Draft a Comprehensive Plan to Help Protect Business Owners Presenter’s name The presenter’s title goes on this line For financial professional use only. Not for use with consumers or the public.

This information is provided with the understanding that Principal® is not rendering legal, accounting, or tax advice You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements. This seminar provides general education on the topic of individual disability insurance options for business owners. It is not a statement or summary of specific insurance products and services offered by Principal Life. No part of this presentation may be reproduced or used in any form by any means, electronic or mechanical, including photography or recording, or by any information storage and retrieval system, without prior written permission from the Principal Financial Group®. Principal Life Insurance Company, a member of the Principal Financial Group®, Des Moines, IA 50392 Principal, Principal and symbol design and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group. Not a Deposit | Not FDIC or NCUA Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Insured by any Federal Government Agency [Read Slide] For financial professional use only. Not for use with consumers or the public.

Key threats of a disability 1 Keeping a roof over their head 2 Keeping the business open 3 Keeping the business running A business owner may face 4 key threats in the event of a disability: The threat to their Personal Income can be addressed with individual disability income insurance The other threats could affect their business: Short-term risk can be covered with Overhead Expense insurance which can include a Business Loan Protection solution The loss of a key employee due to a disability can be covered with Key Person insurance And, Long-term risk can be covered with Disability Buy-Out insurance Let’s take a closer look at the odds of a disability as well as the options to protect business owner from these threats. 4 Keeping the investment intact For financial professional use only. Not for use with consumers or the public.

The risk of disability What is the likelihood that one or more owners becomes disabled for 3 months or longer?1 Age 1 Owner 2 Owners 3 Owners 27 45% 70% 84% 37 40% 65% 79% 47 32% 55% 57 20% 35% 48% As you can see the chances of a disability lasting 3 months or longer increases with the number of owners. For example: If you have 3 owners that are age 37 the chances of a disability happening to one of the owners is 79%. 2 owners it is 65% and 1 owner is 40%. 1Before age 65. Based on Commissioner’s Individual Disability Table B – Equally Weighted, All Occupation Classes, Unisex. For financial professional use only. Not for use with consumers or the public.

Disability plays no favorites Source: Principal Disability insurance claims payments issued in 2015. The above is for illustrative purposes only and is not intended as an inclusive representation of all claims. . For financial professional use only. Not for use with consumers or the public.

Keeping a Roof Over Their Head Individual Disability Income (IDI) Insurance For financial professional use only. Not for use with consumers or the public.

Why income protection Objective Helps replace a portion of lost income in the event of a disability. Benefits Helps business owner maintain current lifestyle without draining savings or business profits Helps ensure a business owner can continue to provide for their family Valuable employee benefit Clients should contact their tax advisor for details. For financial professional use only. Not for use with consumers or the public.

Keeping the Business Open Overhead Expense (OE) Insurance and Business Loan Protection (BLP) For financial professional use only. Not for use with consumers or the public.

Why Overhead Expense (OE) insurance Objective Reimburses business owners for covered business expenses incurred during a disability. Benefits Helps ensure a business can remain open Premiums are tax deductible (Rev. Rul. 55-264, 1955-1 C.B. 11) Benefits are reportable as income (Rev. Rul. 55-264, 1955-1 C.B. 11) The objective of Overhead Expense insurance is to reimburse a business owner for covered business expenses incurred during his/her disability. OE is a way to help keep the business financially viable. Either for them to return to after they recover or in case the owner cannot return to work and would be forced to sell the business or invoke the buy-out agreement that has been established. If the business owns the policy, pays the premiums and receives the benefits when the owner is disabled the insurance premiums are tax deductible as a necessary business expense. And the benefits received are considered taxable income to the business. This taxation is generally offset by the regular business expenses that are deductible when paid. Clients should contact their tax advisor. Clients should contact their tax advisor for details. For financial professional use only. Not for use with consumers or the public.

