributions are to be made.
Two types of profit sharing plans extremely popular with small-business owners
are discussed in greater detail on the following pages. These are the age-weighted
and cross-tested profit sharing plans.
Age-Weighted Profit Sharing Plans

An age-weighted profit sharing plan is a type of qualified plan that allocates
proportionately larger employer contributions to individuals who are relatively
older than the other plan participants. In other words, an age-weighted profit
sharing plan allocates employer contributions based on compensation and age. A
conventional profit sharing plan allocates employer contributions based on
compensation alone. The use of age-weighted profit sharing plans was officially
approved by the IRS in regulations adopted in 1993.

Frequently, the business owner, highly compensated employees, and long-term
employees are older than the other employees. In this situation, an age-weighted
profit sharing plan can be used to increase the amount of employer contributions
made on behalf of the key employees. In contrast, an age-weighted plan formula
is inappropriate in situations where the owner-employee is as young as or
younger than the other employees. Also, an age-weighted plan formula is usually
inappropriate in situations where there are significant differences in the ages of
two or more key employees. That is, the older of the two key employees will
receive a significantly larger employer contribution than the younger key
employee, even though their plan compensation is identical. Of course, the same
problem with an age-weighted plan may arise in situations involving non-key
employees with the same or nearly the same compensation. Younger non-key
employees may complain because older non-key employees receive larger
allocations of employer profit sharing contributions even though their earnings
are nearly identical.
Example: Travis Corporation.
Travis Corporation maintains an individually designed profit sharing plan with an

age-weighted allocation formula. The corporation’s goal is to maximize
employer contributions for Ted Travis, key employee and 100% shareholder of
the corporation, and minimize contributions for all other employees. The plan
provides that the employer will make contributions to the plan’s trust in such
amounts as the corporation shall, in its discretion, decide. The following schedule
summarizes the names, ages, and compensation of Travis Corporation’s
employees, all of whom participate in the plan during the current plan year.
Plan
Participant Age Compensation
Ted Travis 55 $150,000
Bill Smith 40 $50,000
For the current plan year, instead of $50,000, Travis Corporation will contribute
$49,425 to the profit sharing plan, which is allocated to the participants in the
following manner. An explanation of the actual calculation is beyond the scope of

this module; it is primarily important to recognize that contributions are based on
compensation and age.
Plan Age-Weighted Allocation

Name
Compensation Allocation Percentage
Ted Travis $150,000 $46,000 93.07%
Bill Smith $50,000 3,425 6.93%
$49,425 100.0%
As planned, Ted Travis ended up with the lion’s share of the company’s
contribution.
Measuring the benefits of an age-weighted profit sharing formula. The

advantages of an age-weighted formula for older plan participants such as Ted
Travis can be illustrated by comparing the age-weighted allocations with those
provided by a conventional profit sharing allocation formula. (Typically, a
conventional profit sharing plan formula provides that employer contributions
shall be allocated in the proportion that each participant’s plan compensation
bears to the total compensation of all plan participants.) For ease of illustration,
we have assumed that neither plan uses permitted disparity (i.e., Social Security
integration). Note that on a percentage basis, the age-weighted plan has increased
Ted’s contribution over 20%, while at the same time reducing Bill’s contribution
by over 65%.
Plan Conventional Allocation

Name Compensation Allocation Percentage
Ted Travis $150,000 $37,500 75.0%
Bill Smith $50,000 12,500 25.0%
$50,000 100.0%
$ Difference % Difference
Age-Weighted Conventional (Age-Weighted (Age-Weighted
Name Allocation Allocation Advantage) Advantage)
Ted Travis $46,000 $37,500 $8,500 23%
Bill Smith $3,425 $12,500 ($9,075) (73%)

Cross-Tested Profit Sharing Plans
A cross-tested profit sharing plan is a type of qualified plan that allocates
proportionately larger employer contributions to highly compensated participants
than to other plan participants. In operation, cross-tested profit sharing plans
weight employer contributions in favor of highly compensated individuals with
earnings above a specified level. This type of allocation formula differs from a
conventional profit sharing plan’s formula, which allocates employer
contributions in the proportion that each participant’s plan compensation bears to
the total compensation of all plan participants. A cross-tested profit sharing plan
formula differs from an age-weighted profit sharing plan formula, which is based
on age and compensation.
Why are cross-tested profit sharing plans important? This type of profit sharing
plan is important for two reasons. First, it can be designed to provide the same
percentage of contributions for a particular category of employees (e.g.,
shareholders or key employees) even though their ages vary significantly.
Second, it can be designed to provide the same percentage allocation (based on
compensation) for all other employees (e.g., non-shareholders or non-key
employees). Therefore, cross-tested profit sharing plans are considerably more
flexible than other age-based plans (i.e., age-weighted profit sharing plans, target
benefit plans, and defined benefit plans), which automatically skew employer
contributions in favor of employees who are relatively older than the remaining
employees, regardless of their classification or status.
Example: Smith Corporation
Smith Corporation is a privately owned company. Together, Rod Smith and Don
Jeffers own 100% of the outstanding shares of stock in the corporation, and each
individual has an equal 50% ownership interest in the corporation. Smith
Corporation sponsors an individually designed profit sharing plan with a cross-
tested allocation formula. The corporation’s goal is to maximize contributions to
the owners, who expect to receive equal allocations.
The plan’s contribution formula provides that the employer will make
contributions to the trust in such amounts as the corporation shall, in its

discretion, decide. Employer contributions for the plan year and forfeitures, if
any, are allocated to participants’ accounts as follows:
Step 1: Employer contributions and forfeitures will be allocated to a highly

compensated participant’s account in the ratio that the participant’s
compensation for the plan year bears to the total compensation for all highly
compensated participants; however, such allocations shall not exceed the
maximum allowed by law.
Step 2: Employer contributions and forfeitures remaining after Step 1 are

allocated to each non-highly compensated employee-participant’s account in an
amount equal to the lesser of one-third of the highest allocation rate provided
under the plan, or 5% of each non-highly compensated employee-participant’s
compensation. (Note: Cross-tested plans must satisfy the minimum gateway
allocation requirement. If the allocation rate for each non-highly compensated
employee is at least one-third of the allocation rate of the highly compensated
employee with the highest allocation rate, the minimum gateway allocation
requirement will be satisfied. Or, if the allocation rate for each non-highly
compensated employee is at least 5% of his or her compensation, the minimum
gateway allocation requirement will be satisfied.)
Step 3: Any remaining employer contributions or forfeitures will be allocated to

each participant’s account in the ratio that each participant’s total compensation
for the plan year bears to all participants’ total compensation for that year.
The following schedule summarizes the participants’ names, ages, and

compensation for the current plan year.
Plan
Participant Age Compensation
Rod Smith 55 $225,000
Don Jeffers 45 $225,000
Ed Adams 35 $50,000
Will Brown 40 $30,000
Jim West 25 $25,000

Based on this information and the plan’s cross-tested allocation formula, the
following allocations are made to the participants’ accounts for the current plan
year. As intended, the two owners received the bulk of the benefits (in equal
shares).
Allocation as a
Cross-Tested Percentage of the
Plan Total Total Employer
Participant Age Compensation Allocation Contribution
Rod Smith 55 $225,000 $45,000 47%
Don Jeffers 50 $225,000 $45,000 47%
Ed Adams 35 $50,000 $2,500 3%
Will Brown 40 $30,000 $1,500 2%
Jim West 25 $25,000 $1,250 1%
Advantages and disadvantages of a cross-tested profit sharing plan formula.

The advantages of a cross-tested profit sharing plan formula for the owners of
Smith Corporation (Rod Smith and Don Jeffers) are best demonstrated by
comparing the results of cross-tested allocations with those of a conventional
profit sharing allocation formula (where the contribution is allocated based on the
percentage determined by dividing a participant’s compensation by the total of
all participants’ compensation).
Plan Conventional Allocation

Name Compensation Plan Allocation Percentage
Rod Smith $225,000 $38,498 41%
Don Jeffers 225,000 38,498 41%
Ed Adams 50,000 8,555 8.9%
Will Brown 30,000 5,133 5.4%
Jim West 25,000 4,278 4.5%
$545,000 $93,250
As previously discussed, a cross-tested plan formula can be used to overcome

some of the drawbacks inherent in age-weighted plans and still weight
contributions in favor of specific classes of employees. (For example, Smith

Corporation seeks to favor the owners and provide them with equal
contributions. At the same time, contributions to the plan for other employees
have been reduced dramatically.) This is the principal advantage of a cross-tested
plan formula over an age-weighted plan formula. One significant disadvantage of
a cross-tested plan formula (when compared with an age-weighted formula) is
that additional employer contributions are required to provide increased benefits
for the favored group of key employees. In contrast, an age-weighted plan is
frequently used to maximize benefits for the oldest key employee and to
minimize the overall cost to the employer who funds the plan; the amount of
contributions for the other employees in an age-weighted plan depends upon their
age and plan compensation.
Because cross-tested profit sharing plans are used to accomplish quite different
goals than those of age-weighted plans, a cost comparison of the two types of
plans is somewhat misleading. Nevertheless, an employer may want to know the
costs involved for each type of plan. Why? The cost of funding an age-weighted
plan may be significantly less than the cost to fund a cross-tested plan; therefore,
an employer may favor a less expensive alternative.
$ Difference % Difference
Cross-Tested Conventional (Advantage to (Advantage to
Name Allocation Plan Allocation the Owners) the Owners)
Rod Smith $45,000 $38,498 $6,502 + 16.89%
Don Jeffers 45,000 38,498 6,502 + 23.24%
Ed Adams 2,500 8,555 (6,055) (70.77%)
Will Brown 1,500 5,133 (3,633) (70.77%)
Jim West 1,250 4,278 (3,028) (70.78%)
$93,250 $93,250 $0
Simplified Employee Pension (SEP) Plans

A SEP is an employer-sponsored retirement plan consisting of individual
retirement accounts (IRAs) or individual retirement annuities for participating
employees. In this kind of plan, the employer is not locked into any specific
commitment to contributions, but makes contributions to employee IRAs on a

discretionary basis. All employees, even part-time workers and employees who
have left the business during the tax year, must be included among those who
receive the benefit. Like other defined contribution plans, employer contributions
up to 25% of a participating employee’s compensation are a tax-deductible
expense to the company and are not currently taxable to the employee. All
contributions are immediately vested for employees.
Salary Reduction SEP (SARSEP) Plans

After 1996, new SARSEPs cannot be established, although plans established
before 1997 may continue to operate. In this form of plan, the employer sets up
the opportunity for employees to contribute part of their pretax earnings to the
SARSEP. Typically, the employer may not contribute at all to such a plan.
SARSEPs were available only to businesses with 25 eligible employees or fewer,
and at least half of the employees must agree to participate before the plan can be
established. You might think of a SARSEP as a “401(k)” plan for smaller
businesses.
Savings Incentive Match Plan for Employees (SIMPLE)

The same 1996 legislation that repealed the SARSEP plan also created a
simplified retirement plan for small businesses called the savings incentive match
plan for employees (SIMPLE). SIMPLE plans can be adopted by employers who
employ 100 or fewer employees. Employers who no longer qualify are given a
two-year grace period to continue to maintain the plan. A SIMPLE plan can be
either an IRA for each employee or part of a qualified cash or deferred
arrangement (401(k) plan).
A SIMPLE plan is not subject to the nondiscrimination rules generally applicable

to qualified plans (including the top-heavy rules, i.e., disproportionate benefits to
higher-salaried employees), and simplified reporting requirements apply. Within
limits, contributions to a SIMPLE plan are not taxable until withdrawn.

A SIMPLE retirement plan allows employees to make elective contributions to
an IRA. Employee contributions have to be expressed as a percentage of the
employee’s compensation and cannot exceed $12,500 per year for 2017.
Thereafter, the limit will be indexed for inflation. For 2017, employees who are
age 50 or older may make a $3,000 catch-up contribution. The limit is indexed
for inflation. Eligible employees are given 60 days before the beginning of any
year (or the 60-day period before first becoming eligible to participate in the
plan) to elect to participate in the SIMPLE plan. And each employee of the
employer who received at least $5,000 in compensation from the employer
during any two prior years and who is reasonably expected to receive at least
$5,000 in compensation during the current year generally must be eligible to
participate in the SIMPLE plan. Self-employed individuals can also participate in
a SIMPLE plan.
The employer/sponsor is required to satisfy one of two contribution formulas.

Under the matching contribution formula, the employer generally is required to
match employee elective contributions on a dollar-for-dollar basis up to 3% of
the employee’s compensation. Under a special rule that applies to SIMPLE IRAs
only, the employer can elect a lower-percentage matching contribution for all
employees (but not less than 1% of each employee’s compensation). A lower
percentage cannot be elected for more than two out of any five years.
When the employer uses the matching contribution, the $270,000 limit on
compensation (in 2017) does not apply; however, the employer may not
contribute more than the employee. Thus, for an employee earning $416,667 and
contributing the maximum $12,500, the employer 3% match would equal
$12,500.
Alternatively, for any year, in lieu of making matching contributions, the

employer may elect to make a 2% of compensation non-elective contribution on
behalf of each eligible employee. For the purposes of the 2% of compensation
non-elective contribution formula, no more than $270,000 of compensation (in
2017) can be taken into account with respect to any eligible employee.

No contributions other than employee elective contributions and required
employer matching contributions (or, alternatively, required employer non-
elective contributions) can be made to a SIMPLE account.
All contributions to an employee’s SIMPLE account have to be fully vested.

Contributions to a SIMPLE account generally are deductible by the employer. In
the case of matching contributions, the employer is allowed a deduction for a
year only if the contributions are made by the due date (including extensions) for
the employer’s tax return. Contributions to a SIMPLE account are excludible
from the employee’s income, so employer matching or non-elective contributions
to a SIMPLE account are not treated as wages for employment tax purposes.
SIMPLE IRA accounts, like IRAs, are tax-deferred accounts. Distributions from
a SIMPLE retirement account generally are taxed under the rules applicable to
IRAs. Thus, they are includible in income when withdrawn. Tax-free rollovers
can be made from one SIMPLE account to another. A SIMPLE IRA account can
be rolled over to an IRA on a tax-free basis after a two-year period has expired
since the individual first participated in the SIMPLE IRA plan. To the extent an
employee is no longer participating in a SIMPLE IRA (e.g., the employee has
terminated employment) and two years have expired since the employee first
participated in the SIMPLE plan, the employee’s SIMPLE account is treated as
an IRA.
Early withdrawals from a SIMPLE IRA account generally are subject to the
10% early withdrawal tax applicable to IRAs. However, withdrawals of
contributions during the two-year period beginning on the date the employee
first participated in the SIMPLE IRA are subject to a 25% early withdrawal tax
(rather than the 10%).
A SIMPLE plan can also be adopted as part of a 401(k) plan. In this case, the
plan does not have to satisfy the special nondiscrimination tests applicable to
401(k) plans and is not subject to the top-heavy rules. The other qualified plan
rules continue to apply.

