Business Life Insurance

When a business owner dies, a multitude of potential issues can occur:

The surviving owners want to (1) either secure or keep control of the business without interference from the decedent’s heirs; (2) quickly transfer of the decedent’s interest at a reasonable price; and (3) maintain the allegiance and backing of employees, customers, and creditors during and after the transition in ownership.

The decedent’s heirs want (1) continuing financial security after the loss of the decedent’s salary and benefits; (2) either preservation of the business interest or a judicious sale at an appealing price; and(3) quick payment of the decedent’s estate (including proper tax valuation of the business interest, if they plan to sell it).

The Reality

Disputes and possibly even litigation might arise between the decedent’s heirs and the surviving owners. Postponements in the transition to replacement ownership and in establishing the decedent’s estate may be inevitable. Loss of customers, employees, or lack of creditor support could damage the business—and perhaps even force its closing.

The Answer

A formal, written buy-sell agreement among the business owners is necessary to ensure an organized and positive transition in business ownership following an owner’s death. The contract sets a reasonable price for the business interest and terms of sale that are acceptable to all parties.

The value established in a buy-sell agreement usually establishes the amount for estate tax purposes, which helps to avoid estate settlement delays and IRS challenges. If the owners are related, they should secure a professional appraisal of the business. Check with your legal counsel for advice on this subject. An existing buy-sell agreement encourages confidence in the ongoing vitality of the business in the eyes of customers, creditors and employees.

The Net Result

A properly designed and funded buy-sell agreement satisfies the valid concerns of all parties involved by assuring business continuation that benefits sellers, buyers, employees, customers, and suppliers. When a business owner dies, the consequences depend to a great extent on how well the business prepared for such an event.

What the Surviving Owners Want

The surviving owners typically look to retain total control of the business without interference from the decedent’s heirs. They may also hope the heirs promptly sell them the decedent’s interest at a fair price, while striving to retain the loyalty and support of employees, customers, and creditors during and after the change in ownership.

Key Person Life Insurance

Key person life insurance aids in repaying a business for economic loss when a key employee dies. While the insurance is covering the life of a key employee critical to the survival and success of the company, this type of policy is seen as a method in which to use life insurance as a mechanism to offset a business risk.

The Justification

A key employee is usually highly paid, responsible for management decisions, has a major effect on revenues, and has a good connection with customers and creditors. This type of employee may or may not be an owner. A business can suffer from a key employee’s death through loss of the person’s management skill and experience, disruption in sales or production, missed business opportunities, credit difficulties (such as the inability to make payments or a creditor’s reluctance to extend credit), and the increased expenses associated with hiring and training a replacement.

The Approach

The business gives the employee notice that it intends to buy life insurance on the employee and obtains the employee’s written approval. The business then applies for and is the owner and beneficiary of a policy on the key employee’s life. One method for determining the amount of insurance is the contribution to earnings method. The business estimates the employee’s annual
contribution to earnings, multiplies it by the number of years the employee would have worked, and discounts this earnings stream to its present value.

Another method is the cost to replace experience method. With this, the business takes the amount of compensation paid to the key person reduced by the salary required to pay someone else to perform the key person’s routine duties. The difference between the key person’s pay and the replacement person’s salary is then multiplied by the number of years required to bring a replacement to the key employee’s level of experience. Lastly, the calculated replacement cost is added to any search and hiring costs for the replacement.

Tax Effects

The premiums are not tax-deductible, since the business is the policy owner and beneficiary, and not an employee. The proceeds paid to the business are typically excluded from federal income tax if the notice and consent requirements have been met. If the proceeds are paid in installments, the interest portion of each installment is taxable to the business.

Properly structured, the insurance has no tax impact on the key employee unless the employee is also one of the business owners. In this case, the value of the decedent’s stock or other business interest in his or her estate may be increased when the business receives the life insurance proceeds.

Additional Advantages

If the insured doesn’t die while employed, the business can access the policy’s cash value for other purposes. The policy can demonstrate financial stability to creditors or be used as collateral for a loan.

For key employees who are owners, the policy could help fund a buy-out of the deceased person’s business interest. If the policy isn’t needed to protect the business, it can be used to provide deferred compensation funds or retirement income for the key employee.

End Result

Key person life insurance can serve several uses benefiting a business—both during the key employee’s life and after the employee’s death.

Key Person Life Insurance

The employer recognizes a key employee whose death would result in financial loss to the business. The business gives the employee notice that it intends to buy insurance on the employee and obtains the employee’s written consent.

The employer applies for, owns, and is the beneficiary of insurance on the key employee’s life. The premiums are not deductible by the employer.

If the employee dies, the insurance company pays the policy proceeds to the employer as the policy’s beneficiary. These proceeds indemnify the company for the economic loss suffered as a result of the key person’s death.

Business Life Insurance

When a business owner dies, a multitude of potential issues can occur:

The Reality

The Answer

The Net Result

What the Surviving Owners Want

Key Person Life Insurance

The Justification

The Approach

Tax Effects

Additional Advantages

End Result

Key Person Life Insurance

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