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Life Insurance for Businesses
As a business owner, it is imperative that you have a succession plan. No matter the size of your business---from a sole proprietorship to a global Limited Liability Company---having a succession plan in place is necessary and prudent planning. Business owner life insurance is something that needs to be planned for well in advance.
After all, the benefits of having life insurance for estate planing and buy-sell business succession plans are numerous. This article will cover the various instances where life insurance for a business owner can make a huge difference for those you love.
Life insurance for business succession planning
Business owner life insurance provides many options. First, it allows the business to continue on without the owner. Ask yourself, would your business be able to operate if you were no longer around? With the proceeds from life insurance your business, your family, and/or business partner can use the money to hire a replacement, provide income to purchase the deceased’s portion of the business, or provide needed liquidity to avoid a fire sale of the business.
It is important to reiterate that business life insurance provides a period of time for the business to make necessary transitions upon the death of an owner, provide liquidity to pay bills and salaries to avoid a fire sale of the business, and/or provide a surviving owner(s) to buy out the deceased partner’s share of the business.
Life insurance for a business owner also creates income replacement. If your family relies on the income produced from your business having a lamp sum cash payout upon your death might be the difference between your family being able to pay bills, such as the mortgage, and losing their home. Further, if no other family member could run or desires to run the business upon your death, then life insurance is necessary to allow your business to be sold or closed---income that will go towards paying off any outstanding debt or taxes.
How important is life insurance in case an owner dies prematurely? Consider a real life example.
Case study #1
This is a real life case study of business owner life insurance at work. This case study is based on circumstances of a real life client. We will call him Steve. Steve had a business that he ran by himself for 25 years before he called us. Steve had no life insurance even though he was a father of four and was the primary bread winner. Steve ran a window cleaning service and over the years the company had grown substantially. However, when Steve called us he had not put a plan in place to either pass the business on to family or to sell the business off down the road.
Upon our first conversation with Steve we knew he needed life insurance as a business owner. His family relied on his income to pay the bills and maintain the lifestyle they had grown accustomed to. We talked over some different scenarios and went over the various types of insurance products that might be of value. In the end, Steve decided on a guaranteed universal life insurance policy to age 90. At the time Steve was 50 years old.
Steve passed a few years later at the young age of 54. His family was devastated. However, a horrible situation would have turned out to be downright unfathomable had Steve not had life insurance. The life insurance allowed his family an opportunity to mourn for Steve before being forced to make any decisions about the business.
In the end the family sold the business to an investor who was interested in taking over a well established window cleaning business. But what Steve left was priceless. Steve provided income right away from the life insurance proceeds. In addition, his family also was able to sell the business for three times the company’s revenue. Without the life insurance proceeds, his family might have been pressured to sell the company for much less.
This story had a somewhat happy ending in that Steve was able to provide for his family from the grave. But it could have been very different had Steve not made the decision to buy life insurance for his business. Without life insurance Steve would have left no liquidity to his family. His family in turn would have had to scrounge up some money to pay the bills or would have been forced to liquidate the company as soon as possible. In the end, the family would probably have had to sell for a price well below market because they had bills to pay and no money in the bank to pay the bills with. But thanks to Steve’s good planning, the family actually made out quite well, leaving a legacy for his family instead of a disaster.
Life insurance for business owners who exceed federal exemption limit
Life insurance is often used as an estate planning tool to cover estate taxes, both federal and state. If your estate is over the federal exemption level then you can be hit with taxes. The rate on estate tax depends on your income and may be as high as 40% in 2020.1 This is why life insurance for a business owner is so important. Without a plan in place, 40% of your estate over the federal exemption level could go to Uncle Sam. But there are ways to avoid this outcome. One such way is to fund an irrevocable life insurance trust.
An Irrevocable Life Insurance Trust may be a good choice if assets are above the federal exemption level. One way to use an ILIT for a family business is to provide for both children: those who are active in the family business and those who are not. The strategy would be to leave the business to children that are actively involved and leave life insurance to the children not involved. An ILIT will provide the necessary liquidity to the non active children to provide their share of your estate, without forcing the children active in the family business to have to come up with money to pay their siblings off.
Buy sell agreements for business owners
Another great use of life insurance for business owner succession is a buy-sell agreement. Funding a buy sell agreement with life insurance is a popular strategy among business owners who either lack the capital to purchase the business outright or who share a business loan together.
One great strategy when covering a business loan with a fixed payback period is to use term life insurance. Term life insurance for business succession planning is the cheapest way to purchase a buy sell agreement. The way it works is each business partner owns the policy and is the beneficiary of the other partner’s life insurance. The deceased owners share is bought from the family of the deceased at a price determined in advance. You can have an experienced business law attorney work out the details of the buy sell agreement with you and your business partner.
For larger businesses with more than two or three owners a different buy sell strategy can be effectively implemented. This buy sell agreement strategy requires the insurance to be taken out on all the business owners and makes the business both the owner of the policy and the beneficiary. This way all money flows back into the business to be used as necessary by the remaining business owners.
Case study #2
Bob and Carl have a business together. Bob and Carl also have a loan together for over one million dollars. Enter a buy sell agreement.
Bob and Carl have an attorney draft a buy sell agreement. Bob and Carl both purchase life insurance and name each other as the beneficiary. Upon the death of either Bob or Carl, the surviving partner will have the necessary funds to buy out the deceased partner’s interest in the business. Due to the nature of the business, a buy sell agreement is extremely important. Without it, the deceased partner’s family will have an opportunity to make decisions on the direction of the company. The problem is neither Bob nor Carl’s family knows anything about the business.