Chapter 2 Review
1. Distinguish between a profit sharing plan and a money purchase pension
plan.
Go to answer.
2. Discuss the benefits of an age-weighted profit sharing plan.

Go to answer.
3. Discuss two reasons why cross-tested profit sharing plans are important.
Go to answer.
4. Describe a simplified employee pension (SEP).

Go to answer..
5. Describe a savings incentive match plan for employees (SIMPLE).

Go to answer.

Chapter 3: Property and Liability
Risk Issues for High Net Worth
Clients
recommendations.
Client Profiles
I
magine you are attending a charity event and at the dinner table you are
seated with some very interesting people. To your left are Ann and Chris,
and you learn through your conversation that Ann started her own company
several years ago and it recently went public. She also shares that she is on the
board of the charity that is hosting the function and that she and her husband will
be hosting the next fundraising event at their property later this summer.
To your right are Leslie and Ben, who share that Ben invented a board game that
has become quite popular and as a result of this financial success have moved
from their traditional four-bedroom home to a 6,000 square foot, seven-bedroom
home in a very nice part of town. They are very excited about their new home
and the fact that they can finally afford to send all three of their children to
private school and have a live-in au pair. The au pair takes the children to and
from school and to the various after school activities, allowing Ben and Leslie the
time needed to focus on their respective careers. While Ben is typically home
every evening, Leslie’s job requires a great deal of travel.
Finally, across from you is Ron, who has been divorced twice and is currently
single. You discover that Ron is the CFO of a large American-based corporation
with offices all over the world. While he occasionally travels overseas, he
Chapter 3: Property and Liability Risk Issues for High Net Worth Clients  35
primarily works in New York City and San Francisco and his employer provides
a condo for him in both cities. While he has his primary residence here, he shares
that he appreciates being able to come home every evening to his own belongings
wherever he is working and, since he has a very good salary, he can afford to
maintain his lifestyle.
As the evening winds down and you are waiting for the valet to bring your car,
you see Ann and her husband again as the valet brings their Bentley to them. As
fate would have it she catches your eye and asks you to call her next week to
discuss her risk management issues among other things. Flattered by this offer,
you gladly agree and say farewell.
The next valet brings Ben and Leslie’s brand-new Corvette Z06. Before hopping
in and speeding away, Ben shakes your hand and gives you his card, asking you
to give him a call next week as well. As your car is brought up, Ron says
goodbye and also asks you to give him a call soon to discuss his situation. As you
drive away you can hardly believe how well the evening went and are excited
about learning more about these interesting people and discovering how you can
help them.
The following Monday you call the number Ann gave you and speak with her
personal assistant, who makes arrangements for you to meet Ann and Chris at
their home in two weeks once Ann returns from a business trip to Europe. You
are also able to schedule a meeting with Ron later this week before he heads off
to New York. It takes several calls and messages back and forth, but you are
finally able to reach Ben, who schedules an appointment with you for early next
week at their new home.
When you meet with Ron, you find him to be a very down-to-earth individual
who is very practical. His home is nice and in a nice neighborhood, but no one
would be able to discern from appearances that he has amassed a net worth of
over $3 million, most of which is his invested assets. He shares that while he
makes a good living, he has significant expenses due to the divorces and his
lifestyle. Still, he is able to pursue one of his passions of continually adding to his
wine collection, which consists of several hundred bottles, some of which are

quite valuable. He owns just one car, which is a new Lincoln MKX. Ron enjoys
his privacy, but also shares that he enjoys his neighborhood because many of his
neighbors have become longtime friends in the 20 years he has lived here. They
often entertain each other and Ron shares that he hosts an amazing Super Bowl
party every year. Ron wonders what you might suggest he do in order to
adequately protect himself and his assets.
A few days later when you go to see Ben and Leslie, you stop at the gatehouse
upon entering their neighborhood and are allowed in. As you approach the house,
you see the Corvette sitting next to a minivan and a Lexus SUV. As expected, the
home is very nice and quite well-decorated. Ben introduces you to the au pair as
she herds the children toward the minivan and soccer practice, leaving the three
of you to talk. Ben and Leslie tell you they purchased the new home because the
children are growing and they need the extra space for them as well as room for a
live-in au pair. They have a net worth in excess of $12 million and are concerned
that they may not be addressing the various risks they are exposed to, especially
with regard to lawsuits. They ask you to evaluate their situation and recommend
strategies so that they are protected.
When the day arrives to go see Ann and Chris, you pull through the gated
entrance to the home and make your way along the quarter-mile-long driveway.
At first you see an average-sized dwelling, a large detached garage, a corral and
stables along with horses in a fenced pasture. As you come around a curve in the
driveway, you notice a Ferrari parked just in front of what can only be described
as a mansion.
The door is opened by a butler who says that you are expected and leads you to a
room just off the foyer, which is clearly designed for receiving guests. You
notice several excellent pieces of art and a beautiful grand piano gracing the
room as another member of the household staff arrives and asks if you would
prefer water or coffee. Ann arrives momentarily and after a few moments of idle
conversation she asks you what exactly you can do to help protect her and her
family.
While the example of an extremely wealthy family may not be the typical
prospective client you have, many high net worth people you may know or run
across share many of the same risks the extremely wealthy are exposed to. Even
well-paid people with high-profile positions who don’t yet have a great deal of
wealth established may find themselves exposed to some of these same risks,
which for them is more a result of their lifestyle than pure wealth.
High net worth clients have an even greater need for risk management than the
average American, not just because they tend to own more things, but also
because of the types of things they are more likely to own. Property risks will
often include high-end homes with expensive contents, including various
collections. These collections may be of fine art, wine, antiques, and other one-
of-a-kind items. The car they may drive for everyday use could be a Mercedes
Benz S class sedan, but they may also own other expensive or collectible
automobiles. Those with a high net worth are also more likely to own boats and
yachts, planes and jets, high-end collectibles and other valuables. It is also more
likely that they will own lots of “toys” such as ATVs, personal watercraft, and
snowmobiles that they have at their residence or keep at their second (or third)
home.
But the additional risks high net worth people face isn’t limited to just property
risks. Due to the fact that many high net worth individuals have a great deal of
assets, they can become the target of lawsuits because they have deep pockets.
They are also at greater risk for kidnapping and extortion than the average
American. Similarly, families with domestic employees have additional risks
related not only to the risks they would have as an employer, but also the risks
inherent in having non-family members in the home who may share private
family information with others.
Many high net worth individuals earned their wealth as business owners and as
such have a reputation and a brand to manage and maintain. There may be
intellectual property that needs to be protected as well as the value of the
business. Additionally, they may have risks associated with traveling or living
outside of the United States and the need for insurance products that provide the
protection they need while overseas.

Many of these personal and property risks bring liability risks with them and,
because they have a great deal to lose, high net worth families need to ensure
they have adequate protection from their exposure to lawsuits. These can even
come from seemingly innocuous activities like being on the board of a local
charity, hosting dinner parties, or entertaining on the yacht while it is docked.
Risk Management Techniques

Once a risk is identified, the techniques used to manage that risk are risk
avoidance, risk minimization, risk transfer, and risk retention.
Figure 1: Risk Management Techniques
Risk Avoidance
Risk avoidance is simply not doing things that expose one to risk. For example, if
someone wants to avoid the risk of death due to hitting a tree at 50 miles per
hour, they can choose to not ski. Risk avoidance is not always feasible. As an
example, if someone wished to avoid the risk of dying in an automobile accident,
giving up driving may not be a practical solution if adequate public transportation
is not available.
Risk Minimization
Risk minimization is employing strategies to reduce the likelihood or the severity
of loss caused by a particular risk. Skiing within one’s ability and wearing
appropriate protective gear is an example. Wearing one’s seat belt while driving
and ensuring the brakes work are also examples of risk minimization.
Risk Transfer
Risk transfer occurs when one individual or entity takes on the risk on behalf of
another. When buying a lift ticket at a ski resort, the ticket or receipt states that
the skier assumes all risks inherent to skiing, up to and including death. This is an
example of the resort transferring the risk of skiing on their property to the skier.
Buying auto insurance effectively transfers the risk of damaging one’s car or
someone else’s car or injuring a person to an insurance company. Insurance is the
most common method of risk transfer.
Risk Retention
Risk retention may be intentional or unintentional. It may be the case that an
individual with no health insurance determines that the risks associated with
skiing are worth it and takes no steps to avoid, minimize, or transfer the risk. It
may also be the case that this same individual doesn’t understand the risks of
skiing and unintentionally assumes them. Likewise, individuals who drive
without car insurance are retaining the property and liability risks associated with
driving. More typically, people choose to retain risk when the potential for loss is
unlikely or the cost of a loss is small.
These four techniques are applicable for all clients, regardless of net worth.
However, as clients gain wealth, typically greater risk retention is utilized
through the use of higher deductibles or simply choosing to assume the financial

costs of uninsured losses. When addressing risk management with high net worth
clients, a combination of these techniques may be the most effective method for
managing risk. The greatest concern with these different management techniques
is the unintentional risk retention. It is best for the client to be aware of the risks
they are taking, and knowingly decide to do so.
Property Risks for the High Net Worth Client

As we mentioned in the introduction to this chapter, to varying degrees, high net
worth clients will often have high-end homes, high-end cars and high-end
collections. Adequately protecting these items is a bit more complicated than
calling your local insurance agent and buying a policy. Unique property generally
requires unique risk management and insurance solutions.
Homeowner Risks
Insufficient Coverage
One of the biggest mistakes high net worth people make is assuming that a
standard homeowners insurance policy will adequately protect them in their high-
end home. These standard policies are designed for the masses and when a
homeowner has a unique property like Ann and Chris or a high-valued property
like Ben and Leslie, or even a more traditional home that has been modified with
a wine cellar (or other unique enhancements), these policies often come up short
at claim time. That is absolutely not the time to find out that your homeowners
insurance is inadequate.
This often happens because the couple didn’t start out wealthy, and so their first
home insurance policy might have been a renter’s policy for their first apartment.
When they graduated to a house, it was an average home and an average
homeowners policy was just what they needed. When they bought the high-end
home, they simply called the agent they’d been dealing with all along who was
more than happy to write the policy.
The risk management needs of high-end properties are much greater. For
instance, if the home is older there may be a need for an extra ordinance or law
endorsement in order to bring the property up to code when damage is repaired.
Restoration cost coverage will be needed if the home has historical value, as
standard contemporary materials may not be adequate to restore the property.
Some items may not be able to be replaced, so extra high limits and guaranteed
replacement cost or restoration cost coverage may be needed. This would also
apply to custom or unique features and materials.
If significant remodeling has been done, such as a room in the basement

converted to a wine cellar, specific coverage will be needed so that specialized
rooms or features can be replaced. There may be additional residences or other
buildings on the property that will need adequate dwelling and contents coverage
not offered by standard policies. A standard homeowners policy would cover the
building itself, but contents would fall under the standard contents coverage. In a
scenario similar to that of Ann and Chris, a separate residence and stables would
need enhanced coverage.
In Ron’s case, he has personal property in three different locations. While there is
coverage for personal property under the contents coverage for his primary
residence, there would be limited or no coverage for the contents of the two
condos he lives in. When a client has multiple residences, owned or not, they
need to ensure that their personal property is covered.
Risk management is more than just insurance, and high net worth clients need to
take measures to protect themselves and their property from loss. Clearly, the
security needs of high net worth clients are greater, so an off-the-shelf security
package is not going to be adequate. A security system should be installed that
protects against home invasion and also provides smoke and carbon monoxide
alarms. Providing deterrents to would-be home invaders and early warning
systems increases the level of protection.

Flood Coverage
Another area of concern for high-end homes is flood damage. Many people, and
this certainly includes high net worth individuals, do not know that about 25% of
all flood claims happen in areas designated as low to moderate risk for flooding.
As a result, many people who need flood insurance don’t buy it, and damage
caused by surface water is excluded by all standard homeowners policies. For
example, in September 2013, after significant rainfall, properties in the
mountains and foothills of Colorado were damaged by floodwaters. A couple
years before, flooding occurred in Vermont in the spring after a lot of snow melt
and significant rain. Then add the different hurricanes—Sandy in 2012 and Irma
in 2017—during which many areas that were considered low risk were flooded.
While unlikely, it can still happen, and after the damage is done is not the time to
find out that there is no coverage for it.
However, even if people with high-end homes want to purchase flood insurance,
there is another problem: standard flood policies provide only $250,000 of
coverage on the dwelling and $100,000 on contents. Worse yet, except for
equipment necessary for maintaining living conditions (furnace, hot water heater,
washer, dryer, plumbing, electrical, and some drywall), there is no coverage for
items in the basement. Think of the wine collection or the home theater or gym
that may be in the basement for which there is no coverage. Fortunately, a few
companies offer broader flood coverage and higher limits so that these homes can
be better protected.
Earth Movement
Another similar issue is earth movement or earthquake coverage. There are vast
areas of the United States where at least some risk for earthquake or earth
movement can occur. Typically, this is not included automatically with any
homeowners policy and needs to be added by endorsement. Once again, high-end
homes need to add this endorsement in order to be protected, and the specialty
carriers can do this.
Lawsuits
Another, often overlooked, risk homeowners have is the risk of being sued by
people who are guests at the property. Ron certainly has this exposure every year
when he hosts the Super Bowl party. The risk is even greater for Ann and Chris
when they host the charity fundraising event because even more people will be
over. If alcohol is served at either Ron’s or Ann and Chris’s, there is additional
exposure for guests who may over imbibe and then injure themselves or others. If
a guest falls and seriously hurts himself, the clients’ entire net worth may be
exposed to a lawsuit. The wealthier the homeowner, the bigger the target for a
personal injury attorney.
Some examples of lawsuit settlements from Chubb, an insurance company that

specializes in excess liability coverage, include:
1. While taking items to his trash, a man was attacked by a neighbor’s three
dogs, which had escaped through an open gate on the neighbor’s property.
The man sustained multiple lacerations to both legs and a lower back injury.
Judgment: $7.7 million
2. After completing his work in the attic of a customer’s home, a heating and
cooling service technician fell through the floor of the attic, falling nearly 20
feet. He sustained injuries to his back, hand, foot, ribs, shoulder, and wrist.
Judgment: $8.9 million
3. While traversing a crosswalk, a woman was struck by an oncoming vehicle.

