Life insurance is an important financial asset for many, or even most, people. For business owners, though, the need is particularly acute.
When you own a business, you don’t just have to worry about protecting your family’s financial well-being in the event of your untimely death (though, of course, that is still very important). You also need to look out for the well-being of your partners, employees, and the business itself.
Most small-business owners play a vital role in their businesses’ operations. An owner’s death therefore presents, at the very least, a major disruption.
To weather the storm, a business needs a source of liquidity to overcome the likely decrease in revenue until the deceased owner can be replaced or the business’s strategy adjusted.
Likewise, surviving partners or the business itself may need cash to buy out a departed owner’s interest from his or her estate or heirs.
Or, if a deceased owner is irreplaceable, a business needs a source of funding while it is winding down, and to assist employees and partners in transitioning to other employment.
In each of these scenarios, a life insurance policy covering the business owner eases the strain on surviving family members, business partners, and employees by providing a ready source of cash when it’s needed most.
And there are plenty of other contexts in which life insurance for business owners can be the difference between a business-ending catastrophe and a financially manageable – though still difficult – transition.
These are just a few of the more relevant functions life insurance can serve for business owners:
Life Insurance as an Employee Benefit
This article is more interested in life insurance as a means of protecting a business, partners, and family members from financial stress resulting from the death of an owner or critical employee.
However, it’s worth noting that group life insurance, executive bonus (section 162) arrangement, split dollar life insurance and deferred compensation plans can be a valuable perquisite that business owners can provide to employees at relatively low cost.
In most cases, various life insurance companies offer reduced rates for life insurance purchased through a group plan compared to individually purchased policies. This is due to the demographic variety within a group. The insurer’s risk is spread out among insureds of varying ages, health conditions, and genders, so it can charge generally lower premiums.
A business can offer to pay some or all of its employees’ life insurance premiums or simply make the coverage available for employees to purchase at their election.
Either way, employees have the opportunity to obtain an important financial asset, and employers help look out for the financial well-being of employees’ families.
Group policies are usually limited to term coverage, though employees sometimes have the option of converting term coverage procured through a group plan into a personal whole-life policy.
Personal Life Insurance for Business Owners
A personal policy covering a business owner is typically issued to the owner him or herself and benefits a spouse or other family member.
A personal policy serves the income-replacement purposes customarily associated with life insurance – providing a means of support for a surviving spouse, children, or other dependents. For business owners, though, personal policies provide additional protections beyond just income replacement.
With a small business especially, the owner often needs to undertake personal obligations to secure lines of credit or loans for the business. This can come in the form of a personal guaranty of the business’s credit-worthiness or a pledge of personal assets as collateral for a loan.
In the event of an unexpected death resulting in decreased business revenue, personal assets are potentially jeopardized.
Life insurance allows family members to preserve those personal assets by facilitating payment of any business debts asserted as claims against a decedent owner’s estate.
Life insurance also protects heirs’ inherited interests in a business by facilitating payment of estate taxes.
Because a deceased owner’s interests in a business are included within his or her taxable estate, the executor of an insufficiently liquid estate may be forced to sell off assets, including shares in the family business, to pay the taxes.
The loss of shares sold by an executor could potentially result in heirs losing some or all managerial control. A life insurance policy can provide cash to avoid this dilemma.
The current (2019) federal estate-tax exemption is $11.4 million, which means only estates with assets exceeding that amount qualify for the tax.
While the current exemption is historically high, a successful small business with valuable equipment and inventory, combined with a personal residence and retirement account, can quickly push a business owner’s estate over the threshold – even if the estate has little cash.
State Death Tax
Thirteen states also have estate taxes with exemption amounts substantially lower than the federal level. Life insurance covering a business owner ensures funds are available to pay any applicable estate taxes. And, if no estate taxes end up being due, the policy proceeds won’t be taxable income to the beneficiaries.
Even if family members elect to sell a deceased owner’s business, life insurance proceeds provide a cushion allowing heirs to be patient in finding a buyer, thereby avoiding a hurried sale below market value.
Or, if an heir intends to take over operations or hire a replacement manager, the cash can support the family until the successor gets up to speed and revenue returns to normal levels.
Life Insurance as a Funding Source for Buy/Sell Agreements
A buy/sell agreement (or “buyout agreement”) is a contract between the owners of a business created as part of an exit strategy and/or succession plan.
