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Helping your tax clients manage risk

Shutterstock_401845456After another successful busy season, it’s time to take a broader look at your clients’ needs. While tax is one important component of your clients’ financial picture, they need help in other important areas.

They may not be aware that managing risk affects their financial picture. There’s a significant relationship between your clients’ financial well-being and risk management.

Here’s one great example: The greatest potential economic loss for most clients is income loss, either through death or disability. Insurance often best addresses that risk because of the potential magnitude of the loss. If a client dies, beneficiaries inherit the death benefit free of any federal and state income tax, which can be tremendously helpful to those who were depending on the decedent’s income stream. If the policy has a cash value feature such as a universal life insurance policy, the cash value accumulates on a tax-deferred basis. It may be accessed through loans and taxed on a first-in, first-out basis, meaning that any premiums paid on the policy are taken out first and would be tax-free.

Another intersection of tax and risk management involves determining the individual’s insurable interest. Many tax forms offer valuable information to underwriters. For life insurance underwriting purposes, especially for small business owners, their tax return determines income. Property and casualty insurance planning also relies on a tax return, including Forms 1040, 1065, 1120 or 1120-S. An umbrella policy, which can protect clients being sued, may look to both income and asset values to help decide the best amount of insurance for a client in the case of a tort. Both assets and income (via wage garnishment) are available to creditors in the event of a judgment. As CPA financial planners, our work on the client’s tax return can be the primary informant of the type and amount of coverage applicable to a client.

What tax nuances come into play when considering the appropriate type and amount of insurance coverage?

Clients typically want to minimize the tax they pay, within the law’s limits. At the same time, though, it’s important to know that the income level reported on Form 1040 is the primary factor in an underwriter’s decision on how much insurance a client may purchase. Clients purchase life insurance to provide a benefit that will replace cash flow, not necessarily their income as reported on their Form 1040. There are a variety of items that reduce current income but may not affect cash flow, such as depreciation and capital losses.

As a result, insurance companies unsurprisingly ask CPA financial planners to provide additional information and background to influence the level of insurance qualification. It is typical for an insurance underwriter to set an amount that is five to seven times annual reportable income, while also taking into consideration any significant business or personal debts for the insured. Income verification is necessary because an insurance contract must be economically sound.

What are some effective strategies for protecting your clients and their businesses should there be an adverse event?

CPA financial planners often are the first advisers to address small business clients’ questions about the viability of their business if one company owner dies. When putting together a buy-sell agreement to address these concerns, the client’s personal facts and circumstances, as well as the tax code, dictate the agreement terms. Choosing the entity type, the intent of the buy-sell agreement and whether there will be a stepped-up basis, are a few of the income tax considerations that will significantly affect the client’s family and the business co-owners.

Some of the many other insurance contracts that have an important relationship with income tax and personal financial planning include: 

  • Disability insurance contracts, which may be used by individuals or in a business setting as part of a buy-sell agreement.
  • Business overhead expense insurance, which pays the insured’s business overhead costs if they become disabled.
  • Cyber liability insurance, which protects against financial losses from breaches or other cybersecurity events.

The list of insurance coverages that clients may use to protect against economic loss is potentially endless, just as are the economic risks clients may face. Tax practitioners’ expertise and knowledge of client situations make them well-qualified to advise on insurance concerns.

If you want to sharpen your ability to consult with clients on these issues, consider the AICPA Risk Management and Insurance Planning Certificate Program. This dynamic program includes eight courses that cover critical steps in the risk management and insurance planning process, from insurance contracts and annuities to deferred compensation, and it’s one step closer to the CPA/PFS credential. For more information, listen to this podcast episode on taxes and risk management.

Susan Tillery, CPA/PFS, AEP® (Distinguished) Nominee and Tom Tillery AEP®, CFP®, CLU®, are co-founders of Paraklete® Financial, Inc., an integrated fee-for service personal financial planning firm. Susan and Tom provide financial planning without asset management or product sales.  With more than 60 years’ combined experience in financial services, they have also co-authored the AICPA Certificate Program, The Essentials of PFP textbook, and the PFP Boot Camp.


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