The impact resulted in traumatic brain injury and damage to one leg that
ultimately necessitated an above-the-knee amputation. Judgment: $26.2
million
4. While riding his motorcycle down a highway, a man was struck by a vehicle
traveling the wrong way. He sustained multiple fractures, including his arms,
collarbone, pelvis, and jaw. The injuries also resulted in infertility, pain and
suffering, mental anguish, and lost wages. The vehicle occupants, all minors,

were intoxicated at the time and had left a party at the defendant’s home
where alcohol was served. Judgment: $47.5 million
5. While riding his motorcycle through an intersection, an individual was struck

by a vehicle that ran a red light. The impact caused the man to be thrown
from the motorcycle and to pass away at the scene from the resulting injuries.
The family of the victim sought wrongful death, compensatory, and punitive
damages from the driver for motor vehicle negligence. Judgment: $50
million
Liability Umbrella Policies

To protect themselves and their assets from lawsuits, high net worth clients
should have very high liability limits on their home and automobile policies to
provide a base level of coverage. A liability umbrella policy that adds additional
coverage beyond what is included in the base policy should also be purchased.
For many people, a $1 million umbrella is adequate, but for high net worth
clients that is probably not nearly enough. In the examples that were given, a
$1 million umbrella would definitely not be sufficient. A common question that
arises is “what is the appropriate level of coverage?” To answer this question, it
is important to understand what an umbrella policy will do and what it won’t do.
Some planners and insurance agents will recommend that the liability umbrella
coverage amount equal the level of assets the client has. This might be adequate
for a client who has a couple million dollars of assets, but when a client has $10
million, $20 million, or more the additional question arises is “how much is too
much?”
A common misconception is that a liability umbrella protects assets. In a way,

that might be true; however, that is not a completely accurate statement. The
reality is that an individual can be sued above and beyond any liability limit they
might carry. In fact, liability limits typically are not disclosed or are known to the
claimant or attorney. As an additional note, not only can current assets be
targeted in a lawsuit, but future earnings as well. Suppose a client has $1 million
in assets and a $1 million umbrella policy. Further, suppose he negligently causes
an accident that leaves a middle income couple significantly injured and
permanently disabled. More likely than not, a claim would be made in excess of
$1 million. If the claimants are successful, they not only could collect from the
umbrella but also from the other $1 million in assets and if that was not enough,
have a judgment entered to attach future earnings.
What a liability umbrella will effectively do is to provide a readily accessible,

liquid resource to settle a claim and pay for defense costs. Even when an injury
exceeds the policy limits, many plaintiffs’ attorneys will encourage their clients
to settle for policy limits. There are multiple reasons for this. The first is that the
client might need money sooner rather than later to cover medical expenses or
other expenses related to the injury. Another reason is that it is rather costly,
especially for the attorney fees, to take the case to trial. If they are able to settle
the case for a value, even if it is less then they might be able to fully recover, that
puts money into both the attorney’s and the client’s hands. Another factor that is
weighed is that if the case goes to trial, the claimant won’t see any recovered
funds until the case is concluded, which could take several years. In the case of a
significant injury or one that even involves death, during this time, the claimant
must relive the events, which could add stress and discomfort. By accepting a
settlement early in the process, this allows the claimant to bring closure to the
event and to start the transition to post-event life.
The expense of defense costs is another important reason high net worth clients
should consider a liability umbrella policy. Most personal policies will pay
attorneys (defense) fees in addition to the policy limits; however, if the fees are
included in the policy limits, this will reduce the amount that is available to pay
claims, thus potentially leaving the client underinsured. It is possible for a client
to successfully defend against a lawsuit and still end up with thousands of dollars
in expenses that are owed. When defense costs are paid in addition to policy
limits, this additional feature is a very valuable benefit. For example, let’s
assume a client has a $2 million liability umbrella policy, loses a lawsuit, the
settlement is $2 million, and defense costs are $250,000. The liability umbrella
will pay $2.25 million, covering the settlement and the cost of defending against

the lawsuit. Review the policy terms and provisions to be certain you know what
level of protection the client will have.
A very important consideration when purchasing a liability umbrella is to

consider the financial strength of the insurance company as well as their claim
handling process. Some companies are very fair and make appropriate settlement
offers to claimants, while others may employ tougher negotiating tactics. It is not
uncommon with a significant injury for some companies to review the case and
immediately offer policy limits.
For high net worth clients, umbrella coverage in the area of $2 million to
$10 million might be appropriate. Of course, there will be situations where
coverage in excess of $10 million will be the right recommendation for the client.
Typically, clients with a very high net worth will be working with attorneys who
specialize in asset protection. While beyond the scope of this module, attorneys
will recommend special trusts and titling assets in such a way that will protect the
assets from creditors and lawsuits. These tactics and an appropriate liability
umbrella policy should provide appropriate protection for these clients. What’s
more, the coverage needs to grow as the client’s net worth grows. Once again,
high net worth clients will need to turn to specialty insurers with the capability
and expertise to offer and service clients with this high level of exposure.
Automobile Risks
While high net worth clients may own exotic and unusually expensive cars like
Ann and Chris or Ben and Leslie, many “millionaire-next-door” types may drive
nice, but not unusual cars. Many of these cars can be covered by an off-the-shelf
auto policy, but when a vehicle is a collectible or an exotic car, specialized
coverage is needed. Stated value or agreed value policies are needed to protect
these expensive vehicles. Additional security measures should also be taken to
protect the cars when they are garaged or being driven to reduce the likelihood of
damage or theft.
Low Deductibles
A common mistake made by high net worth individuals when it comes to their
automobile insurance is maintaining deductibles that are too low. Again, this is
likely a carryover from when they weren’t wealthy and simply called the
insurance agent they’ve dealt with for years. They may have replaced several
cars on the same policy, but never evaluated their coverage to determine if it was
appropriate. Clearly, people with significant assets can afford higher deductibles
in order to lower their overall insurance costs.
Low Liability Coverage
Certainly the risk associated with the loss of or damage to expensive cars can be
significant, but the greatest potential for loss associated with high net worth
drivers is the liability exposure they have from driving. People with money have
more to lose as a result of an at-fault accident and as such should have much
higher than usual liability coverage. An additional risk comes from other people
driving the owners’ car. If Ben or Leslie’s au pair causes an accident while taking
the children to soccer practice, Ben and Leslie have a liability exposure. As we
discussed above, higher than usual liability limits and an umbrella policy are
needed for high net worth clients. In the case of the au pair, it is important for
Ben and Leslie to disclose to the insurance company the au pair’s name and
license number as a household driver. This would also be the case of any
individual who regularly drives one of the vehicles.
Liability insurance is designed to protect the insured from the lawsuits and
resulting damages caused when the insured is at fault. It essentially exists to pay
other people. What happens when your high net worth client is not at fault, but
instead is seriously injured by an uninsured? What about the millions more who
have woefully low liability limits and are effectively underinsured? Fortunately,
automobile policies can include uninsured and underinsured coverage. High net
worth clients need to purchase the maximum they can on their auto policies and
make sure uninsured/underinsured coverage is included in their liability

umbrella. This addition to the liability umbrella is not common with standard
insurance carriers, so a specialty company might need to be sought out.
Valuables and Collections

Many high net worth clients, like the clients we have been using as examples,
own collectibles of some sort. It may be like Ron’s wine collection or Chris and
Ann’s fine art and cars, or it could be jewelry, antiques, or any number of things
depending on the passions and tastes of the client. Most homeowners policies
only offer some limited coverage for these items, which is usually well below
what is needed to replace them if they are damaged or destroyed.
Items such as fine art, wine, and jewelry need a coordinated risk management
plan to properly be protected. And let’s not forget the antiques, china, rugs, and
furs that may be in the household. In addition to security measures in the home,
protection must be in place if the items are on loan or in transit from one property
to another. Artwork may need insurance not only for damage but also to protect
against a defective legal title in cases of forgery and fraud. Proper valuation using
independent appraisers and an up-to-date and accurate inventory are needed so
that an appropriate amount of insurance coverage can be purchased. Because
these types of items are frequently moved and of high value, specialized inland
marine insurance should be purchased to protect them for full value.
The “Toys”
It is not uncommon for individuals with significant resources to also own high-
end “toys” such as sailboats, yachts, and aircraft. While these items may be used
for travel, they are often the pursuit of a passion for their owner. Some watercraft
may be large enough that a staff is needed to navigate when in transit. And
aircraft may need a pilot. But oftentimes, the owner has the necessary training
and credentials to operate their own boat or plane. A host of maritime laws and
regulations come into play for yacht owners. Guidelines for crew come under
laws such as the Jones Act, the Death on the High Seas Act, and the Federal
Longshore and Harbor Workers Act, as well as general maritime law. Yachts and
large sailboats are also used as floating venues for entertaining guests while
docked. Protection from accidents and injuries is clearly needed. Aircraft
fortunately are involved in very few accidents, but when they are the results are
usually catastrophic.
The insurance for these big toys is quite specialized, and an expert in providing
coverage for these should be consulted. Protection for the property itself and high
liability limits should be purchased to adequately protect the owner from loss or
lawsuits resulting from the operation of yachts, sailboats, and aircraft.
In addition to the big toys discussed above, there are often several smaller toys in
the form of snowmobiles, personal watercraft, and all-terrain vehicles. While
these may not need to be insured for property damage (because their owners
could probably afford to replace them if they were destroyed or repair them if
damaged), the liability exposure that comes from operating them can be
significant. Once again, people other than the owner may be operating them
when friends or extended family are enjoying time with the owners, expanding
the opportunity for something to go wrong and a lawsuit to result.
International Risks
High net worth individuals typically will travel to a much greater extent than
other demographics. In addition to traveling to foreign countries, they may
temporarily live abroad for work (as in the case of an expatriate), or just for
pleasure. In any of these cases, there are numerous concerns.
Traveling Abroad
When planning to travel abroad, there are some basic precautions everyone
should take. Most health insurance policies do not provide coverage outside the
United States and its territories. Travel insurance policies can provide coverage
for out-of-pocket expenses for co-payments, co-insurance, deductibles, and other
charges, as well as providing for transportation to quality medical facilities.
When planning to drive in a foreign country, coverage can be obtained from the

rental car company, but this may not be nearly enough for a high net worth
individual. A liability umbrella policy can provide coverage worldwide, but the
time to determine if that is the case is prior to leaving the U.S. Additionally, any
valuables that are taken abroad should be listed and covered on an inland marine
policy that provides worldwide coverage.
We will cover personal security issues such as kidnapping and extortion in the
next chapter. These risks are most prevalent in foreign countries where organized
crime rings, anti-American sentiment, and terrorist activity are greater risks.
Taking the necessary precautions to reduce these risks and obtaining kidnap and
ransom insurance can provide some peace of mind when traveling overseas.
Living Abroad
When high net worth people plan to live abroad, whether for a matter of months
or for several years, another layer of complexity is presented. Certainly all of the
risks mentioned when merely visiting another country apply, but in addition to
these, there are additional risks when planning to remain overseas for a period of
time. When traveling, if a ring is lost or stolen, an inland marine policy will pay
to replace it. When living abroad, an inland marine policy won’t cover household
goods, so international property coverage is needed.
At the same time, the personal property that is left behind in the home or in
storage also needs to be protected. And, if property is being shipped from the
United States to a location overseas, transit insurance may be needed. When
planning to live overseas, it may be necessary to purchase international auto
coverage to ensure that adequate liability limits are in place and that coverage
coordinates with an umbrella policy that provides coverage where the client will
be living. Similarly, international health insurance is specifically designed for
Americans who live overseas.
Another consideration is what to do with the home while the high net worth
client is out of the country. For instance, Ben and Leslie may decide to rent their
home while living in England for a year. They will need to decide if they will
rent it with their furnishings or if they will store their belongings and the tenant
will furnish the home. Regardless of what they decide with respect to their
property, the tenant will need renter’s insurance and a properly drawn up lease
will need to be used to ensure each party understands their rights and
responsibilities. Leaving the home unoccupied is another option. All of these
options will require reviewing the homeowners policy to determine what is
covered and what is not covered based on the decisions made. There are specialty
insurance carriers that commonly deal with situations such as clients who live
internationally for periods of time. Working with these insurance companies will
reduce the likelihood that a significant risk is overlooked. These companies often
provide risk managers who can properly advise clients concerning their choices.
The bottom line when your high net worth client is traveling or living abroad is
to take the time to plan the actions that need to be taken to protect against
international risks. Planning for the personal, property, and liability risks that
international travel and living present is well worth the effort.
Chapter 3 Review
1. Identify and define the four risk management techniques and provide an
example for each.
Go to answer.
2. What are some property and casualty risks that are unique to high net worth
clients?
Go to answer.
3. What additional risks does traveling abroad expose clients to?

Go to answer.

Chapter 4: Personal, Security, and
Professional Risks
Entertaining Guests
M
ost people occasionally entertain guests from time to time. Ron, with
his Super Bowl party, and Ann and Chris, who will be hosting a
charity event, each has a risk of lawsuits from guests who may be
injured or may injure others. While everyone normally has a wonderful time and
no one gets hurt, all it takes is one person who is careless or intoxicated and a
significant liability exposure occurs. Even if the host is not held liable for the
damages, the defense costs can be quite high.
High net worth clients are at a greater risk for lawsuits in general because of their
wealth. That certainly applies to when they are entertaining at their home, so
adequate risk management is necessary to protect against such an event. In
addition to ensuring the property is well maintained, providing transportation for
guests who have had too much to drink makes sense. High net worth individuals
may have established a qualified personal residence trust (QPRT) in order to pass
the property to heirs upon death. Technically, the trust owns the property and is
the named insured on policy with the owners being added as additional insureds.
This, along with a specialized liability umbrella policy, will help protect the
client in the event of lawsuits.
Chapter 4: Personal, Security, and Professional Risks  53

Serving on a Board
Another activity that high net worth clients often participate in is being a member
of a board. Volunteering to serve on a board for a not-for-profit is often a way for
them to give their time to charitable causes. Whether or not it is a paid position,
board members are exposed to liability from their position on the board.
Although infrequent, allegations of financial mismanagement, improper
employment practices, sexual harassment, and professional errors and omissions
can be expensive. Once again, the cost to defend oneself against these allegations
can be expensive even if no damages are awarded.
A couple of “real-life” examples from AIG:
1. The local chapter of a national service organization was named in several

articles alleging mismanagement and misappropriation of funds. Subsequent
investigations revealed that the chapter’s executive director approved a
number of questionable payments—some of which were disclosed but
misrepresented, and others of which the board had no knowledge. The board
members authorized a public response and temporarily suspended certain
powers of the executive director, who subsequently resigned. The executive
director later filed claims for defamation, wrongful termination, and
discrimination, seeking damages in excess of the chapter’s $1 million policy.
2. The board of a residential cooperative building was sued by an applicant who

was denied approval to purchase a unit. The applicant claimed the board
discriminated against him based on his sexual orientation. The applicant later
added a defamation count to the lawsuit.
Since liability umbrella policies exclude coverage for these actions, high net
worth clients who serve on boards should be protected by directors and officers
(D&O) insurance. The organization itself may have an employment practices
liability policy as well as a D&O policy. If so, those serving on the board should
obtain a copy and review it to ensure they are insured adequately. If not, they
should purchase their own.

