You’ve poured your heart and soul into building your business.
What would happen in the event of an unexpected death of a key employee or partner?
In a recent report conducted by the National Association of Insurance Commissioners, 71% of small business owners said they “depend heavily on a few key people” to keep their business running smoothly.
You’ve got to protect your business by insuring these key individuals with Life Insurance!
In this article, we’ll show you how.
Here are the quick links to the topics we’ll be discussing:
- Cover a Key Person
- Cover a Business Partner
- Cover Yourself – (A Single Business Owner)
- Other Uses for Life Insurance in Business
Coverage for a Key Employee or Executive
If you have an employee or key executive that your business simply couldn’t function without, you might consider taking out a life insurance policy on his/her life. This is called life insurance for business – key person.
… And you don’t have to be a tiny 2-3 man operation to rely heavily on one individual.
If I may cite that NAIC report again, they found that “among firms with $1million+ annual revenue, almost half still acknowledge that they are ‘very dependent on one or two key people to keep operations running smoothly.’”
For your business, this individual could be your top salesperson, or perhaps that one customer service manager whom all your clients love, and is the reason they continue to buy from your company.
Consider the follow financial burdens due to the loss of a key employee:
- Loss of Sales Revenue
- Retention of current clients
- Replacement costs (hiring, training, learning curve, etc.)
- Loss of vision, leadership, and direction – In the case of an executive
How it Works
With the knowledge and consent of the employee or executive, the company applies for an individual policy on the life of the key person.
The key players in this purchase are:
- Employee/Exec. – is the insured only.
- Company – is the applicant, owner, payer, and beneficiary of the policy.
- Insurer – the company providing the insurance.
- Insurance Agent – finds the best policy at the lowest cost.
As an individual policy, it will be underwritten based on the good health of the employee, meaning the premium will be based on the health class at which the policy is approved, and there is no guarantee of approval.
Upon the death of the key employee, the insurance carrier will pay out the proceeds of the policy to the company, which it can use however it sees fit.
Key person life insurance can also be used as an employee benefit.
Note: The company should consult with its tax advisor for deductibility of premiums paid on key person life insurance. If premiums are written off, the death benefit proceeds could be taxable.
Determining How Much Coverage to Buy
My clients generally purchase two to three times the key employee’s annual salary, but when an employee contributes significantly to profit or client retention, a case can certainly be made for more. I’ve insured a key employee up to 15 times salary.
For more information, see our article about Key Person Life Insurance.
Life Insurance to Cover a Business Partner
If your business has multiple partners, most buy-sell agreements will mandate that upon the death of one partner, this partner’s share of the business should be bought out by the remaining partner/s.
This way, the deceased partner’s spouse or beneficiary will not end up inheriting a portion of a business he or she is incapable of running.
Life insurance is most often used to fund this agreement, since it can be purchased for pennies on the dollar.
The most common types of buy-sell agreements are:
- Cross-Purchase Agreement – Each owner or partner buys a policy on the other. When a shareholder dies, the remaining partner/s uses the proceeds to buy out the interest of the deceased partner.
- Stock Redemption Agreement – The corporation owns the policies on each owner. Upon the death of a shareholder, the corporation buys out the interest of the shareholder.
Pros and Cons of the Cross-Purchase Agreement
Advantages: This plan could be simple to buy and administer when only two or three partners are involved, and all partners are around the same age, and in good health. With similar age and health, the policy premiums should be similar.
This plan can also be cheaper if the shareholders are in a lower tax bracket than the corporation, and may be better for estate planning as the proceeds from the life insurance are not included in the deceased shareholder’s estate. (Seek your own tax counsel for your business’ particular situation).
Disadvantages: The downfall with this plan is it can be a pain to administer if multiple partners are involved. Since each partner owns a policy on all the other owners, you may end up with literally dozens of policies. For example, in a firm of 5 partners, (5 partners X 4 policies on other partners = 20 policies!)
An additional con could be the disparities in premiums between the policies. Premiums may vary widely depending on the age and health of each shareholder. Some businesses make up for the difference in premiums by raising salaries or bonusing the partners who pay more, but even this can be unfair when you consider the owners may be in different tax brackets.
Pros and Cons of the Stock Redemption Agreement
Advantages: Simplicity is the best advantage in this strategy. The corporation only owns one policy on each shareholder.
There could also be tax advantages to this strategy, depending on the tax bracket of the owners. Each business should seek its own tax counsel, but the general rule of thumb is: “If the corporation is in a higher tax bracket than the owners’ personal tax bracket, then the corporation should pay for the policies,” which would lead to a stock redemption plan.
Disadvantages: The cross purchase plan may be preferred to the stock redemption agreement if the owner has a large estate. If a corporation owns life insurance for the purpose of funding the stock redemption, since the deceased owner owns an interest in the business, the chances are high that the life insurance policy will be included in the owner’s estate.
Another disadvantage of the stock redemption form of the buy-sell agreement has to do with tax implications to the remaining shareholders. Have a tax professional explain this to you, but generally speaking, the remaining shareholders won’t get the benefit of the step-up in basis when the corporation purchases the deceased owner’s interest.
For more information about buy-sell agreements, click here.
Other Uses for Life Insurance in Businesses
There are multiple uses for life insurance in your business, including the following:
- Employee Benefit Programs
- Split Dollar Plans – Death benefit goes to the company and cash value to the employee.
- (or the Reverse of the Above)
- Group Life Insurance – The business may pay for some or all of a policy covering them for a set amount or multiple of the employees’ income.
- Life Insurance to Guarantee a Small Business Loan
We cover all these and more at our main Life Insurance for Businesses hub, so be sure to visit there if you have any further questions.
What if I’m a One-Man (or Woman) Operation?
If you are the sole owner of your business without any partners or employees, you should still think about purchasing life insurance to protect your family.
Furthermore, with some very simple planning, you can use life insurance to help with business continuation and succession planning.
For more on this, I’d like to direct you to the Smart Passive Income website, where I was so fortunate to be invited to share a guest post recently about Business Continuation Essentials for the “Solo Entrepreneur.”
What’s the Best Type of Life Insurance Policy to Fund a Business Insurance Need?
- Term Life Insurance – If you would like to simply cover the short term need for insurance on the life of a key individual, for the lowest possible cost, term is the way to go.
- Cash Value / Permanent Plan – You may want a plan with more flexibility. With a cash value plan, you could set a vesting schedule on the cash, for example, as an employee benefit. The cash would also still remain on your company’s balance sheet, and and the key individual ever leaves, or you decide to cancel the policy for some reason, you will get some cash back from the policy, whereas you won’t get anything back from a term policy. I recommend looking into indexed universal life pros and cons for this strategy.
What’s the Next Step?
First of all, take action now!
Simply give us a call to discuss your unique situation at 888-603-2876 or get started with a quote using our instant quote form to the right. It only takes a minute!