This is why a buy sell agreement is so important. Bob or Carl can take over the business in its entirety when their business partner dies. There is no need to have to worry about the deceased partner’s family trying to “figure” the business out. Now Bob and Carl can move forward with the assurances that, God forbid, one of them dies prematurely, the business will survive. But more importantly, the deceased’s family will have the financial support needed to move on with their life.
A buy sell agreement may be set up so that it is good up to a predetermined age of the business owners, or tied directly to an outstanding loan. If the business owners need a buy sell agreement to last the rest of their lives. If that is the case, universal life or whole life insurance would be the best choice. If the buy sell agreement only needs to last to a certain age (for example, until each business owner retires at age 65), or until a loan is paid off (i.e. a ten year loan) then term life insurance might be a less expensive way to get the same results. And a million dollar term life insurance policy can be very affordable.
Key man life insurance
Another way life insurance adds value for a business owner is with key person business life insurance. Key man insurance provides income to the business in the event a key employee dies. A key man is one whose death would create an extreme disruption of the business. By insuring the life of the key employee, a business owner can use the life insurance proceeds to hire a replacement or provide liquidity to avoid a fire sale of the business if the business needs to be sold.
Farmers and Ranchers are business owners who need life insurance
Farmers and Ranchers should also consider some sort of life insurance. After all, they are business owners in their own right. Their business may not be a brick and mortar establishment. However, farmers and ranchers run their business just like any other business owner. There are relationships to be made, products to sell, quotas to meet, and families to protect.
Case study #3
Awhile back we worked with a farmer. He took care of his land and his family relied on his day in and day out toil to put bread on the table. This farmer knew what mattered most---his family. And he did what was needed to provide for them.
Throughout the course of applying for life insurance he faced a few hurdles. He suffered from heart disease. The life insurance company asked a lot of questions. It took a few months to get him the life insurance he so badly needed. And we were able to get him life insurance at a fair price for someone with heart disease.
In the end, he passed away 9 months later. As sad as his passing was, the reality is, his family was much better off because he had life insurance then if he had died with no life insurance in place. The farm was not generating any income because of his failing health. However, as a result of having life insurance, his family was able to pay off outstanding debt and sell the farm for a fair price instead of being forced to liquidate everything.
Executive Bonus Plan
Another excellent use of life insurance for business is using life insurance to fund an executive bonus plan. There are many advantages, such as:
- Tax deductible to the business
- Non Qualified Plan: The employer selects the employee
- Simple Set up and Implementation
- Excellent Employee Retention Tool
What type of business life insurance to use?
There are two main types of life insurance that business owners need to be aware of: Term and Permanent Life Insurance, which includes Whole and Universal Life.
Term life insurance lasts for a set period of time. Once the insurance expires, it can be renewed annually. However, the premiums will increase every year. The strategy with term life is to lock into a term that covers a specific event, such as the life of a loan or mortgage. Once the loan is paid down you can stop paying for life insurance.
To reiterate, term life insurance can be tailored to a specific time. For example, you might have a 10 year business loan. A ten year term would protect the business owner’s interest and be a cheaper way to protect the business than a permanent policy. That is why term life insurance is great to cover small business loans and/or hard money loans.
However, sometimes term life insurance does not provide long enough coverage. That is where universal and whole life insurance comes in.
Cash value whole life insurance offers many benefits. The main features are that it lasts your whole life, and offers guaranteed premiums, death benefit, and cash value accumulation. Some companies also pay a dividend.
Universal life insurance comes in a variety of flavors. The safest way to go is to purchase guaranteed universal life insurance to age 121 (GUL to 121). This product provides coverage for the rest of your life with a fixed premium. Another
Indexed Universal Life works in similar fashion. However, the advantage of an IUL over a GUL to 121 policy is that an IUL accumulates more cash value. For someone who may need a loan down the road, cash value can be borrowed against. However, if you are just looking for a permanent policy for the lowest price, guaranteed universal life to age 121 is the best bet.
For more on IULs, please see our article, Indexed Universal Life Insurance Pros and Cons.
Survivor life insurance for business owners
Another less used but great way for business owners to leave a legacy is with survivorship life insurance. Both business owners would take out a single life insurance policy. Upon the passing of BOTH owners, the insurance would pay out a lump sum to the beneficiary(ies). This is a great tool to use for a married couple who runs a family business or for two business owners who desire to provide for each others family upon their passing. The advantage of the insurance is it is cheaper than buying two separate permanent policies. The disadvantage is both policy owners have to die in order for it to pay out.
Are you concerned that your business partner and/or spouse might stop paying premiums? You can always purchase paid up or single premium second to die life insurance. As a result, the death benefit would already be secured with no need for future premiums.
Using Collateral Assignment for life insurance
Another tip for business owners looking for life insurance is to consider collateral assignment. Many sole proprietorships and partnerships are in need of funding to get the business off the ground. As a result, a small business loan will be utilized. Small business loans and hard money loans typically will require life insurance on the borrower. It is imperative that the borrower and primary insured take out the life insurance and use a collateral assignment to convey the portion of the life insurance to the bank.
Using collateral assignment to cover a loan will provide for your family. Basically, the collateral assignment will earmark life insurance proceeds in relation to the amount owed on the loan. The remainder of the life insurance will be for the benefit of a loved one, such as a wife or kids. If you do not use a collateral assignment and instead make the bank the sole beneficiary, the bank will be able to collect on all the life insurance payout, regardless of the amount the bank is actually owed. Click here for more on collateral assignment and life insurance for SBA loans.
The importance of talking this over with a professional
When it comes to business succession and life insurance, there are a few resources you need to tap into. One would be a certified public accountant. Another would be an attorney. And finally, you would need to speak to a licensed life insurance professional.
1. The Motley Fool, "Here Are the 2020 Estate Tax Rates"