Who needs Overhead Expense (OE) insurance Business Owners Self-Employed Professionals Owners of a service business often need OE insurance. The business owner’s personal experience, expertise and customer relationships are often what make the business successful. Without their day-to-day participation in the business, business income could drop drastically. Keep in mind that not all business owners need OE insurance. Some are large enough or established enough to maintain a consistent level of income even if the owner cannot work and therefore would not need OE insurance. Most self-employed professionals, specifically sole proprietors and partnerships, have a real need for OE insurance. Professionals like doctors and dentists must maintain expensively-equipped offices and staff of nurses and technicians. The income of the practice, however, depends solely on the skill and experience of the professional. For financial professional use only. Not for use with consumers or the public.

Five questions to identify the need 1 Can the business maintain a reasonable level of income during the owner’s disability? 2 How would your client continue to pay business expenses when he/she can’t generate revenue because of a disability? 3 Where would the money come from? A business owner may face 4 key threats in the event of a disability: The threat to their Personal Income can be addressed with individual disability income insurance The other threats could affect their business: Short-term risk can be covered with Overhead Expense insurance which can include a Business Loan Protection solution The loss of a key employee due to a disability can be covered with Key Person insurance And, Long-term risk can be covered with Disability Buy-Out insurance Let’s take a closer look at the odds of a disability as well as the options to protect business owner from these threats. 4 Would the business have to turn clients away? 5 Would they be able to keep the doors open? For financial professional use only. Not for use with consumers or the public.

Designing an OE policy Elimination Period Coordinate with Disability Buy-Out (DBO) Benefit Period Benefit Factor Maximum Aggregate Benefit Factor Maximum Monthly Benefit End of the Benefit Period only Beyond the end of the Benefit Period but only to the Maximum Monthly Benefit Beyond the end of the Benefit Period with Carry Forward feature When designing an OE policy for your client there are several elements to keep in mind. Most Overhead Expense policies have a 30, 60 or 90 day elimination period (waiting period). When determining the length of the elimination period you should discuss how long the owner can pay the monthly expenses on their own before the OE policy starts to pay. Also, remember that benefits usually start to accrue after the elimination period is satisfied and are payable 30 days later. So if your client selects a 60 day elimination period, benefits will not be paid until 30 days after that (90 days total). The Benefit Period or Benefit Factor is usually 12, 18 or 24 months. This number is used in conjunction with the maximum monthly benefit to calculate the Aggregate Benefit Amount (the maximum amount of coverage paid during a disability). To calculate the maximum aggregate benefit take the benefit factor times the maximum monthly benefit. If the client has a DBO policy with a 365 day elimination period then he/she would want a 12 month benefit factor on the OE policy. If he/she were to select a 24 month benefit factor for the OE policy, benefits would stop paying at 12 months because the buy-out process would start and the owner is no longer responsible for the expenses. The maximum monthly benefit is the most money paid to the insured in a given month of disability. This amount depends on the types of business expenses, the owner’s occupation class and the type of business covered. For financial professional use only. Not for use with consumers or the public.

What types of expenses are covered Sample covered expenses Mortgage or rent payments Utilities Employee salaries and benefits - some limitations Payments for leasing or purchasing furniture and equipment Accounting, billing, and collection fees Janitorial, security, and maintenance Premiums for malpractice, property, and liability insurance Professional trade dues and subscriptions These are the types of expenses that are usually covered by an overhead expense disability insurance policy. For financial professional use only. Not for use with consumers or the public.

What types of expenses are not covered Salary and benefits for the insured For any person sharing the business expense with the insured The cost of goods sold, merchandise of products Moving expenses Parking fees Depreciation These are the types of expenses that are not usually covered by an overhead expense disability insurance policy. For financial professional use only. Not for use with consumers or the public.

Alternatives to Overhead Expense (OE) insurance Use accounts receivable to pay expenses Partners will cover the business expenses Use personal disability income benefits or personal savings Borrow money Close the business/office temporarily Sell the business [Discuss each point, and the pros and cons of each potential solution.] If these are not viable options for your business owner clients, then they need OE insurance For financial professional use only. Not for use with consumers or the public.

