Businesses of every size and type operate on a risk-reward basis. Risks are everywhere, from investing in new equipment in hopes of earning new business, to hiring a new employee on the strength of a resume and a 30-minute interview.
However, any good businessperson will also agree that thoroughly considered risks are not only necessary, but the key to long-term growth and success. The trick is in minimizing possible risks and maximizing potential rewards.
The subject of life insurance can send shivers up the spines of the most hardened businesspeople. After all, no one likes to consider their own mortality. But there are benefits to business life insurance that deserve serious consideration and are too often overlooked. Life insurance by its nature protects against the ultimate unanticipated event — and success in business relies on anticipating the unexpected.
Here are some common ways to ensure your business is protected if the worst should happen.
A successful business partnership, like any good relationship, is based on how the personalities of the partners interact and the way each partner complements the other. This is one of many reasons changing partners is more complicated than changing socks.
Buy-sell agreements recognize the value of the partnership and work to ensure that in the event a partner leaves the relationship, the remaining partner will have the opportunity to buy them out rather than being forced to accept a new partner who may not be to their liking.
Buy-sell agreements protect each partner’s interest by using contractual terms to determine the value of a partner’s share. A well-written buy-sell agreement will also have trigger mechanisms that compel a partner to relinquish his or her shares. Triggers can include disability, retirement, and death. In the event of death, the deceased partner’s heirs are required to cede control to the surviving partner or partners in accordance with the terms of the buy-sell agreement.
The Problem with Death
Death is seldom an anticipated event. Sure, we all know we’re going to die at some point, but we don’t think it’s going to happen any time soon, and certainly not while we are in our prime. Still, it happens, and when it occurs in a business partnership the surviving partner may not be financially equipped to buy out the deceased partner’s heirs.
The solution to the death problem in a buy-sell agreement is to fund the agreement with life insurance.
After the partners have decided on a value for the business and a mechanism for future valuations, life insurance policies are purchased for each partner. The face value of the policies is based on the value of the business. For example, in a business worth $100,000 with two partners, each life insurance policy would be for at least $50,000. The beneficiaries of the insurance would be each partner’s heirs. In the event of the death of a partner, the buy-sell agreement is triggered and the insurance is used to buy out the deceased partner’s share.
Advantages of Funding with Life Insurance
The most notable advantage of funding a buy-sell agreement with insurance is that there is no burden on the surviving partner to liquidate assets in order to raise cash.
Since life insurance proceeds are generally paid in a very timely manner, the business and surviving partner are able to continue normal operations without the fear of having to deal with unintended partners. And in most cases, the proceeds paid to beneficiaries are free from federal income taxes, as in contrast to a direct payment by the surviving partner.
Disadvantages of Funding with Life Insurance
The single biggest disadvantage of funding a buy-sell agreement with life insurance is that sometimes there’s a difference in insurability of the partners.
Partners who are roughly the same age and in the same state of health will be subject to similar premiums; a partner that is older or in poor health may not be insurable at all or subject to a higher premium. In the event one partner is uninsurable, an alternative means of funding will have to found.
Of course, life insurance premiums become a business expense that must be met in order to keep the policies in force and the agreement funded.
Key Person Insurance
Regardless of their industry or type, all businesses have one thing in common: They rely on people to run them. While that may sound like a wildly obvious statement, consider what happens when an integral member of the team — such as an owner, partner or manager –is suddenly removed from the game. Turmoil ensues. In fact, the disruption to the smooth flow of operations increases in direct proportion to the degree of involvement of the owner, partner, or employee.
Some of the things that can go wrong when a key person is lost unexpectedly include:
- Loans or mortgages may be called.
- Dramatic loss of revenue due to lost sales.
- Customers may lose confidence and turn to competitors.
- Inadequate cash on hand to survive while recovery takes place.
These and other hardships can befall any business, from a sole proprietorship to a C-corporation with hundreds of employees. Life insurance can provide an infusion of cash in such an event that can be used to help the business navigate the uncharted waters of the loss.