Personal Security Risks
Wealth offers many advantages, but it also comes with greater risk. The
increasing income disparity in the United States has become the focal point of
special interest groups and politicians, and the 1% is increasingly the target of
verbal attacks, especially during economic downturns. Most wealthy individuals
are very concerned about their personal safety as a result of
 workplace violence
 home invasions
 muggings
 kidnapping
 extortion
 identity theft
 cyberattacks
Cybercrime
For obvious reasons, criminals are attracted to wealth and desire to acquire some
of it for themselves. The greater the wealth, the greater the likelihood that a more
sophisticated level of criminal will target a high net worth person. These
criminals often have skills or access to skilled specialists along with the means
and technology to carry out their crimes.
It seems that almost every week there is a news story about the latest business to
have customer data hacked. Celebrities and even prominent politicians have had
their personal data leaked by cybercriminals. It is relatively easy to gather a great
deal of information about people and the more public the person, the more
information there is. Wealthy business owners and highly paid executives, by

nature of their position, have a great deal of public information that can be
accessed by even a simple internet search.
Protecting against identity theft, keylogging (a method cybercriminals use to

track each keystroke and mouse click), and phishing is important. Carefully
protecting passwords, having security programs on your computer, and never
clicking a link in an email that requests personal information are all good
protective measures. Purchasing identity theft coverage is also a good idea, and it
can often be obtained through an endorsement on a homeowners policy.
While access to personal information can lead to theft and fraud, it can also lead
to much more serious threats such as kidnapping, extortion, and home invasion.
The kidnapping threat is relatively low in the United States, but the risk of
kidnapping is much greater when traveling abroad. For criminals in some
countries, kidnapping is a way of life. Taking adequate security measures to
prevent kidnapping is the best course of action, but kidnap and ransom insurance
can provide peace of mind for high net worth clients who frequently travel.
Extortion
Access to one’s personal information can also lead to extortion. These crimes are
rarely reported because of the potential for embarrassment or unwanted public
attention. Often, extortionists are simply paid to make the problem go away.
Sadly, the biggest threat to wealthy people comes from people they know and
trust. Personal assistants, domestic staff, business associates, and even family
members may attempt to cash in on information they hold. Besides taking
obvious care with whom information is shared, kidnap and ransom insurance
should also be considered because it also pays claims for extortion payments
made.
Risk Management Strategies

Perhaps the best preventive measure high net worth clients can take to reduce the
likelihood of personal and security losses is to educate themselves as to how,

when, and where threats can materialize. Security specialists exist who can
develop a comprehensive security plan that involves home protection and
security, protection while traveling, and preventing identity theft and other
cyberattacks. As discussed previously, appropriate and adequate insurance is
often available to reimburse the client as well as help with legal fees. Clients
need to understand the risks they face and what they can do to prevent them, as
well as how to respond to them if they occur.
Professional and Employer Risks

Professional Risks
Many high net worth clients earned their wealth as business owners or as highly
compensated executives. Although most people do their best to avoid the
spotlight, sometimes that is unavoidable for those with a high net worth. And, as
you can imagine, a high profile brings with it greater risk. Those with much to
lose have more to be concerned about. The higher the profile, the bigger the
lawsuits when unfortunate events occur.
High net worth business owners have worked hard to build their business. In the
process, they have also built their brand, and it is often closely tied to their name.
It takes years to build a good reputation and only moments to destroy it. That can
be more financially devastating than any other risk if your livelihood depends on
the success of your business. For this reason, care needs to be taken with the use
of social media. One embarrassing photo or emotional rant can greatly damage
one’s reputation, and in this world of instant information, reputation management
has become an industry unto itself. These services keep an eye on their client’s
web footprint and reduce or eliminate negative history. Prevention is the best
insurance against a public relations nightmare.
Another valuable asset many business owners need to protect is their intellectual
capital. This consists of all the things that make their business unique and
includes the knowledge, experience, relationships, and human resources that
create value. It may also consist of trademarks and patents as well as brand

names that the business has developed. If a business owner client has invented a
product or a process that is unique, it may be the business’s most valuable asset.
They should work with a patent attorney to protect it properly.
Employer Risks
Additional risks business owners face involve their employees. From the moment
the first employee is hired, the business owner is exposed to several additional
risks. The employee could get sick or hurt on the job or claim that they were the
victim of unfair hiring practices. They could claim they are the victim of unfair
employment practices such as sexual harassment, being overlooked for a
promotion, or wrongful termination. They can also steal from their employer—
from office supplies to trade secrets and anything in between. They can also
harass their fellow employees and even commit violence.
In addition to implementing appropriate training programs designed to reduce

issues like these, employment practices liability insurance can be purchased to
protect business owners from claims arising from employees alleging
mistreatment, whether the alleged mistreatment comes from the employer or their
fellow employees. Employment practices liability insurance can be purchased as
a stand-alone policy or it may possibly be added to an umbrella policy. All
employers should have workers’ compensation insurance to protect themselves
when their employees are sick or hurt due to job-related activities.
Many high net worth individuals, whether or not they are business owners,
employ nannies or au pairs, personal assistants, and other domestic employees.
The same risks that apply to employees of a business apply to domestic
employees as well. An additional risk is that oftentimes domestic employees are
treated as extended family rather than as the employees they are. This familiarity
can lead to personal litigation when inappropriate comments are made or actions
taken and the worker decides to cash in. Disgruntled domestic employees can
cause all sorts of embarrassing and expensive claims due to discrimination,
sexual harassment, or wrongful termination.

Domestic employees also have access to their employer’s home and the valuables
inside, and personal assistants may even have access to bank accounts. These
situations increase the risk of theft for high net worth clients. Domestic
employees may also overhear private or even intimate conversations not meant to
be shared outside the home. This increases the risk of a public relations problem
and the expense and embarrassment that a high profile scandal can cause.
There are some non-insurance risk management strategies that can be utilized to
reduce risks with regard to employees. However, domestic employers should also
ensure they are in compliance with state and federal law and employment
practices, especially with regard to properly conducting background checks,
immigration status, monitoring employees, and payroll tax requirements. A
mistake some people make is to attempt to classify domestic employees as
independent contractors. The employer can’t simply make this determination.
Instead, the nature of the work relationship determines whether a person is an
employee or independent contractor. Domestic employees are almost always
employees rather than independent contractors.
An excellent preventive measure that can be taken is to conduct extensive

background checks on all employees, domestic or otherwise. However, there are
rules to be followed to remain in compliance with Fair Credit Reporting Act,
which regulates how background checks are conducted. Another risk
management strategy is to install hidden cameras to monitor domestic
employees. Video recording at one’s home must also be done in accordance with
appropriate laws. Generally, video-only recordings are perfectly legal, but voice
recording may require prior permission. Certainly immigration laws need to be
followed as well to avoid unwanted attention.
Being an employer clearly adds another layer of exposure to risk and the
potential for lawsuits and public relations nightmares. Taking the necessary steps
to be educated about these risks and the rules that need to be followed will go a
long way to properly advising your clients. As always, when presented with a
question that is beyond your level of expertise, refer your clients to qualified risk
managers who can properly advise your clients.

Chapter 4 Review
1. What are some risks associated with entertaining guests and serving on a
board, and what can clients do to protect themselves?
Go to answer.
2. What are personal security risks? How can clients protect themselves?
Go to answer.
3. Identify professional and employer risks and what clients can do to protect
themselves.
Go to answer.

Chapter 5: Life and Disability
Insurance for the Wealthy Client
Life Insurance
T
he primary purpose of life insurance is to provide liquidity or cash
necessary to pay for expenses related to the death of the insured. These
expenses may be related either to personal or business needs, and are not
limited to what is usually referred to as “final expenses.” In addition to these
“final expenses,” many individuals have additional personal concerns: unfulfilled
plans and goals, ongoing immediate family needs (e.g., regular income,
children’s education, etc.), taking care of the remaining spouse, and providing for
parents and extended family.
For high-earner clients who have not yet accumulated substantial wealth, there
may be a significant need for life insurance to replace lost income and provide
for college funding for children, especially if the client is the sole breadwinner in
the household. As the client accumulates more and more wealth, those assets can
mitigate against the need for life insurance death benefits, but the need for the
favorable tax treatment of life insurance cash values may still remain. In the
instance when a life insurance policy was purchased to protect a certain need and
then later on that need no longer exists, the client will need to make a decision as
to whether to cancel the policy or redirect its purpose to another need.
For example, a young physician client with a high annual income may buy a life
insurance policy to replace lost income and pay off the significant amount of
student loans that were accumulated in pursuit of her medical degree. As the
years go by, as the loans eventually are paid off and wealth is accumulated, the
Chapter 5: Life and Disability Insurance for the Wealthy Client  61

original need for the life insurance has diminished or disappeared. However, the
physician client may find that at this point in her life, she has limited options for
tax-deferred retirement savings vehicles due to her income level and that she may
already be contributing the maximum to her qualified plans. Since it is possible
for the cash values in a life insurance policy to be withdrawn on a tax-favored
basis, a policy originally purchased to pay off student loans and replace lost
income can be used to build additional funds that can be used in retirement.
Similarly, the policy could be used for legacy planning purposes if she desires to
use it to provide for a portion of an inheritance for children or a charity.
There may be business-related exposures as well. There may be a termination of

sole proprietorship or partnership due to death of the owner or key employee, or
there may be a need for converting business assets into personal assets for the
family in the event the business owner does not die before retirement. Cash value
life insurance can provide additional funds for the owner or his heirs while plans
are made to transfer business assets to the owner or his family or while
determining whether the business should be liquidated, and at what price.
Once again, as a business owner client accumulates wealth and maxes out
qualified retirement plans, cash value life insurance originally purchased to fund
a buy-sell agreement can be used on a tax-favored basis to supplement retirement
income needs if the client retires from the business prior to death.
Types of Life Insurance

This is by no means an exhaustive list of exposures, but it gives an idea of the
large number of areas that may be impacted by an individual’s death. Life
insurance was developed to help deal with these concerns. There are two main
divisions of life insurance: temporary and permanent. Temporary life insurance is
designed for exposures that are not expected to last for a lifetime (e.g., college
funding for children usually has an exposure period of about 18–24 years). Life
insurance that is expected to be needed only for a short duration or term (hence
the name “term insurance”) is relatively uncomplicated, pure protection and can
be purchased for one or more years at a fairly reasonable premium.

Life insurance designed to cover exposures that are expected to last for a normal
lifetime is considered to be permanent coverage. This permanent coverage,
known generically as whole life (even though whole life is just one of many
permanent policy types), has an initial premium cost that is higher than term
coverage, with the extra premium amounts going into a cash value account. This
cash value account is invested so that, as the insured ages, the premiums
necessary to keep the insurance going will not increase. The insurer dips into the
cash value account to collect additional expenses related to the increased cost of
insurance as the individual ages (known as the mortality charge). Most of the
variations in permanent life insurance are related to the way in which the cash
value account is managed and invested. Although many variations exist, the four
main types of permanent life insurance are whole life, variable life, universal life,
and variable universal life. Each of the types may or may not be appropriate,
based on the insured’s goals and risk tolerance level.
Multiple-Life Policies
Most life insurance is structured to cover one life, but some policies cover more
than one life. These can be either first-to-die or second-to-die policies, also
known as survivorship policies. These policies traditionally have been whole life
contracts, but other products have also expanded into the multiple-lives arena.
First-to-Die Policies
A first-to-die policy may be used in either a personal or a business situation. It

promises to pay the face amount on the death of the first of two or more covered
persons. For example, if one of three covered business partners dies before
retirement, the business is provided with enough cash to purchase his or her share
of the business without invading current assets (buy-sell or cross-purchase
agreements are usually used for this purpose).
If the policy is written on a husband and wife, the policy pays on the death of the
first and may be terminated at that time. Instead of two policies covering the risk
of either dying first, this policy covers that risk in one contract. The survivor,

then, may be without coverage, or the joint life contract may provide the survivor
with the right to purchase another policy without evidence of insurability or to
continue with the same or a lesser amount of coverage. A first-to-die policy
might be used to cover a mortgage or an education fund.
Premiums for a first-to-die policy are generally more than the cost of insurance
on any one of the people insured, but they are less than the combined premium of
individual policies on each of them.
Second-to-Die Policies
The survivorship life policy pays when the last person dies, not at the first death.
This policy is especially attractive in estate planning situations when the
unlimited marital deduction is used. For example, after the husband dies, his
entire estate passes estate-tax-free to his wife; when she dies, a well-structured
policy will provide the liquidity necessary for the wife’s estate taxes. With proper
estate planning, the insurance benefits may avoid estate taxes while being
available to pay taxes arising from the transfer of other assets.
For additional flexibility, this product is usually built on the universal life
platform. Premiums for a second-to-die contract generally are lower than the cost
of two separate policies. This type of policy is particularly advantageous in
situations where one insured is highly rated and older, since the underwriting will
concentrate on the person who is likely to be the second to die.
Tax Treatment
Many high net worth individuals make creative use of the cash value account in
permanent life policies. This practice can be useful, but it also creates potential
problems. Due to abuses, laws have been enacted to limit the use of life insurance
primarily for investment purposes, as the government created a definition for life
insurance that relates cash values directly to the death benefit. The result has
been that there are substantial tax implications regarding the way in which an
insurance product is designed by the company and paid for by the insured. If the

cash values of a policy become too large relative to the death benefit, the policy
ceases to qualify as life insurance for some purposes; the growth in cash values is
no longer tax deferred, and the policy owner has to report the annual gain as
taxable income.
In 1988, Congress passed the Technical and Miscellaneous Revenue Act,

legislation creating modified endowment contracts (MECs). If a policy fails what is
known as the seven-pay test, any policy withdrawal (including loans) may be
subject to taxes and penalties. The seven-pay test states that no more than the
equivalent of seven net annual premiums can be deposited into a policy during the
first seven years (i.e., with an annual premium of $2,000, no more than $14,000
can be deposited into the policy at the end of year seven). However, if the insured
put $1,200 in for each of the first four years (a total deposit of $4,800), then in year
five our insured could put in as much as $5,200 (more than the $2,000 annual
premium, but creating a total of $10,000). To put in $5,500 that year would push
the total up to $10,300, or more than the allowable $10,000 in year five, thus
creating a MEC. All withdrawals from MECs will be taxable as ordinary income
(on a LIFO basis), and may be subject to a 10% early withdrawal penalty (i.e.,
everything in excess of the basis will be subject to taxes, and if applicable, the
penalty). However, even after a policy fails the 1988 tests and becomes a MEC, it
will still have a death benefit that is income tax free.
Tax legislation in 1996 addressed accelerated death benefits. Accelerated death

benefits are defined as those benefits paid by a life insurance company to a
terminally or chronically ill person. The 1996 legislation made these payments,
including payments made under a viatical agreement, income tax free (with some
limitations).
Private Placement Life Insurance