Business Loan Protection Objective Reimburses the owner for covered business-related loan obligations during a disability. Typically available as a rider on an OE insurance policy. Benefits Protects the ability to make loan payments in the event of a total disability Helps keep the business open and operating Creates good will and helps eliminate financial hardships Creates peace of mind The business loan protection solution generally reimburses the owner each month during his or her total disability for the covered business-related loan obligation. Plus, Protecting your ability to make loan payments in the event of a total disability: May help secure a loan from a financial institution, since it shows your ability to pay back the loan in the event of a disability (must have a contract/agreement in place prior to obtaining the BLP product) Helps keep the business open and operating – helping retain employees and customers Helps eliminate financial hardships and create piece of mind with employees and other owners. Creates goodwill with customers, employees, creditors, lenders, shareholders and stakeholders that there is a “contingency” plan in the event of a total disability. For financial professional use only. Not for use with consumers or the public.

What’s covered with a Business Loan Protection solution Loans that Can be covered Loans that Cannot be covered Term Lines of Credit Commercial Mortgage Credit Card Loans for Working Capital or Increase in Inventory Interest Only Lease Financing Revolving Line of Credit Here are some examples of loans that may or may not be covered by a business loan protection solution. For financial professional use only. Not for use with consumers or the public.

Hypothetical example Business Loan Protection solution If the total aggregate loan obligation (including principal and interest) is $2,000,000 and the loan has monthly loan obligations of $10,000 payable over 200 months, clients could choose to have their BLP rider have either a: $20,000/month for 100 months (total payment of $2,000,000); or, $10,000/month for 200 months (total payout of $2,000,000) May want to consider using more than one carrier depending on the maximum benefit issued. [Read the Slide and Discuss] For financial professional use only. Not for use with consumers or the public.

Keeping the Business Running Key Person Disability Insurance For financial professional use only. Not for use with consumers or the public.

What is Key Person disability insurance Objective Protects small to medium-sized businesses from the loss of employees critical to the success of the business due to a total disability Benefits Demonstrates financial stability Expense management assistance Benefits are generally received income tax free Key Person disability insurance is designed to help protect small- to medium-sized businesses if an employee critical to the success of the business becomes totally disabled. Demonstrates financial stability to customers, creditors, shareholders and other stakeholders. It shows you have a contingency plan in the event of a death or disability. Benefits help offset the costs of temporary staffing needs, finding a replacement, recruiting, filling revenue gaps, etc. Although the premiums are not deductible, any proceeds or benefits you receive are income tax free For financial professional use only. Not for use with consumers or the public.

Who is a Key Person Typically someone who: Is critical to the livelihood of the business May or may not be one of the owners Is responsible for management decisions Is highly paid Has a significant impact on sales May have a special rapport with customers or creditors A key person is someone who may or may not be an owner, is critical to the livelihood of the business and is highly paid. Generally they have a significant impact on sales and are responsible for management decisions. For example: The receptionist at a law firm who has a great rapport with customers. For financial professional use only. Not for use with consumers or the public.

What are the effects of a disabled key employee Loss of management skill and experience Disruption of the business when clients withhold or delay their business until the impact of the employee’s disability is known Difficulties when cautious creditors wait until they can assess how the disability affects the business Increased expenses associated with hiring and training a key employee’s replacement 1 2 By establishing and properly funding a buy-sell agreement, the disabled business owner knows that their interests will be protected because a fair agreement has been established prior. The agreement will assure a definite price and buyer for their business interest that otherwise might be difficult to sell. It will also assure that their financial future is no longer contingent upon the strength of the business and will provide money which they may need to pay medical bills and living costs. 3 4 For financial professional use only. Not for use with consumers or the public.

How it works Premium Principal Life Employer Benefits The employer pays the premium and is the owner of the policy insuring the key employee in the event of a Total Disability. If the key employee becomes Totally Disabled, the employer receives benefits, generally tax-free. For financial professional use only. Not for use with consumers or the public.