Designed to promote long-term stability and decrease risk of disagreements between partners, buy/sell agreements define the circumstances under which an ownership interest can be sold, establish limitations and requirements for purchasers, and determine how an exiting partner’s interest is calculated.
A buy sell agreement funded with life insurance provides liquidity at a crucial time.
Typically, when a “triggering event” occurs, buy/sells require the business (“redemption agreement”) or other partners (“cross-purchase agreement”) to buy an exiting partner’s shares.
The idea is to ensure that managerial control remains with existing owners while also guarantying that departing partners or their heirs receive fair compensation for an interest that might not otherwise be easily marketed.
For instance, a buy/sell agreement with a mandatory buyback could prevent a deceased partner’s spouse from acquiring voting power in the company and, at the same time, provide a means of support for the surviving spouse.
Triggering events usually include death, disability, termination, and retirement, and can also include bankruptcy and divorce (the latter of which is of greater importance in community-property states). A buy/sell can also serve as a means of resolving otherwise irreconcilable conflicts that arise between owners.
To ensure sufficient cash is available to purchase a departing owner’s interest, buy/sell agreements frequently require that the business or other owners obtain life insurance policies covering each owner. Then, if an owner dies, policy proceeds are used to finance the buyback.
As noted above, death is not the only triggering event included in most buy/sell agreements, which raises the question of how a buyback is financed for other triggers.
For businesses that aren’t cash flush, whole life insurance (as opposed to term) offers at least a partial solution since a policy’s cash value can provide some or all of the purchase price in the event of a triggering event other than death.
If a partner retires, the policy can be surrendered and the cash value applied toward the purchase price.
If the policy has not yet accrued sufficient value to cover the entire valuation, the company could cover the remainder through a cash payment or by executing a promissory note and paying installments.
Whole-life policies are also available that accelerate payment in the event of an insured’s permanent disability.
If a disability rider is in place and an owner becomes disabled, policy proceeds are available to cover a purchase required by a buy/sell agreement – providing a means of support for the disabled former owner in the process.
The actual price paid for a departing owner’s interest is determined using a method specified in the buy/sell. When negotiating and executing the agreement, the owners can stipulate an agreed price, adopt a valuation formula based on assets and revenue, or require the company to retain an independent valuation expert.
Some buy/sells use different prices or valuation methods depending on the triggering event involved. An agreement might call for a lower price if a member resigns prior to retirement age or is terminated than what would be paid if an owner dies or reaches retirement age.
Although life insurance is not absolutely essential to a buy/sell agreement, it avoids the burden on a company of a large, unexpected outlay or the long-term liability on the business’s books from a promissory note.
And, for exiting partners and their heirs, funding a buyout with insurance avoids the risk that the business struggles in the partner’s absence and is unable to pay off a promissory note.
Key Person Life Insurance
Key person insurance (a/k/a “key man insurance”) provides financial protection for a business in the event of the death of an employee or owner who is vital to the business’s functioning.
Company’s typically purchase key person insurance covering employees who will be difficult or impossible to replace and whose loss is likely to result in a significant financial setback to the company.
Generally, a key person policy is issued in the name of the business itself, and the business is responsible for paying the premiums. If the insured key person dies, the insurance company pays the policy proceeds to the business.
Policies are also available that pay out if the insured key person becomes disabled. In many cases, the financial impact on a business of an invaluable employee’s disability is just as traumatic as if the key person had died.
Benefits of a Key Person Policy
Proceeds from a key person policy enable a business to bridge the gap until a replacement can be secured or the business can alter its strategy. The cash lets the company continue paying bills and employee salaries, and avoid the risk of bankruptcy, until its revenue stream is able to recover.
Or, if the key person is truly irreplaceable, key person insurance affords a means of funding the company’s wind-down process – paying off business debts and protecting guarantors, and allowing for severance payments to employees and final distributions to shareholders.
For business owners, life insurance is more than just a means of providing for loved ones if tragedy strikes. It is also a key component in succession planning and disaster mitigation.
Owners interested in learning more about how life insurance can help protect their professional legacies should consult with a planning expert with experience developing life insurance strategies for business owners.
So what are you waiting for? Give us a call today for a complimentary strategy session.