Key Person Life Insurance:
Most businesses have a key person who is responsible for a large portion of the revenue. Many times this person has a unique and hard to replace skill set or talent that is vital to the organization. In a small business this is usually the owner, the founders, or perhaps a key employee or two. These are crucial people to a business. Their absence could potentially devastate the company.
Key person life insurance works like this: A company purchases a life insurance policy on its key employee(s), pays the premium, and is the beneficiary of the policy. If that person dies, the company receives the benefit. This coverage is vital to a small business because the death of a key person can cause the immediate interruption of cash flow. The purpose of key person insurance is to provide the funds to help the company survive the loss. The proceeds are now available to cover expenses, pay off debts, distribute money to investors, and or pay severance to employees until a replacement can be found. In many cases, key person life insurance is the difference between a company surviving or having to declare immediate bankruptcy
A buy–sell agreement, also known as a buyout agreement, is a legally binding agreement between co-owners of a business that governs the situation if a co-owner dies, is forced to leave the business, or chooses to leave the business. It is essentially a premarital agreement between business partners/shareholders.
An insured buy–sell agreement (one that is funded with life insurance on the participating owners’ lives) is often recommended by business-succession specialists and financial planners to ensure that the buy–sell arrangement is well-funded and to guarantee that there will be money if the buy–sell event is triggered by death.
How funding with life insurance works
When using life insurance to fund a buy-sell agreement, the company or co-owners buys life insurance policies on the lives of each owner. If one of the owners were to die, the company or surviving owners receive the death benefit, and the money is used to purchase the business interest from the surviving family members. The company is now free and clear of any debt to the deceased owners family, and can continue on as before, ensuring it’s continuity.
The buy-sell agreement should be fully funded
The amount of insurance coverage purchased should equal the value of the ownership interest. This will ensure that the proceeds are sufficient to buyout the owners share of the business. However, if all that is affordable is insurance coverage for a portion of the interest, you can always start there and increase coverage at a later time.
Business Succession Planning
Life insurance can be a valuable tool in a business succession plan.
The following are examples of strategies on how life insurance is commonly used to ensure a business continues beyond the life of its owners.
Estate liquidity: Some business owners will wait until death to transfer most of their business interests to one or more of their children. If the business owner has a taxable estate, life insurance can provide the heirs the cash necessary for them to pay estate taxes. This techniques is particularly useful to business owners because business interests cannot be readily liquidated. Typically, the insurance policy will be owned by an irrevocable life insurance trust so that the beneficiaries will receive the proceeds both income and estate tax free.
Estate equalization: A business owner can also use life insurance to provide equitable treatment to the children who are not involved in the business. The idea is to leave the business to the active children, and life insurance to the inactive children. This strategy serves to equalize the inheritances among all of them. It also prevents the need for the active children to purchase the business interests from the inactive children. This can save the business from financial hardship, particularly if it comes at a time when the business is unable to afford it. This happens often if the business owner was still active in the business at the time of death.
Disability buy out insurance is very similar to Buy-Sell and Key Person life insurance. The difference is disability insurance pays in the event a covered person is unable to work due to a disabling accident or illness. A Key Person’s disability policy can cover a financial gap in income that the loss of a key person can cause to a company. Disability Buy-Out insurance is designed to provide the funds necessary to purchase an owner or partner’s interest in a small business if that person becomes disabled.
How does disability buy-out insurance work?
Disability buy out insurance should be integral to any business continuation or succession plan. Small business owners agree to buy any disabled owner’s interest in the business at a pre-arranged price. That purchase will be funded with disability insurance, the same way a life insurance policy buys out a partner at death. The buyout will allow the remaining owners to continue operations, while financially compensating the disabled partner for his shares.
What is the process to creating a Disability Buy Out Plan?
The first step in purchasing disability buy out insurance is to have a thorough and accurate valuation of the business. Once a fair market value has been established for the business, the owners then must enter into a buy-sell agreement setting conditions that will automatically generate a sale of a disabled owner’s interest. Finally, a disability buy out insurance policy is purchased on each business owner or partner to provide the funds needed to buy out that share in the business in the event of a disability.
Premium finance
Premium Finance is a highly successful strategy to provide high net worth individuals with large quantities of life insurance with no out of pocket costs or expense. Just like any leverage strategy Premium Finance is based upon using a Bank’s money rather than the client’s money to pay the premium. It allows for the client to pay premiums while still keeping funds available for better uses.
Lenders that are approved by the Life Insurance Company provide the funds. These large financial institutions offer low interest rates. The idea being that the clients freed up money can earn a higher return. The collateral for this loan is primarily the cash values within the policy, and may include some additional assets pledged as additional collateral during the first few policy years.
This program provides significant benefits for the insured and family which includes:
- Substantial life insurance for the client over their lifetime
- No out of pocket cash requirement for the company during the entire term of the insured’s life
- Tax free non-qualified retirement income for the life of the insured
- Substantial tax free death benefits to cover estate taxes
The Life Insurance Policy Values are designed to grow over time at a faster rate of return than the loan cost. This allows the client to maximize premium funding during the first 7 years, and will give the client the option to defer the interest entirely with no cash out.