How can the benefits be used Benefits can be used at the discretion of the employer, but common uses are Bridging the revenue gap Hiring and training a replacement Filling temporary staffing needs Benefits cannot be assigned to the key employee [Read the slide] For financial professional use only. Not for use with consumers or the public.

Alternatives to Key Person disability insurance Business Cash Flow Borrow Money Sell the Business Here are some of the alternatives to Key Person disability insurance: Owners may use business cash flow to help pay for hiring and training a new employee They may need to borrow money to fund the loss Or they may even need to sell the business For financial professional use only. Not for use with consumers or the public.

Keeping the Investment Intact Disability Buy-Out (DBO) Insurance For financial professional use only. Not for use with consumers or the public.

Why Disability Buy-Out (DBO) insurance Objective DBO Insurance is to fund the purchase of a disabled owner’s interest under a buy-sell agreement in the event of a long-term disability. Benefits Income tax-free – the disabled owner is only taxed on the gain from the sale of the business.* Provide a funding solution for the business The objective of DBO insurance is to fund the purchase of an owner’s interest in the business if the owner cannot return to work and would be forced to sell the business or evoke the buy-out agreement that has been established. It is basically a way fund a buy-sell agreement in the event of a total disability. *Clients should contact their tax advisor for details. For financial professional use only. Not for use with consumers or the public.

Who needs DBO insurance Small businesses with five or fewer owners More than one owner Need to have a plan for succession Have considered funding with insurance Owners that depend on each other to keep the business running smoothly Disability Buy-Out insurance is designed for small- to medium-sized businesses with more than one owner, need to have a plan for succession in place and need each other to keep the business running smoothly. The maximum number of owners that are available may vary from company to company but most will allow from 2-10 in the higher occupation classes and 2-5 in all others. All full-time eligible owners must apply for insurance, if they do not already have an existing disability buy-out policy. Some excellent prospects are owners of law firms, CPA firms, advertising agencies, computer/software companies, distribution companies, engineering companies and architectural firms. For financial professional use only. Not for use with consumers or the public.

Three questions to identify the need If your business owner client became disabled and was unable to work, would the other active business owners buy his/her business interest? At what price would they be interested in buying? At what price would your disabled client be interested in selling? Would his/her partners have the funds available to buy your client’s share? 1 2 By establishing and properly funding a buy-sell agreement, the disabled business owner knows that their interests will be protected because a fair agreement has been established prior. The agreement will assure a definite price and buyer for their business interest that otherwise might be difficult to sell. It will also assure that their financial future is no longer contingent upon the strength of the business and will provide money which they may need to pay medical bills and living costs. 3 For financial professional use only. Not for use with consumers or the public.

How does DBO insurance work Non-disabled client(s) are reimbursed for expenses paid during the buy-out process Premiums are non-deductible1 Benefits are received income tax free2 The disabled owner is taxed only on the gain from the sale of the business. The gain may be considered an installment sale if at least one payment is to be received after the close of the tax year in which the sale was made. The non-disabled owner(s) are typically reimbursed for buy-out expenses paid during the buy-sell process. Premiums are not deductible and benefits received are income tax-free. The disabled owner is taxed only on the gain from the sale of the business. The gain may be considered an installment sale if at least one payment is to be received after the close of the tax year in which the sale was made. Clients should contact their tax advisor for details. Clients should contact their tax advisor for details. 1 IRC 265; Rev. Rul. 66-262, 1966-2 C.B. 105 2 IRC 104(a)(3); Rev. Rul. 66-262, 1966-2 C.B. 105 For financial professional use only. Not for use with consumers or the public.

Advantages of a buy-sell agreement to the Disabled Business Owner Creates a buyer at a fair and definite price Financial future no longer dependent on strength of business Provides income to cover expenses 1 2 3 By establishing and properly funding a buy-sell agreement, the disabled business owner knows that their interests will be protected because a fair agreement has been established prior. The agreement will assure a definite price and buyer for their business interest that otherwise might be difficult to sell. It will also assure that their financial future is no longer contingent upon the strength of the business and will provide money which they may need to pay medical bills and living costs. For financial professional use only. Not for use with consumers or the public.