Private placement life insurance (PPLI) policies are offered through insurers both
in the United States and abroad to high net worth individuals. These policies are
anything but “off-the-shelf.” They are highly customizable, and in many ways

structured as much (or more) to be investment vehicles as to be typical life
insurance policies.
Much of the flexibility in PPLI policies is in where and how the cash account is
invested. Policy owners are able to use a variety of mutual funds, hedge funds,
funds of funds, and other equity and fixed-income instruments. Owners may be
able to transfer assets into PPLI policies with potentially positive tax
consequences. Rapidly appreciating assets may be a particularly good choice for
transfer into a PPLI policy. Policy owners can also choose and change
investment advisers managing the assets in the policy. As you might suppose, the
premium dollar amounts involved are high—typically in the millions of dollars
(usually paid over a period of years to avoid status as a MEC—see below).
Separate accounts must remain diversified to stay within legal guidelines. PPLI
policies are typically structured as VUL (variable universal life) policies, and
retain all the tax benefits of non-PPLI policies (e.g., tax-deferred growth, tax-free
death benefit, etc.). Potential PPLI owners need to realize that, in order to satisfy
legal guidelines, they have to give up a great deal of control over assets placed
within the PPLI. There is still a large amount of flexibility, but this loss of
control should be considered. PPLI policies have come under significant federal
regulatory scrutiny. While still potentially viable, individuals should exercise
caution to ensure compliance with current regulations.
PPLI policy owners should be aware of two potential problems of overfunding.

The first is the most crucial: if the policy fails the guideline premium test and the
cash value accumulation test (under IRC Section 7702), the policy may lose its
full status as a life insurance policy. If this happens, one of the primary
advantages of life insurance—tax-deferred growth—will be eliminated, and the
policy owner must report the annual gain as taxable income. It is also possible
that some of the death benefit may become taxable. To avoid this potential
pitfall, be careful how much money is deposited into the policy, and structure the
policy to have an increasing death benefit. In this way, the required “corridor”
between the cash value and the death benefit will be maintained.

The second problem, being classified as a modified endowment contract
(MEC), is somewhat less significant than the first. As stated above, in order to
avoid MEC status, the policy owner cannot deposit more into the account
during the first seven years than the equivalent of seven annual net premiums.
If more money is deposited, the policy will be classified as a MEC, and once a
policy becomes a MEC it remains a MEC. A subsequent withdrawal in an
attempt to return a policy to its non-MEC status will not work. As previously
mentioned, MEC status means that any withdrawals from the policy (e.g.,
loans, partial cash withdrawals) will be taxable as ordinary income (on a LIFO
basis), and may be subject to a 10% early withdrawal penalty (if under age
59½). This is only a problem if the owner wishes to make withdrawals from the
policy, so it is important to pay attention to his or her goals when deciding the
best way to proceed.
It should also be noted that even if a policy avoids MEC status during its first
seven years, it may still be subject to MEC rules should there be any material
change such as the addition or removal of riders, or a change in the coverage
amount. At this time a new seven-year premium limit is instituted. Finally, it
should be understood, that by their very nature, all single-premium life policies
are considered to be MECs. This being said, there are situations where the fact
that a policy is a MEC is not necessarily a bad thing. Perhaps a client has a
lump sum of money and wishes to use some of that to create a legacy with no
plans to ever access that cash value. In this case, the fact that the policy is a
MEC is unimportant because the death benefit proceeds would still be paid
income tax-free.
Annuities
An annuity, in simplest terms, is a way to create a regular stream of income
payments. Insurance companies, rather than investment firms, offer annuities
because they include some benefits related to mortality (e.g., life income, refund,
joint life, fixed period, and fixed amount options). Annuities may provide income
immediately (an immediate annuity), or income payments may be deferred (a
deferred annuity). Additionally, both earnings and income payments may be

fixed or variable. Variable annuities are invested in subaccounts that are similar
to mutual funds, while fixed annuities are conservatively invested in the
insurance company’s general account. Typical investments in an insurance
company’s general account include high-grade bonds, real estate, money market
instruments, preferred stock, and other safe investments.
Private Annuities
Private annuities are generally used as part of estate planning and are similar to
PPLI, except they have no pure insurance component. Income-producing assets
and/or cash are placed into a private annuity structure (e.g., LLC or other). By
doing so, the donor can remove assets from his or her estate, thereby potentially
eliminating future gift or estate tax liabilities, and the donor can get a stream of
income from the annuity while alive. If the current income stream is equal to the
value of the original assets, it should keep the donor from having to pay gift taxes
on the transfer (which is usually made for the benefit of a child or other family
member). Payments received by the donor are usually taxable as ordinary income
based on recovery of basis, gain, and interest. It should be noted that the IRS
tends to closely scrutinize private annuities. In fact, private annuities tend to have
pretty complex tax and estate planning requirements and ramifications, so care
should be taken in setting up and maintaining them.
Disability Insurance
Disability income insurance is another risk management product that is often
needed prior to a client developing substantial wealth. A high income earner will
most likely need to protect against losing that income due to a disabling illness or
injury until they have enough money saved that the funds they have accumulated
mitigate against the need for an insurance policy to replace lost income because
the funds earn enough interest to cover the family’s expenses. This is important
for high income earners who have not yet accumulated enough wealth that can
generate income regardless of whether the client is able to work or not.

Finding and Using the Right Tools
An issue that arises with a more affluent client is locating insurance carriers that
can provide the type and amount of insurance needed. For this clientele, “off the
shelf” products may not meet their needs. If you do not have the expertise in
advanced markets, it is imperative that you have the ability to access brokers or
insurance carriers who have the expertise to navigate this marketplace to develop
the best solution for the client.
Specialty brokers and carriers exist to fill the niche that wealthy clients create.
They are often able to obtain preferred underwriting methods, place large cases,
and arrange for any reinsurance that may be needed for large death benefit cases.
The insurance companies they use are chosen for their financial strength and
product performance, as you would for any other client, but their selection
criteria also includes the company’s willingness to commit resources to serving
the affluent market as well as the company management’s accessibility and
capability.
Chapter 5 Review
1. Compare and contrast term and cash value life insurance. When would term
life insurance be preferred? When would cash value life insurance be
preferred?
Go to answer.
2. In what situations would a first-to-die policy be appropriate? When would a

second-to-die policy be appropriate?
Go to answer.
3. Compare and contrast ordinary annuities and private annuities.

Go to answer.
4. Where do high net worth clients typically need to go to get the insurance
products they need?
Go to answer.

Chapter 6: Exit Planning for the
Small Business Owner
W
hat is my business worth? Who can I sell my business to? Will the
proceeds allow me to secure my family’s financial security? These
are questions that most would think have exact and straightforward
answers. But, for the small business owner, they are anything but exact and
straightforward, and they are of critical importance in those inevitable situations
when all or part of a business is sold or transferred to another party.
After completing this chapter, you will be able to:

Even small businesses that succeed may not stay in business indefinitely, and
those that do often change hands. In both cases, the business is disposed of in
some way, either through liquidation or transfer of ownership. Any number of
events can trigger a disposition of the business. Typical causes include the
following:
 retirement of the owner-manager;
 death of the owner, a partner, or the controlling shareholder; or
 divorce, physical disability, or mental incapacity of a key person in the

business, especially if that key person is an owner.
As any experienced investment professional will attest, the problem of illiquidity is

a major concern to small business clients. After years of building value in their
enterprises, business owners have a natural interest in reaping what they have
sown: for their children’s education, for the purchase of a vacation home, or for
simply enjoying their wealth while they still have their health. Unfortunately,

liquidating part or all of a small business can be difficult and may require technical
assistance. Few investment professionals will have the resources and expertise to
materially assist in this effort, but understanding the issues involved in selling a
business is important in building trust and rapport with the client. Additionally, a
successful exit plan requires the input of multiple disciplines. Oftentimes an exit
planning team is assembled that includes CPAs, estate attorneys, business
attorneys, merger and acquisition attorneys (for larger deals), investment bankers
(once again, for larger deals), business consultants, business brokers (for smaller
company deals), financial advisers, and even family counselors.
A Primer on Exit Planning

Let’s now shift our focus to exit planning strategies that can be developed over
time to allow the business owner the chance to exit the business with full
financial security and on their terms (when, for how much, and to whom to sell
the business). Many wealth management advisers may not be familiar with the
idea of exit planning, so let’s start with a definition of that term as provided by
the Business Enterprise Institute (BEI).
Exit planning is the creation and execution of a strategy allowing owners to

exit their businesses on their terms and conditions. It is an established
process that creates a written roadmap or exit plan, involving efforts of
several professions facilitated and led by an exit planning advisor who
ensures not only the plan creation, but its timely execution.
Similar to the increased need for retirement and estate planning, exit planning has
come to the forefront in large part due to the baby boomer generation. In his 2012
eBook titled Beating the Boomer Bust, John Dini lays out a compelling thesis
around the impact that the baby boomer generation has had on business
formation in the United States. The boomers are defined as the 78 million people
born in the 20-year period between 1945 and 1964. By 1965 the boomers, who
were all still all under age 20, represented 40% of the American population. As a
result of the weighting of boomers in our society, everything that this generation
Chapter 6: Exit Planning for the Small Business Owner  71

did and accomplished has impacted American society and our economy for the
past 70 years.
College graduations tripled beginning in 1965 as boomers began graduating and

entering the workforce. The sheer number of new college graduates led to a
highly competitive environment within the corporate ranks, which then led to
many of those boomers wanting to build something on their own and go into
business for themselves. The result was a sharp increase in business formation,
going from approximately 300,000 new businesses in 1975 to 700,000 in 1986.
Presently, the youngest boomers are in their early 50s and are less likely to be
looking at starting or acquiring new businesses, while the older boomers are
largely thinking about transitioning to retirement and therefore looking to sell
their businesses.
So what will that process of selling a business look like for a retiring boomer
business owner? According to Dini, it will look quite different in the coming
years than it did for those early boomers who were on the leading edge of the
boomer wave. The early boomers still had a burgeoning market of up-and-
coming boomers to sell their business to, but that won’t be the case going
forward. The reasons are many, but the key drivers are based in simple math and
changing American demographics and culture.
Per data from the National Center for Health Statistics, the general fertility rate in
2015 is tied with the lowest rate on record. You can see in Figure 2 that the trend
that began in the 1970s has largely persisted for the last 40 years. The birth rate
math doesn’t support the continued growth of a business buying segment of the
population. Beginning in 2018 there will be approximately 23% fewer people
turning age 45 than at the peak of the boomer cycle, which is when gen X’ers
will be entering their prime business buying years. Think of it in terms of only
three buyers for every four sellers, which is not exactly a “seller’s market.”

Figure 2: Births by Generation, 1940–Present
Source: http://blogs.wsj.com/economics/2016/06/07/behind-the-ongoing-u-s-baby-bust-in-5-charts/
The second driver in this scenario is that of our changing American culture. Gen
X’ers are not mini-boomers—by and large, they don’t want to repeat the
approach that their boomer parents took in raising families while also striving to
get ahead of their contemporaries. Gen X’ers have different values from their
boomer parents. They value work-life balance more than their parents did, and
they have the ability (in part through technology) to work in alternative
environments. Telecommuting, home-based businesses, and job sharing are
among the examples of the choices the gen X’ers have that their parents did not.
The preceding discussion does not mean that boomer business owners won’t find
a market for their business when it comes time to sell, but it does mean that the
less prepared boomer owners may not get the full value out of their years of hard
work and sacrifice. The preparation that goes into a successful exit is what we
will explore next.