Owners and Partners
In most cases, no one is more essential to the success of a business than an owner or partner. As life insurance can be used to fund a buy-sell agreement, it can also be used to provide a cushion of funds for a surviving partner.
The funds can be used to engage a consultant to assist in operations while a replacement partner is found. The funds could be used as bonus to attract a new employee that is hired to assume the duties of the lost partner.
For sole proprietors, insurance specifically earmarked for the continuing operation of a business can ensure you’re able to pass on a viable business to your heirs. The surviving family of businesses owned and managed by a single individual can quickly descend into chaos in the absence of strong leadership. While it is possible for many businesses to survive for a very short term of a couple of weeks, anything beyond that generally results in an accelerating rate of decay.
The bottom line on life insurance payable to the business when an owner or partner dies is that it provides much needed time — time to marshal resources and to implement a succession plan.
How Much Insurance is Enough?
Determining the amount of insurance you will need depends upon factors that vary from one business to another, and from one person to another.
A starting point to determine your need is understanding what you hope to accomplish with the insurance — for example, paying the salary of a new manager for six months while he or she gets up to speed, or covering fixed overhead expenses while the business is liquidated or sold.
Once you decide what you want the money to go toward, work with your accountant to calculate the cost of implementing your plan should the unthinkable occur.
Death and Taxes
When Benjamin Franklin paraphrased Daniel Defoe’s words from “The Political History of the Devil,” saying, “In this world nothing can be certain, except death and taxes,” he probably wasn’t thinking of life insurance and business. Nonetheless, it applies perfectly.
Business life insurance resides at the intersection of death and taxes, which makes understanding that relationship essential. As with everything else in the federal tax code, changes in circumstances change the way rules are applied.
Unlike other types of insurance, where IRS rules are as close to universal to all businesses as possible, the tax treatment of life insurance is situational. The issue is complicated further by the fact that C-corporations have different rules than S-corporations. Misapplying the rules can result in a substantial tax liability as well as penalties. The root of the difference stems from the fact that C-corporations are not treated as people by the IRS for tax purposes, while S-corporations are.
C-Corp: Life insurance premiums paid by the business that cover the lives of officers and employees are deductible when the business is not the beneficiary. Premiums paid for life insurance where the business is the beneficiary of the policy are not deductible.
S-Corp: The same basic rules as a C-corporation apply here, but because the income and deductions are taxed on the shareholder’s 1040 form, differences in premium amounts among shareholders must be equalized. As the extent of my expertise in complex tax matters comes from being married to a CPA, my recommendation is that you consult with yours for a more detailed explanation.
Key Employee Insurance: A business of any kind cannot deduct life insurance premiums paid to cover the life of a key employee if the business, owner, or partner is the beneficiary of the policy.
Buy-Sell Premiums: The premiums are deductible as long as the partners are not the beneficiaries of the policies. This can present a problem if there is an expectation that proceeds in excess of the value of the business are to be returned to the business or surviving partner. Once again, in these situations it is vital that you discuss the matter with a CPA.
Life insurance proceeds paid to individuals are generally not taxable (federally) as income up to $5.25 million. Proceeds greater than $5.25 million may be subject to estate taxes.
However, if the policy is payable to an estate or other entity, it may be both taxable as income and subject to estate taxes. Rules vary from state to state, and consulting with a tax professional in your state before making a decision is always the best course of action.
Proceeds of life insurance that are paid to a C-corporation or other business entity, such as a partnership, are not taxable as income.
Term vs. Permanent
Business life insurance is no different from the life insurance you would purchase to protect your family, and so is the choice between term or permanent insurance.
A term policy offers the advantage of lower premiums, with the disadvantage of being temporary. There are situations where life insurance is only needed for a specific period — for example, as security for financing. Other situations include funding a buy-sell agreement for a specified period of time — for instance, if a partner plans to retire within the term of a policy.
Permanent insurance, such as whole life, is higher in cost but has the advantage of accumulating cash value. In a buy-sell agreement, the accumulated cash value may also be used to partially or fully fund a buyout of a partner. Accumulated cash values in a policy for a key employee may be used to provide a retirement bonus or severance pay.