Advantages of a buy-sell agreement to the Active Business Owners Assures that they can buy out the disabled business owner Maintains business continuity Avoids involving family members in the management of the business Safeguards the remaining business owner(s) from being bought out by competitors 1 2 3 By establishing and properly funding a buy-sell agreement, the disabled business owner knows that their interests will be protected because a fair agreement has been established prior. The agreement will assure a definite price and buyer for their business interest that otherwise might be difficult to sell. It will also assure that their financial future is no longer contingent upon the strength of the business and will provide money which they may need to pay medical bills and living costs. 4 For financial professional use only. Not for use with consumers or the public.

What you need to know about the buy-sell agreement Fair market value Date to establish the agreement The date the owner first becomes disabled; or, The trigger date of the buy-sell agreement Method of payment Lump-sum Monthly When is the first payment due Some types of information that you will want to gather from your business owner clients in order to set up a buy-sell agreement are: The fair market value. This can be calculated using several different methods. The date to establish the agreement. Either the date the owner first becomes disabled or the trigger date of the buy-sell agreement. What method of payments is needed and how should it be paid? In one lump sum, monthly installments or maybe a combination of both. When is the first payment due? The Buy-Sell agreement does not typically need to be completed before you submit an application, but does need to be in force at the time total disability begins, except in New York. New York requires the Buy-Sell agreement to be in effect at the time of the application. For financial professional use only. Not for use with consumers or the public.

Common method to calculate Fair Market Value Fair Market Value = (100% owner’s salary + business profit) x goodwill multiplier + book value Here is one of the many ways to calculate Fair Market Value Fair Market Value = (100% owner’s salary + business profit) x goodwill multiplier + book value To determine the value of a business, it is important to have an understanding of the following definitions: Book Value (net worth) – Total assets minus total liabilities at the beginning of the year underwriting reviews. (found in balance sheet) Goodwill – an intangible asset of business (ie: customer list, location, reputation), which is generally not carried on the balance sheet, but is a factor in the business valuation. This factor typically ranges from 1-5. The majority of businesses use a factor of 2-3. For financial professional use only. Not for use with consumers or the public.

Example of Fair Market Value A manufacturing company with two owners and total owner compensation of $200,000; business profit of $100,000 and book value of 150,000. (200,000 + 100,000) x 31 + 150,000 = $1,050,000 $1,050,000 / 2 owners = $525,000 of DBO insurance 1 2 [Read the slide and discuss] 1The multiplier selected in all scenarios should be based on the overall factors of the case, i.e., earing trends, number of years in the business and the nature of the business. For financial professional use only. Not for use with consumers or the public.

Method of payment Lump sum payment Tax ramifications to the business and owners should be considered.* Premium structure is most expensive because the insurance company is committed to paying 100% of the proceeds in one payment. Monthly payments Tax ramifications for the insured should be considered.* Lower premium results because the insurance company retains the assets longer and may not have to pay out the entire benefit. [Read the slide] *Clients should contact their tax advisor for details. For financial professional use only. Not for use with consumers or the public.

Types of buy-sell agreements Cross-purchase agreement Works best with two or three owners The insurance company reimburses the non-disabled owner(s) Entity purchase agreement Best to use with multiple owners The insurance company reimburses the corporate entity [Read the slide] For financial professional use only. Not for use with consumers or the public.

Cross-purchase agreement Who owns the policy Each owner owns a policy on each of the other owners What happens after a disability The non-disabled owner(s) purchase the disabled owner’s share in accordance to the Buy-Sell Agreement and receives policy benefits (up to the maximum policy limit) as a reimbursement The non-disabled owner(s) then own the business, and the disabled owner has been paid the price agreed upon Each owner owns a policy on each of the other owners. This arrangement may require business owners to purchase and maintain several policies if there are more than two owners. After a total disability, the non-disabled owner(s) purchase the disabled owner’s share in accordance to the buy-sell agreement and receives policy benefits (up to the maximum policy limit) as a reimbursement. The non-disabled owner(s) then own the business, and the disabled owner has been paid the price agreed upon. For financial professional use only. Not for use with consumers or the public.