The Steps in the Exit Planning Process
Each year the Business Enterprise Institute Inc. (BEI) surveys business owners
on their plans to transfer ownership of the business and move into the next phase
of their lives. The 2016 Business Owner Survey uncovered some interesting facts
related to the surveyed business owners’ exit plans, including:
 79% of the respondents plan to exit their businesses in the next 10 years
 75% would exit today if their financial security were assured
Looking at the two items above, one can see that a majority of the respondents
are eager to exit their businesses, if not now, then sometime in the next 10 years.
So what have these owners done to prepare their business and themselves for the
eventual sale of their business? Not enough, according to the data provided in
Figure 3, which compares the state of exit planning readiness in 2014 to that in
2016.
Figure 3: Preparations Made for Business Ownership Sale

Source: Business Enterprise Institute Inc., 2016 Business Owner Survey Report.
Although progress was made since the 2014 Business Owner Survey Report,
there is still plenty of work to be done. Here are some takeaways to consider:
 Only 45% have identified all the necessary steps to successfully exit their
businesses.
 Of those, relatively few (17%) have committed the steps to a written exit
plan.
 Meanwhile, 38% have yet to take the first step, and 73% do not have a
financial target in mind.
Those are some pretty sobering statistics when you think about how unprepared
the majority of business owners could be when the time comes to sell their
business. Especially in light of what was presented earlier in this chapter
regarding the shrinking pool of potential business buyers.
So how can you help your business owner clients move forward in the exit
planning process? The short answer is to start educating them on the realities that
they face. This can be accomplished through fact finding that goes beyond their
personal wealth, and integrates the business exit plan with the clients’ personal
plans for retirement and other goals that they have. You will likely need to
collaborate with other specialized advisers on the exit planning team, such as a
CPA, a CFP or other financial adviser, an estate attorney, a business attorney, an
insurance agent, and perhaps even a family counselor.
The exit planning process moves through several steps before arriving at the
successful exit plan.
1. goals are established for both the personal and business areas of the client’s
life,
2. resources are identified and quantified,

3. gaps between the goals and the resources are identified,
4. alternative paths to close the gap are investigated, and
5. a plan that accomplishes the business owner’s goals and allows the owner to
achieve financial independence before giving up control of the company is
recommended.
Such a process should sound familiar to you, as it closely resembles the steps that
you follow when you are currently working through the wealth management
process with clients.
In the next section we will take a close look at the four primary paths for business
owner exit planning: transfers to insiders, transfers to children, third-party
transfers, and sale to an employee stock ownership plan (ESOP).
Potential Exit Planning Paths

While there are multiple exit planning paths available to business owners,
including liquidation and initial public offering, there are only four that
consistently lead to a successful exit when the business owner proactively plans
for an exit. We will explore those four strategies in order of the usage reported by
BEI members (2011 BEI Member Survey). Please note that much of the content
we will be discussing is only scratching the surface of the exit planning process.
Transfers to Insiders
An insider transfer, which could be a sale to existing co-owners or to key
employees, was the path utilized 41.0% of the time. When structured properly,
the money used by the insiders to purchase the exiting owner’s stake actually
comes from the cash flow of the business, so it is not necessary for the insiders to
have cash on hand or to borrow funds to make this strategy work. However, for
such a transfer to work, the exiting owner must have time on his or her side, as it
takes more time for an owner to gradually sell their ownership stake than it

would take to complete a third-party sale or a sale to an ESOP. The time element
has a positive effect as well, as the owner can structure the deal to meet their
goals well in advance of the eventual departure date, while possibly still retaining
the flexibility to sell to a third party if conditions change.
Counted among the primary advantages to an insider transfer are the following:
 The design can provide for the owner to retain control of the company until
the owner receives all of the money they need out of the sale.
 The co-owners and key employees develop a new sense of responsibility for
growing the company and improving on its management and execution.
 The selling owner may realize greater overall income than a third party or
ESOP sale would generate, as the owner is still an active employee earning
salary and bonus, while also very likely receiving the perks of ownership
during the multi-year transfer period.
 The periodic and final installments due the exiting owner will be paid on an
increasing business value.
There are some potential pitfalls to consider with an insider transaction as well.
The exiting owner may receive relatively little in upfront money, and depending
upon the cash flows of the company they may not receive all of the funds
necessary to achieve financial security at the desired time. As mentioned, it also
takes longer to use this exit strategy, so it won’t work if an immediate need to
exit were to arise. The longer the time frame for the buyout period, the greater
the amount of business risk that will be encountered. Also, it may be difficult to
transfer an ownership interest to a key employee, as oftentimes those individuals
are employees for a reason—they lack the necessary skills and mindset to be
owners.

Third-Party Transfers
The next most utilized exit planning strategy is a third-party transfer, which was
used 29.0% of the time. A third-party transaction could involve either a strategic
buyer (perhaps a competitor that is looking at geographic expansion) or a
financial buyer (this might be a private equity firm, hedge fund, or venture
capital firms that would later sell the company or take it public in order to realize
their return on investment).
There are numerous reasons that an owner would consider a third-party sale,
some financially motivated and some values motivated, which could include the
following:
 A realization that the owner has taken the company as far as they care to and
they now want to cash in on their sweat equity.
 The owner no longer has the passion and drive necessary to maintain the
daily work schedule.
 There is no successor in place for an insider transfer or a transfer to the next

generation.
 Completing a sale “sooner, rather than later” is a priority for the owner, as
the owner doesn’t want to take the risk that an insider sale or a transfer to
children won’t provide the necessary money to meet the owner’s financial
security goals.
Speed of the transaction, which can usually be accomplished in one year or so,
and acceleration of cash flows to the owner are key benefits to a third-party sale.
There are, of course, potential obstacles to be overcome in a third-party sale. The

process can be emotionally exhausting for the seller. Kevin Short, an investment
banker and CEO of Clayton Capital Partners, has referred to this as “deal
fatigue.” The sale process can take a year or longer to complete, and it will
involve a lot of due diligence examination on the part of the buyer and very
likely more than a few buyer requests for concessions. Some owners feel that

they are giving in all along the way and at a certain point they have had enough,
and the deal itself could be jeopardized by the emotions they are feeling.
Another factor to consider is the costs associated with the third-party sale, such
as investment banker fees that can run $5,000 to $10,000 per month during the
sale process and a contingent fee that is a percentage of the final sale price. While
there are many ways that the fees can be structured, Short advises owners that for
a $5 million sale they may be looking at fees totaling $500,000 from all sources:
investment bankers, attorneys, CPAs, etc.
The final point to cover in this section is that third-party sales can be
accomplished through either a negotiated sale, where the buyer is already
identified, or through a process known as a controlled auction. Even if a buyer
has expressed interest in acquiring your client’s company, there may be other, as
yet unknown, potential buyers that may be willing to offer more for the company,
and that is one benefit to the controlled auction process. The negotiated sale will
be less costly than the controlled auction that is facilitated by an investment
banking firm. However, the controlled auction gives the seller more control and
more options, while the competition among multiple buyers can provide greater
financial reward.
Transfer to Children
Following closely behind third-party exit plans is the transfer to children of the
exiting owner, which was used 24.0% of the time. Transfers to children are
usually accomplished over a five- to 10-year time frame, so once again, this is
not an exit path that can be used successfully for a scenario in which the owner is
looking to sell quickly. The benefits to transferring ownership to children run the
spectrum from financially motivated goals to values-based goals, including
 The parent owner achieving financial security, but with some of the cash
flows coming after departure.
 The time element (5–10 years) provides the owner with an opportunity to
prepare themselves and the business for the transition. The child successor(s)

are a “known entity” and they can be developed to effectively take over
during the transition period, and as mentioned earlier with the insider sale,
the owner continues to earn income that can help support their eventual
retirement lifestyle.
 Gift taxes on any ownership interest gifted to children can be eliminated or at

least minimized through the use of a grantor retained annuity trust (GRAT).
 The values-based goals revolve around keeping the business as a focal point
of the family, providing above-average income opportunities to the children,
keeping the company anchored in the community, and satisfying the
expectations of those business-active children who want to carry on the
legacy of the family business.
It has already been noted that a transfer to children strategy is not suitable when a
quick timeframe is required and the parent owner may not realize full financial
security at the point of departure. The other major challenge is one of family
dynamics. In a situation where there is only one child, and that child is also a
business-active child, there is no issue. However, consider the implications if
there are multiple children and one or more are actively working in the business
while others are not. Issues related to fairness, both in terms of value and timing
of transfers, can start to fracture the family relationships. These potential issues
are best handled in a direct manner, with all the business-active child and non-
business-active child ramifications laid out and explained thoroughly. Some
parties may still feel slighted, but that is where the family counselor member of
the exit planning team can be of benefit.
Sale to an Employee Stock Ownership Plan (ESOP)

The final exit planning path that we will discuss is in a very distant fourth place
at 1.2% of the successful exit plans. That should not be a surprise, as the
employee stock ownership plan, or ESOP, is not a highly utilized qualified
retirement plan to start with. Per the National Center for Employee Ownership
(www.nceo.org), there were 6,795 ESOPs covering 13.9 million participants in
place at December 2015. Contrast that with the 556,736 defined contribution

plans and 75.4 million active defined contribution plan participants at December
2012 and you can see why ESOPs are not as well understood by advisers and the
public in general (source: Private Pension Plan Bulletin Abstract of 2012 Form
5500 Annual Reports, U.S. Department of Labor Employee Benefits Security
Administration, January 2015).
An ESOP is a qualified defined contribution plan (therefore regulated by the IRS

and the Department of Labor) under which shares of a corporation are acquired
and held in trust on behalf of active employees. There are several tax benefits
associated with an ESOP, including:
 the company’s ability to deduct contributions (cash or stock) to the ESOP,
 under certain conditions the sellers of C corporation shares can defer a

capital gain event by reinvesting the sale proceeds into other securities (a
Section 1042 “rollover”),
 no income tax is assessed on the earnings of the ESOP assets until a

distribution from the plan occurs, and
 when used in an S corporation environment, the earnings of the S corp shares

held in the ESOP are not subject to federal income taxes.
The ESOP is a useful device for achieving several business purposes: (1)
rewarding employees for active service to the firm, (2) sharing ownership with
employees, and (3) providing an orderly transfer of ownership. As a result,
ESOPs can be extremely attractive vehicles for disposing of some or all of a
closely held corporation, with or without an outside buyer’s involvement. ESOPs
can be used by regular C corporations and S corporations, but ESOPs cannot be
used by partnerships.
Closely held corporations, which enjoy no active market for their shares, have
found that the ESOP can provide the liquidity they desperately need. By setting
up an ESOP and its plan for the purchase of shares, the semblance of a market is
established.

Example. Consider a hypothetical case of Abernathy Farm Manufacturing Inc., a
C corporation owned exclusively by John Abernathy and members of his
immediate family. Over a number of years, the firm has done well and has grown
to employ 40 people in the rural community where it is located. Abernathy has
nearly all of his wealth tied up in the business and he would now like to convert
his investment in the business to cash. However, there is no ready market for the
shares and the few potential buyers he has dealt with have not committed to
keeping the company and its employees in the small community. On the advice
of his attorney, Abernathy finds that he can both “do good” and “do well” by
utilizing an ESOP. He can give loyal and diligent employees a piece of the
company, and he can gradually turn his paper ownership of the company into the
cash he needs to meet his own financial security goals. Alternatively, under IRC
Section 1042, he can use the cash to buy “qualified replacement property”
(defined as stocks or bonds issued by U.S.-based operating companies) to
provide retirement income—and this is an area in which the investment
professional can serve the business owner.
Aside from the tax benefits mentioned previously, ESOPs offer additional
benefits to the owner, such as allowing the owner to meet their financial security
objectives while still maintaining a role in the company after the sale if they so
desire. By gradually selling a controlling interest to the ESOP, the owner
maintains control for a period of time while they are also preparing the
management team for the owner’s departure. Values goals can also be met, such
as ensuring the company remains in the community while also providing the
employees with a potentially lucrative retirement benefit in which they have a
hand in growing the value.
ESOPs are complex vehicles, and the dual oversight of the IRS and DOL helps to
drive up the cost of establishing and maintaining an ESOP. Depending upon the
size of the company, the upfront costs for plan design, valuation services, and
governmental filings could range from $50,000 to $350,000, and there would
also be annual costs related to ongoing valuation services, third-party
administration, and trustee fees. According to Loren Rogers, Executive Director

at the National Center for Employee Ownership, an ESOP will work best for
companies with at least 30 employees and $6 million in value.
Valuing an Unlisted Business

For any of the exit planning routes discussed here, it is a necessary step to obtain
an independent appraisal of the value of the company. By definition, a closely
held, unlisted corporation is an entity whose shares are owned by a limited
number of stockholders. Very often, members of the same family hold all of the
stock. Because stock ownership is not widely dispersed among outsiders, little if
any trading of the shares takes place. Lacking an established market and a record
of transactions, the traditional standard for measuring fair market value—the
price at which property changes hands between a willing buyer and a willing
seller—is difficult to establish. Corporations that are listed and regularly traded
provide a daily indicator of what the investing public thinks they are worth
through the market value of their outstanding securities. For unlisted and closely
held corporations, however, the valuation task must rely on other methods.
The need to ascertain the value of a business extends beyond the few situations
listed previously. Here are other common reasons to determine a business’s
value:
 Estate planning. Accurate valuation is essential when using a number of

estate planning techniques, as the business in all likelihood represents the
bulk of the owner’s estate.
 Gifts and charitable contributions. A value must be determined for shares

provided as gifts or charitable contributions. This is important from a tax
perspective for both the donor and the donee.
 Divorce. Approximately 50% of all marriages in the United States end in

divorce, and small business owners are represented in this figure. In divorce
settlements, the value of shares in a closely held business needs to be
determined.

