Life Insurance: A Business's Safety Net

Life insurance is an important consideration for business owners, and there are several ways in which it can be used to protect their interests and those of their employees and families. Life insurance can provide financial security for a business owner's family and ensure business continuity in the event of their premature death. It can also be used to attract and retain key employees, offering them and their families protection. In addition, life insurance can be used to fund buy-sell agreements, providing a smooth transition of business ownership in the event of an owner's death and helping to maintain control of the business for current owners. Life insurance can also offer tax advantages and provide a source of capital for businesses, helping them to break free from traditional bank loans and their high-interest rates.

Key Person Insurance

The death of a key person could cause a business to suffer in several ways. There may be a loss of management experience and skills, a disruption in sales and production, and increased expenses due to hiring and training a replacement. Key Person Insurance helps to safeguard a business from these adverse effects by providing a financial cushion to fall back on. The death benefit can be used to cover the costs of recruiting, hiring, and training a replacement, as well as offsetting lost revenue during this transition period.

In addition to life insurance, Key Person Insurance can also include disability coverage. This provides financial protection if the key person becomes disabled and can no longer work. The policy can include a rider for disability coverage, helping the business manage the additional costs and disruption that may occur.

The amount of Key Person Insurance needed will depend on the role of the individual within the company and the size and nature of the business. It is recommended to purchase coverage that is eight to ten times the key person's salary or the monetary value of the individual to the company. This value can be difficult to determine but can be based on the revenue and profits associated with the person or the costs required to replace them.

When deciding on the type of Key Person Insurance, businesses can choose between term and permanent policies. Term policies are generally cheaper and cover a certain period, usually 10, 20, or 30 years. Permanent policies have a cash value aspect that the business can use for various purposes, such as providing bonuses for partners or funding future projects.

Buy-Sell Agreements

A buy-sell agreement is a contract created by business owners to ensure that if one of the members passes away, their ownership interest will be sold to the remaining partners or to the company. A buy-sell agreement can also be triggered if a member retires or becomes disabled.

A buy-sell agreement can be funded by life insurance, which will provide the capital required to purchase the deceased member's ownership interest. This ensures that the business has the financial means to continue operations and that the deceased member's family receives financial support.

There are two common types of buy-sell agreements: cross-purchase and entity-owned arrangements. In a cross-purchase arrangement, each owner holds a life insurance policy on one another and is the beneficiary of that policy. This means that if one owner passes away, the remaining owners will receive the insurance payout and can use it to purchase the deceased owner's shares. However, the number of policies required increases rapidly as more owners are added to the business.

In an entity-owned arrangement, the business itself is the owner and beneficiary of life insurance policies on each owner. This reduces the number of policies needed and simplifies the transaction process when an owner dies, as the business can directly use the insurance payout to buy back the deceased owner's shares.

When creating a buy-sell agreement, it is important to consider the tax implications. While the insurance payout is generally not taxable, there may be tax consequences depending on the structure of the agreement and the type of business entity. It is recommended to consult with tax advisors to ensure compliance with IRS requirements.

Lines of Credit/Loan Requirements

Lenders and creditors often require small business owners to have life insurance before approving a loan. This serves as a protective measure for all parties involved. In the event of the borrower's or business partner's passing, the life insurance policy acts as a financial safeguard, ensuring the repayment of outstanding debts. It protects the interests of both the lender and the borrower's family.

The life insurance policy can be used as collateral for the loan. In this case, the lender becomes the temporary beneficiary of the policy's death benefit until the loan is repaid. If the borrower defaults or passes away, the lender can recover the outstanding loan amount by cashing in the insurance policy. This arrangement is known as a collateral assignment of insurance.

The borrower must be the owner of the policy, but not necessarily the insured. Any type of life insurance policy can be used for collateral assignment, provided the insurance company allows it. It is important to note that the lender does not become the owner of the policy and only has conditional access to it. The borrower can regain control of their policy once the loan is repaid.

When it comes to the cost of life insurance for loan requirements, it is generally more expensive than standard term life insurance. This is because credit life insurance is a guaranteed issue policy, covering individuals regardless of their health status, which poses a higher risk for insurance companies. The cost also depends on factors such as the credit balance, type of credit, and type of policy purchased.