How a cross-purchase agreement works Buy-Sell Agreement Business Owner A Business Owner B Premium Premium Policy and Disability benefits on Owner B Policy and disability benefits on Owner A The buy sell agreement is between each owner. The premium going to the insurance company while the benefits go to the remaining owner to pay for the disabled owners portion of the business. These policies are done on a replacement basis. Only after an owner begins the buy-out process will they receive the funding. Insurance Company For financial professional use only. Not for use with consumers or the public.

Advantages & disadvantages of a cross-purchase agreement Policies are not available to creditors Non-disabled owners receive an increase in their basis Disadvantages If more than 3 owners, the number of policies needed may not be practical If the remaining owner sells the business there can be a tax advantage because of the increase in basis. This is the only possible tax advantage of the cross-purchase over entity purchase. However, a significant disadvantage is the number of policies that could be required under this arrangement. If there are more than 3 owners this is not a recommended method because of the number of policies that would be required. For financial professional use only. Not for use with consumers or the public.

Entity purchase agreement Who owns the policy The business purchases and owns a buy-out policy on each owner What happens after a disability After disability, the business purchases the interest of the disabled owner in accordance with the buy-sell agreement and receives policy benefits (up to the maximum policy limit) as a reimbursement The totally disabled owner has been paid the price agreed upon. [Read the slide] For financial professional use only. Not for use with consumers or the public.

How an entity purchase agreement works Buy-Sell Agreement Business Business Owner B Buy-Sell Agreement Premium Business Owner A In this case the business owns the policy, the agreement is between the owners and the business, and the money is channeled through the business to the disabled owner. Policies and disability benefits on Owners A and B Insurance Company For financial professional use only. Not for use with consumers or the public.

Advantages & disadvantages of an entity purchase agreement Only one policy per business owner is necessary Disadvantages Policies are open to claims by creditors The buy-out will not increase the healthy owner’s basis Advantages Not as many policies needed, one per owner Disadvantages This will not increase the owners basis and if the business is sold after the buy-out the remaining owner would have to pay higher taxes For financial professional use only. Not for use with consumers or the public.

Common Oversights Only addresses the death and not disability of an owner. Addresses disability, but the buy-out clause is not properly funded with disability buy-out (DBO) insurance or other funding source. The amount of DBO coverage is insufficient. The agreement uses a stipulated buy-out price that has not been updated in years. The agreement does not stipulate a mandatory buy-out in the event of an owner’s disability. These are some common oversights made when establishing and maintaining a buy-sell agreement. Identifying these oversights can often lead to a DBO opportunity. The buy-sell agreement only addresses the death and not the disability of the owner The agreement does address disability, but is not properly funded The amount of DBO coverage is insufficient The buy-out price has not been updated in years The agreement does not stipulate a mandatory buy-out in the event of an owner’s disability. Without a mandatory purchase obligation by the company or other owners, a disabled owner may not have a buyer for his or her shares For financial professional use only. Not for use with consumers or the public.

Alternatives to not having DBO insurance Business Cash Flow Sinking Fund Accumulation Loans from Financial Institutions By establishing a funded agreement the disabled business owner knows that their interests will be protected because a fair agreement has been established prior. The agreement will assure a definite price and buyer for their business interest that otherwise might be difficult to sell. It will also assure that their financial future is no longer contingent upon the strength of the business and will provide money which they may need to pay medical bills and living costs. [Discuss each one of the points and the pro or con of each potential solution.] For financial professional use only. Not for use with consumers or the public.

Thank you DI9702 | 02/2017 │ © 2017 Principal Financial Services, Inc. For financial professional use only. Not for use with consumers or the public.