 Buy-sell agreements. When a future sale to a known party is contemplated, a
buy-sell agreement, prepared in advance, can facilitate the sale. If the sale is
later carried out due to the owner’s death—and if the buy-sell agreement was
properly structured—the agreed-upon value can be established for federal
estate tax purposes.
According to the American Institute of Certified Public Accountants (AICPA),

the three most common business valuation approaches are the income-based
approach, the asset-based approach, and market-based approach. The exact steps
in the valuation process are beyond the scope of this course. Regardless of the
chosen methodology, the best approach to establishing the business value is to
work with an experienced professional appraiser who can support the business
valuation should the valuation be challenged at any step in the process.
Buy-Sell Agreements Between Existing

Shareholders
A buy-sell agreement is a document of fundamental importance to the owner(s)
of a closely held corporation, particularly an S corporation where the restriction
on who may be a shareholder is critical. On the surface, it is a simple purchase
and sale agreement. In reality, it is much more, and it can serve as a valuable
business and estate planning tool.
A buy-sell agreement is a contract, either between individual shareholders or

between shareholders and the corporation itself (or other business entity). The
agreement restricts the individual shareholder’s right to dispose of shares in the
corporation over some period of time (say, over the shareholder’s lifetime). For
example, a buy-sell agreement might stipulate that other shareholders must
purchase those shares or must be given the first opportunity to buy a
shareholder’s holdings before those shares could be offered to an outside party.
At the same time, the buy-sell agreement provides a framework for the sale and
purchase of each shareholder’s interest after death. The buyer in this case could
be another shareholder or the corporation itself. Thus, an identifiable party is
obligated to buy the shares from the shareholder’s estate. A similar arrangement

can be crafted, which requires that any shareholder leaving the employ of the
corporation will sell his or her shares to the corporation, thus assuring that all
shareholders have an active interest in the business.
Categories of Buy-Sell Agreements

The buy-sell agreement can be tailored to fit the needs of the contracting parties.
For example, the agreement could specify the transfer of ownership not only in
the case of death, but also in the case of a shareholder leaving the company or in
the event of a divorce decree involving one of the shareholders. There are,
however, a few basic categories of agreements that provide a foundation for
almost all buy-sell arrangements:
 Redemption. This is an agreement between the individual shareholders and

their corporation. At the death of any shareholder, the corporation is
obligated to buy back (i.e., redeem) the decedent’s shares.
 Cross-purchase. This is an agreement among shareholders in which the

estate of the deceased shareholder is obligated to sell its shares to the
surviving shareholders (or give them the right of first refusal).
 Wait-and-see. Upon the death of a business owner, the remaining owners

decide the best way to proceed.
 Third-party buyout. A nonrelated party agrees to purchase the deceased

owner’s interest.
 Hybrid or combination. This combines features of both the redemption and

cross-purchase agreement and requires the decedent’s estate to sell all of the
deceased shareholder’s stock. A typical hybrid buy-sell gives an option to the
surviving shareholders to purchase all or part of the deceased shareholder’s
interest. To the extent that the survivors do not elect to buy, the corporation
must redeem the remaining shares. The hybrid also can work the other way:
The corporation has the first opportunity to buy the deceased’s interest, and the

surviving shareholders have the obligation to buy whatever the corporation
passes over.
Regardless of its form, the buy-sell agreement allows closely held corporations
and their shareholders to realize several important tax and business planning
objectives. These include the following:
 Buy-sell agreements that stipulate a specific share price or formula at which

the buy-sell will be executed establish a value on a shareholder’s interest in
the corporation. In the absence of a marketplace valuation and assuming that
the price or formula is reasonable at the time the agreement is entered into,
this certainty of share value benefits estate planning for all concerned.
However, regardless of the type of buy-sell agreement that is used, the
formula used for computing the share price should be reviewed annually to
be sure it will give everyone concerned a fair price.
 Shares in most closely held corporations are unmarketable in the practical

sense. The buy-sell agreement assures a market and liquidity for the deceased
shareholder’s estate.
 The agreement protects remaining shareholders by giving them the right to

prevent shares from falling into the hands of outsiders or from passing to
inexperienced family members of the deceased shareholder.
 Buy-sell agreements ensure continuity of ownership and management by

keeping shares in the hands of those who are active and interested in the
business.
As pointed out by John Brown in his blog series on business continuity plans,
merely having a buy-sell agreement in place is not sufficient to meeting the needs
of the business and the remaining owners after a buy-sell agreement is triggered.
Challenges for both the business and the deceased owner’s family remain. The
business’s loans may have been dependent upon the personal guarantees of a
deceased owner, or the deceased owner’s role as either an operational expert or
the top revenue generator may be very difficult to replace. The deceased owner’s

family will receive the value for the ownership share, but that may still leave the
family well short of the necessary funds to carry on the lifestyle that the family
was accustomed to previously.
The estate planning implications of buy-sell agreements will be discussed in

Module 7, Estate Planning for High Net Worth Clients. There is, however, one
critical ingredient of any buy-sell agreement that many investment professionals
are well suited to provide: the life insurance or other funding that make these
agreements feasible.
The Use of Life Insurance to Fund Buy-Sell Agreements

Establishing the buy-sell agreement is only the first step, as it is also necessary to
ensure that funds are available to meet the obligation under a redemption
agreement, a cross-purchase agreement, or the hybrid version that utilizes both
approaches. Life insurance proceeds can provide the cash necessary to fulfill the
obligation of either the corporation or the other shareholders to buy out the interests
of a deceased shareholder in a closely held corporation. The problem of liquidity
for the corporation would be solved, as would the problem of funding the shares’
purchase.
With a stock redemption agreement, the corporation owns the life insurance
contract on each owner and would buy the shares back and hold them as treasury
shares. Because the remaining shareholders would then own all of the outstanding
shares, their respective interests would increase; however, since they did not
purchase any more shares, the basis in their interests would remain unchanged—an
important factor if later lifetime sales are contemplated.
In the case of funding a cross-purchase agreement with life insurance, each

shareholder purchases an insurance policy on the life of each co-shareholder
(generally with death benefits in the amounts needed to maintain relative
ownership levels after any shareholder’s death). Here, the co-shareholder is the
insured; the purchasing shareholder is both the beneficiary and the owner of the
policy and pays all premiums. If any shareholder dies, each of the surviving
shareholders receives monies with which to purchase a portion of the decedent’s

interest. The number of insurance policies required under a cross-purchase
agreement could grow very quickly depending upon the number of owners. For
example, a two-owner arrangement would require only two policies, but a three-
owner arrangement would require six policies and a four-owner arrangement
would require 12 policies. Buy-sell agreements funded by life insurance are not
limited to closely held corporations but can be extended to partnerships and sole
proprietorships.
Neither the redemption or cross purchase arrangement will work, however, if any
of the owners is uninsurable. Further, differences in premium costs, the small
dollar amounts of coverage needed for some owners, and other matters such as
the “split dollar” form of purchasing insurance may need to be considered.
The preceding discussion on buy-sell agreements points out a very necessary step
to ensure that a process is in place to smoothly transition business ownership,
most often in the event of either death or disability of an owner. The buy-sell
agreement can also be triggered by the retirement of an owner, but the use of a
leveraged funding mechanism (life insurance) is not available in the retirement
scenario.
The issue of which type of buyout agreement to support with insurance

(redemption, cross-purchase, third-party buyout, wait-and-see, hybrid, or a
combination), however, is complex, as each has important tax consequences for
the surviving shareholders and the corporation. Here again, an accountant may
need to be involved, and an attorney must draft the legal instruments required.

Chapter 6 Review
1. What are the advantages and disadvantages to each of the following exit
paths?
a. transfer to insider
Go to answer.
b. third-party transfer
Go to answer.
c. transfer to children
Go to answer.
d. sale to an ESOP
Go to answer.
2. Explain the major differences between a cross purchase buy-sell agreement

and an entity redemption buy-sell agreement.
Go to answer.

Summary
B
usiness owners and professionals are among the best potential clients for
the investment professional. By nature, they are interested in material
wealth; by disposition, they are more comfortable than the general
population with ambiguity and risk; by experience, they know how to make
decisions involving their personal wealth. Over time, a percentage of these
business owners grow wealthy, creating enormous opportunities for the
investment professional.
This module has presented information about the financial challenges facing
business owners and the ways in which the investment professional can help
them to meet those challenges effectively.
Having read the material in this module, you should be able to:


employees.
recommendations.


Chapter Review Answers
Chapter 1
1. List the advantages and disadvantages of a sole proprietorship.

Advantages of a sole proprietorship are
a. simplicity in setting up
b. ease in decision making and control
c. everything accrues to owner
Disadvantages of a sole proprietorship are
a. lack of checks against proprietor’s business judgment
b. unlimited liability
c. difficulty in raising capital
Return to question.
2. List the advantages and disadvantages of a partnership.

Advantages of a partnership are
a. ease of formation
b. ease in decision making
c. ability to continue after the death or withdrawal of one partner
Disadvantages of a partnership are

a. joint and several liability
b. partnership disagreements can affect operations
c. partner withdrawal can cause financial distress
Return to question.
Chapter Review Answers  91

3. List the advantages of a corporation.
Advantages of a corporation are
a. limited liability
b. ability to raise capital
c. unlimited life of the business
Return to question.
4. Discuss the important tax benefits of a corporation.

Corporations are entitled to a number of tax benefits, particularly
deductions, which are not available to other forms of business. Some
of these, which are deductible by the corporation and not taxable to
the employee, include the following:
a. nondiscriminatory self-insured medical reimbursement plan
b. payments to an accident or health plan
c. cost of group term life insurance up to $50,000
d. meals and lodging furnished for the convenience of the employer
Return to question.
5. Discuss an important tax disadvantage of a corporation.

The most important disadvantage of operating in this form is the
concept of double taxation. A corporation is taxed on its earnings
once. If a dividend is subsequently paid out of earnings to its
shareholders (which is nondeductible), this dividend is then also taxed
to the shareholders. Thus, taxation occurs twice, at the corporate level
and at the shareholder level.
Return to question.

Chapter 2
employees.
1. Distinguish between a profit sharing plan and a money purchase pension

plan.
A money purchase pension plan specifies a fixed percentage of a
participant’s compensation (up to 25%) that the company will
contribute to a pension plan annually, regardless of company
performance. Employer contributions to a money purchase pension
plan cannot exceed 25% of payroll. In contrast, under a profit sharing
plan, the employer may contribute up to 25% of payroll, but the
percentage contributed in any given year is discretionary as long as
the contributions are substantial and recurring. Percentage
contributions may be decreased in years of poor performance or
raised during years of increased profits.
Return to question.
2. Discuss the benefits of an age-weighted profit sharing plan.
An age-weighted profit sharing plan can be used to increase the
amount of employer contributions made on behalf of the key
employees. This type of plan works particularly well when the
owner/employee and key employees are older than the rank-and-file
employees. This is quite often the case in the typical small business.
Return to question.
3. Discuss two reasons why cross-tested profit sharing plans are important.
Cross-tested profit sharing plans can be designed to provide the same
percentage of contributions for a particular category of employees,
such as owner/employees, even though their ages may vary
significantly. They also can be designed to provide the same
percentage allocation based on compensation for all other employees.
Return to question.

4. Describe a simplified employee pension (SEP).
A SEP is an employer-sponsored retirement plan consisting of
individual retirement accounts (IRAs) or individual retirement annuities
for participating employees. In this kind of plan, the employer is not
locked into any specific commitment to contributions, but makes
contributions to employee IRAs on a discretionary basis. All
employees, even part-time workers and employees who have left the
business during the tax year, must be included among those who
receive the benefit. Like other defined contribution plans, employer
contributions up to 25% of an employee-participant’s compensation
are a tax-deductible expense to the company and are not currently
taxable to the employee. All contributions are immediately vested for
employees.
Return to question.
5. Describe a savings incentive match plan for employees (SIMPLE).

SIMPLE plans can be adopted by employers who employ 100 or fewer
employees and can be either an IRA for each employee or part of a
qualified cash or deferred arrangement (401(k) plan). A SIMPLE plan is
not subject to the nondiscrimination rules generally applicable to qualified
plans. Within limits, contributions to a SIMPLE plan are not taxable until
withdrawn. A SIMPLE retirement plan allows employees to make elective
contributions to an IRA. Employee contributions have to be expressed as
a percentage of the employee’s compensation and cannot exceed
$12,500 per year for 2017. Thereafter, the limit will be indexed for
inflation. For 2017, employees who are age 50 or older may make an
additional $3,000 catch-up contribution. The limit is indexed for inflation.
Each employee of the employer who received at least $5,000 in
compensation from the employer during any two prior years and who is
reasonably expected to receive at least $5,000 in compensation during
the current year generally must be eligible to participate in the SIMPLE
plan. Self-employed individuals can also participate in a SIMPLE plan.
The employer/sponsor is required to satisfy one of two contribution
formulas. All contributions to an employee’s SIMPLE account have to be

fully vested. Contributions to a SIMPLE account generally are deductible
by the employer. Distributions from a SIMPLE IRA generally are taxed
under the rules applicable to IRAs.
Return to question.
Chapter 3
recommendations.
1. Identify and define the four risk management techniques and provide an
example for each.
 Risk avoidance is simply not doing things that expose one to risk.
Don’t skydive to avoid dying by high-speed impact with the
ground.
 Risk minimization is employing strategies to reduce the likelihood

or the severity of loss. Wearing seatbelts, maintaining a well-
balanced diet, and regular exercise minimize the risks of health
issues.
 Insurance is the most common method of risk transfer which is
when one entity takes the responsibility for loss on behalf of
another.
 Risk retention may be intentional or unintentional and involves
taking full responsibility for losses. Typically, people choose to
retain risk when the potential for loss is unlikely or the cost of a
loss is small. Deductibles are common forms of risk retention, but
so would be not buying insurance on your cell phone.
Return to question.

2. What are some property and casualty risks that are unique to high net worth
clients?
 Assuming a standard homeowners policy is adequate
 Unique building materials (imported marble, fine woodwork)
 Specialty rooms in the home (wine cellar, home theater)
 Valuables and collectibles (jewelry, art, antiques)
 High-end autos
 “toys”
 Adequate liability insurance (most important!)

Return to question.
3. What additional risks does traveling abroad expose clients to?
Traveling abroad exposes individuals to inadequate on no coverage
for health, auto and property risks. U.S.-based policies rarely provide
coverage overseas, so specific coverage would be needed for these
risks. Living abroad means that people will have to make
arrangements for the property they leave behind (homes, personal
property) in addition to the same issues traveling abroad raises.
Planning for the personal, property, and liability risks that international
travel and living present is critical.
Return to question.

Chapter 4
1. What are some risks associated with entertaining guests and serving on a
board, and what can clients do to protect themselves?
When entertaining guests, there are additional liability risks if guests
were to be injured and there are additional property risks if property is
damaged or stolen. If alcohol is served there would be additional
liability for that as well.
When serving on a board, allegations of financial mismanagement,
improper employment practices, sexual harassment, and professional
errors and omissions can be expensive. Once again, the cost to
defend oneself against these allegations can be expensive even if no
damages are awarded.
Return to question.
2. What are personal security risks? How can clients protect themselves?
 Workplace violence
 Home invasions
 Muggings
 Kidnapping
 Extortion
 Identity theft
 Cyberattacks
Clients should educate themselves as to how, when, and where
threats can materialize. Hire security specialists who can develop a
comprehensive security plan that involves home protection and

security, protection while traveling, and preventing identity theft and
other cyber-attacks. Appropriate and adequate insurance is often
available to reimburse the client as well as help with legal fees.
Return to question.
3. Identify professional and employer risks and what clients can do to protect
themselves.
Professional risks include damage to one’s reputation and the loss of
intellectual property. Employer risks include property and liability risks
as well as allegations of unfair employment practices such as
wrongful termination, being overlooked for promotion, discrimination,
and sexual harassment.
Clients should utilize background checks, conduct regular employee
training, and have adequate insurance in place to protect against
these types of losses.
Return to question.
Chapter 5
1. Compare and contrast term and cash value life insurance. When would term
life insurance be preferred? When would cash value life insurance be
preferred?
Term and cash value life insurance policies provide death benefit
protection. Term policies do so for a specified period of time—a term
—while cash value policies are designed to provide coverage for an
individual’s lifetime. Term policies have no cash value. Cash value
policies earn interest and may earn dividends that can further
increase the death benefit and cash values over time. Both term and
cash value policies offer riders that can be used to customize a policy
to a client’s needs. Term policies will initially provide the same death

benefit as a cash value policy for a much lower premium initially. Term
policies can be renewed after the stated term as one-year term and at
an annually increasing premium.
Term is preferred when a large amount of death benefit protection is
needed for a specific period of time or when cost is a major factor.
Cash value insurance is preferred when the need is permanent.
Return to question.
2. In what situations would a first-to-die policy be appropriate? When would a

second-to-die policy be appropriate?
First-to-die is ideal for funding a buy-sell agreement or for when a
couple wishes to have funds to cover a specific cost upon the death of
either of them, such as paying off debt or funding college for children.
Second-to-die policies are ideal for funding an irrevocable life
insurance trust to provide funds to pay estate taxes. They are also
ideal for couples who wish to leave specific bequests upon the death
of both spouses.
Return to question.
3. Compare and contrast ordinary annuities and private annuities.