Before purchasing credit life insurance, it is essential to review existing coverage, compare rates and coverage with term life insurance, and evaluate any limits or exclusions in the policy.

Employee Benefits/Executive Retirement Compensation

Life insurance is a valuable tool for businesses to attract top talent and build loyalty by helping employees protect their loved ones. It can also be used as a recruitment and retention tool for key executives, who often have higher incomes and need larger death benefit protection.

Group Life Insurance as Employee Benefits

Group life insurance is often a key component of employee benefit packages. An employer pays the policy premium for supplemental term life insurance (with coverage often equal to one year's salary) and the employee elects a spouse, child, or loved one as the beneficiary. This type of insurance provides financial peace of mind for employees and their families in the event of an untimely death.

Executive Retirement Compensation

Employer-paid additions to the baseline coverage can enhance life insurance as a recruitment and retention tool for executives. For instance, an executive package might include a bonus opportunity combined with a permanent policy. In this scenario, a performance-based bonus is paid toward the premium of an eligible Section 162 life insurance plan. This additional executive compensation helps retain employees, provides financial support for the employee's family after their passing, and is a critical tool in the executive's retirement planning.

Tax Considerations

There are many tax considerations around premium payments, refunds, and policy loans for permanent life insurance policies. Employers should work with a qualified benefits manager and experienced financial advisor to ensure life insurance policies work as intended and provide the most benefit to employees and executives.

Whole Life Insurance for Employee Retention

Whole life insurance can also be used as a unique employee benefit. Instead of paying an "employer match" into a 401(k) plan, which is subject to market risk, employers may open life insurance policies on their employees. The business owner receives a tax benefit for paying the insurance premium and has the right to utilize the cash value of the policy, thereby increasing business cash flow. If an insured employee leaves the company, the business owner can transfer ownership of the policy to the employee, allowing them to retain the accumulated cash value.

Deferred Compensation for Key Employees

Life insurance can also be used to fund a deferred compensation program to provide additional retirement benefits to key employees. In this arrangement, the company owns the policy on the executive, and when the employee retires, the company uses the policy's cash value to provide supplemental retirement income. If the executive dies before retirement, the proceeds would be paid to the company, which can then recoup premiums paid and provide a death benefit to the executive's family.

Succession Planning

Life insurance plays a pivotal role in business continuity and succession planning. It can help secure a smooth transition of ownership in the event of a business owner's death or departure. Here are some ways in which life insurance can be used for succession planning:

Buy-Sell Agreements

Buy-sell agreements, also known as business wills, are recommended by business succession specialists and financial planners. These agreements stipulate that when a partner or co-owner dies, the death benefit from the life insurance policy is used to purchase the deceased owner's interest in the business. This helps ensure that control of the business remains with the current owners, and the heirs receive a fair price. There are two common types of buy-sell agreements: Cross Purchase and Entity Purchase. In a Cross Purchase agreement, the remaining partners are obligated to purchase the deceased owner's interest, while in an Entity Purchase agreement, the business entity itself buys out the deceased owner's interest.

Key Person Life Insurance

Key Person Life Insurance, also known as Key Man Coverage, is designed to protect the business from the financial repercussions of losing a key individual. This could be the owner, a long-time business partner, or a key relationship manager with critical revenue responsibilities. The death benefit from this type of insurance can be used to cover the immediate financial needs of the business, such as revenue loss and administration costs associated with finding a replacement.

Employee Benefits/Executive Retirement Compensation

Life insurance can also be used as a valuable benefit to attract and retain top talent. By offering additional life insurance benefits, organizations can set themselves apart when it comes to recruiting and retaining key employees. This can also be used as a tool for executive retirement planning, with policies providing a tax-efficient way to build up retirement funds.

Whole Life Insurance as a Business Secession Plan

Whole life insurance can provide a business succession plan in the event of a business partner's death. A "buy-sell agreement" can be put in place, where a whole life policy is purchased for each business owner. When one owner passes away, the surviving owner uses the death benefit proceeds to buy the deceased owner's portion of the business from their estate. This ensures that the business has the necessary finances to continue operating.

Frequently asked questions