Ordinary and private annuities both are designed to provide a stream
of income. Ordinary annuities are insurance contracts whereas private
annuities are not. Private annuities are much more heavily scrutinized
by the IRS.
Return to question.
4. Where do high net worth clients typically need to go to get the insurance
products they need?
Specialty insurers are usually needed to obtain the unique insurance
policies and coverages that high net worth clients need to adequately
protect themselves and their property.
Return to question.

Chapter 6
1. What are the advantages and disadvantages to each of the following exit
paths?
a. transfer to insider
Advantages to an insider transfer include the fact that the design
can provide for the owner to retain control of the company until the
owner receives all of the money they need out of the sale, the co-
owners and key employees to whom the transfer is taking place
develop a sense of responsibility for growing the company and
improving on its management and execution, the selling owner
may realize greater overall income than a third-party or ESOP
sale would generate, as the owner is still an active employee
earning salary and bonus, while also very likely receiving the
perks of ownership during the multi-year transfer period, and the
periodic and final installments due the exit owner will be paid on
an increasing business value.
Disadvantages include the fact that the exiting owner may receive
relatively little in upfront money, and is dependent upon the
performance of the company and the future cash flows to achieve
financial security at the desired time. The time to complete an
insider transfer is also longer than for a third-party sale. It also
possible that there may not be a clear cut successor within the
company.
Return to question.
b. third-party transfer
There are two primary advantages to a third-party sale. It can be
accomplished quicker than insider transfers or transfers to
children and provides the selling owner with the upfront cash to
meet the owner’s financial security goal.

Among the disadvantages is that the process itself can be
emotionally exhausting for the seller. Deal fatigue can set in as the
buyers perform due diligence and make requests for deal
concessions. Cost is another factor to consider, as investment
banker fees that can run $5,000 to $10,000 per month during the
sale process and a contingent fee that is a percentage of final sale
price. A $5 million sale may incur fees totaling $500,000 from all
sources—investment bankers, attorneys, CPAs, etc.
Return to question.
c. transfer to children
The advantages to a transfer to children include the parent owner
continuing to earn income and profits from the business as they
prepare themselves and the business for the transition. The child
successor(s) are a “known entity” and they can be developed to
effectively take over during the transition period. When properly
structured, gift taxes on any ownership interest gifted to children
can be eliminated or at least minimized through the use of a
grantor retained annuity trust (GRAT). The parent owner or
owners meet the values-based goals around keeping the business
as a focal point of the family, providing above-average income
opportunities to the children, keeping the company anchored in
the community and satisfying the expectations of those business
active children who want to carry on the legacy of the family
business.
Like the insider transfer, one disadvantage is that a transfer to
children cannot be accomplished as quickly as a third-party sale
and the parent owner may not realize full financial security at the
point of departure. Family dynamics and the issue of fairness
could become an obstacle if there are multiple children and one or
more are actively working in the business while others are not.
Issues related to fairness, both in terms of value and timing of
transfers, can start to fracture the family relationships.
Return to question.

d. sale to an ESOP
Tax benefits are counted among the advantages to an ESOP. The
company is able to deduct contributions (cash or stock) to the
ESOP, under certain conditions the sellers of C corporation
shares can defer a capital gain event by reinvesting the sale
proceeds into other securities (a Section 1042 “rollover”), no
income tax is assessed on the earnings of the ESOP assets until
a distribution from the plan occurs, and when used in an S
corporation environment, the earnings of the S corp shares held in
the ESOP are not subject to federal income taxes. The ESOP is
useful for rewarding employees for active service to the firm,
sharing ownership with employees, and providing an orderly
transfer of ownership. Additionally, an ESOP allows the owner to
meet their financial security objectives while still maintaining a role
in the company after the sale if they so desire. The selling owner’s
values goals can also be met, such as ensuring the company
remains in the community while also providing the employees with
a potentially lucrative retirement benefit in which they have a hand
in growing.
Among the disadvantages to an ESOP, is the fact that they cannot
be used by partnerships. ESOPs are complex vehicles and the
dual oversight of the IRS and DOL helps to drive up the cost of
establishing and maintaining an ESOP. Depending upon the size
of the company, the upfront costs for plan design, valuation
services, and governmental filings could range from $50,000 to
$350,000, and there would also be annual costs related to
ongoing valuation services, third-party administration, and trustee
fees. An ESOP will work best for companies with at least 30
employees and $6 million in value.
Return to question.

2. Explain the major differences between a cross purchase buy-sell agreement
and an entity redemption buy-sell agreement.
The major difference is the party(ies) obligated to purchase an offered
interest in the closely held business. With a cross purchase
agreement, the other owners are obligated to purchase; with an entity
redemption agreement, the business is obligated to purchase. This
difference, in turn, leads to a difference in who is the owner and
beneficiary of the insurance policies used to finance the agreement.
With a cross purchase agreement, each owner will own and be the
beneficiary of a policy on the life of each owner from whom he may be
obligated to purchase a business interest. With an entity redemption
agreement, the business entity is the owner and beneficiary of a
policy on the life of every owner.
Return to question.

References
AIG. Excess Liability Coverage Extras. Nov. 2015
Brown, John H. Exit Planning: The Definitive Guide. Denver: Business

Enterprise Press, 2016.
Chubb. Excess Liability Insurance. Whitehouse Station, NJ. 2016.
Dini, John F. Beating the Boomer Bust. San Antonio: eBook,

www.TheBoomerBust.com, 2012.
Fleisher, Martin, Donald R. Levy, and Jo Ann Lippe. Individual Retirement

Account Answer Book, 14th edition. New York: Panel Publishers, a division of
Aspen Publishers Inc., 2008.
Flood, Brian. Wealth Exposed. Hoboken, NJ: John Wiley & Sons Inc., 2014.
Krass, Stephen J. The 2007 Pension Answer Book. New York: Panel Publishers, a
division of Aspen Publishers Inc., 2007 (revised annually).
Leimberg, Stephen R., Robert J. Doyle Jr., and Keith A. Buck. The Tools &
Techniques of Life Insurance Planning. Erlanger, KY: The National Underwriter
Company, 2015.
Research Institute of America. Pension Coordinator. New York: Research

Institute of America, 2007.

About the Authors
Craig Kinnunen, MS, CFP® is an associate professor at the
College for Financial Planning. Prior to joining the
College, Craig enjoyed a long and successful career in
personal financial planning and wealth management.
Craig’s enthusiasm for financial planning extends beyond
the classroom, as he also spends time providing pro bono
financial education and individual financial counseling to
members of the Colorado National Guard. Craig earned a
bachelor of science degree in accounting from Northern
Michigan University and followed that up with a master of science degree in
finance from the University of Colorado in Denver. You can contact Craig at
craig.kinnunen@cffp.edu.
Kristen MacKenzie, MBA, CFP®, CRPC® is an associate

professor at the College for Financial Planning. Kristen
has over 20 years of experience in the financial services
industry, both as an active financial planner and as a
provider of financial education. She graduated from the
University of Connecticut with a degree in economics and
later received her MBA at the University of Colorado. You
can contact Kristen at kristen.mackenzie@cffp.edu.
David Mannaioni, CFP®, MPASSM is an associate professor

at the College for Financial Planning. Utilizing his 30+ years
of experience in the financial services industry, David also
maintains a financial planning practice where he works with
his clients in all areas of financial planning. In addition to his
certifications, David holds life and health insurance licenses
in several states, as well as the Series 6, Series 7, and Series
63 registrations with FINRA. You can contact David at
david.mannaioni@cffp.edu.
About the Authors  105

Index
A master index covering all modules of this course can be found on eCampus.
401(k) plan, 23 Employee stock ownership plan

Accrued benefit, 21 (ESOP), 80
Age-weighted profit sharing plans, 24 Employer risks, 58
benefits, 26 Exit planning, 71
Annuities, 67 sale to an ESOP, 80
private annuities, 68 steps, 74
Benefit formula, 21 third-party transfers, 78
Buy-sell agreements, 84 transfers to children, 79
categories, 85 transfers to insiders, 76
life insurance funding, 87 International risks, 50
Cash or deferred account (CODA), 23 living abroad, 51
Compensation, 19 travel abroad, 50
Corporation, 9 Keogh (HR 10) plan, 24
advantages, 9 Life insurance, 61
disadvantages, 12 funding buy-sell agreements, 87
income tax rates, 11 multiple-life policies, 63
limited liability companies, 15 private placement life insurance, 65
personal service corporation, 13 tax treatment, 64
professional corporation, 17 types, 62
S corporations, 13 Limited liability companies, 15
Cross-tested profit sharing plans, 27 advantages, 16
advantages and disadvantages, 29 disadvantages, 16
Defined benefit pension plans, 19 tax reporting, 16
accrued benefit, 21 Limited liability partnerships, 8
benefit formula, 21 Limited partnerships, 8
compensation, 19 Money purchase pension plans, 23
normal retirement age, 20 Normal retirement age, 20
Defined contribution plans, 22

Partnerships, 6 homeowner risks, 41
advantages, 7 liability umbrella policies, 45
disadvantages, 7 recreational, 49
Personal risk valuables and collections, 49
board membership, 54 Qualified retirement plans, 18
entertaining, 53 Risk management
management strategies, 56 annuities, 67
personal security risks, 55 techniques, 39
Personal security risks, 55 Risk management techniques, 39
Personal service corporation, 13 risk avoidance, 39, 95
Plan types, 18 risk minimization, 40, 95
age-weighted profit sharing plans, risk retention, 40, 95
24 risk transfer, 40
cash or deferred account (CODA), S corporations, 13
23
advantages, 14
cross-tested profit sharing plans, 27
disadvantages, 14
defined benefit pension plans, 19
Salary reduction plans (Section 401(k)
defined contribution plans, 22 plan), 23
Keogh (HR 10) plans, 24 Salary reduction SEP (SARSEP), 31
money purchase pension plans, 23 Savings incentive match plan for
profit sharing plans, 22 employees (SIMPLE), 31
salary reduction SEP (SARSEP) Simplified employee pension (SEP), 30
plans, 31 Small business valuation, 2, 70
savings incentive match plan for Sole proprietorship, 4
employees (SIMPLE), 31
advantages, 5
simplified employee pension (SEP)
plans, 30 disadvantages, 5
tax-qualified retirement plans, 18 Tax-qualified retirement plans, 18
Professional corporation, 17 Umbrella policies, 45
Professional risk, 57 Valuation
Profit sharing plans, 22 unlisted business, 83
Property risks, 41 Valuation of a small business, 2, 70
automobile risks, 47
Index  107

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Module 4

Craig Kinnunen, MS, CFP®

Kristen MacKenzie, MBA, CFP®, CRPC®

David Mannaioni, CFP®, MPASSM

 a greater need for achievement,

 a greater need for control of their activities,

 greater risk-taking propensities,

 a higher level of interest in wealth and material gain, and

 a greater tolerance for ambiguity.

Unlike salaried managers in large corporations, business owners do not act as

In addition to investment planning, small-business owners often require

The chapters in this module are:

The Legal Forms of Doing Business

Personal, Security, and Professional Risks

Life and Disability Insurance for the Wealthy Client

Exit Planning for the Small Business Owner

Upon completion of this module, you should be able to understand certain

2  Considerations for Business Owners

4–1 Explain important tax and non-tax characteristics, advantages, and

4–2 Explain how various retirement plans may be utilized to reduce

4–6 Explain the characteristics, advantages, and disadvantages to the

4–1 Explain important tax and non-tax characteristics, advantages, and

Types of Businesses, Their Characteristics,

According to the Small Business Association (SBA), over 70% of businesses in

4  Considerations for Business Owners

Disadvantages of Sole Proprietorships

 The sole proprietor has “unlimited personal liability”—that is, legal

Chapter 1: The Legal Forms of Doing Business  5

 The tax advantages on employee benefits available to corporations are less

6  Considerations for Business Owners

 They are easily formed, requiring only a partnership agreement between

 Decision making is relatively simple, as the number of parties involved is

 Like the proprietorship, the partnership is a pass-through entity and

 The enterprise can survive the death or withdrawal of one or more

Chapter 1: The Legal Forms of Doing Business  7

The Limited Partnership

1. General partner(s). There can be one or more of these. Their liability is

2. Limited partners. This class of partner plays a passive role—primarily that

Limited Liability Partnerships

8  Considerations for Business Owners

Approximately 20% of businesses are corporations, and while this is a relatively

 The owners (shareholders) have “limited liability.” The debts of the

Chapter 1: The Legal Forms of Doing Business  9

 Theoretically, the life of a corporation is infinite. The death of any single

 Certain expenses are uniquely tax deductible for C corporations. Current

1. an income tax exclusion for benefits received by employees under a

2. an income tax exclusion for employees for amounts received from an

3. an income tax exclusion for the cost of providing employees (not

10  Considerations for Business Owners

 Corporations also receive a partial exemption for income tax purposes

Corporate Income Tax Rates

Table 1: Corporate Tax Rate Schedule

Taxable But Of the

$ 50,000 75,000 $ 7,500 + 25% $ 50,000

75,000 100,000 13,750 + 34% 75,000

100,000 335,000 22,250 + 39% 100,000

335,000 10,000,000 113,900 + 34% 335,000

10,000,000 15,000,000 3,400,000 + 35% 10,000,000

15,000,000 18,333,333 5,150,000 + 38% 15,000,000

18,333,333 — 6,416,667 + 35% 18,333,333

Chapter 1: The Legal Forms of Doing Business  11

Second, distributions of those same corporate profits to shareholders in the form

12  Considerations for Business Owners