- If used properly, life insurance can bolster business operations, fund succession agreements, optimize estate plans and provide liquidity.
- The amount of coverage a business may need depends on the intent, whether it’s to cover key personnel, pay off debts or fund buy-sell agreements.
- Improper use of life insurance can have drawbacks. For example, life insurance premiums and investment losses can erode the capital of a company.
How Business Owners Can Use Life Insurance
Life insurance is generally viewed as a risk management tool that provides financial benefit to named individuals in the event of the policyholder’s death. However, life insurance has applications that can extend far beyond this baseline feature — especially for business owners.
At a high level, life insurance can improve the continuity and resiliency of a business and facilitate the achievement of mid- to long-range financial goals, such as paying off debt and equalizing estate distributions. It’s important to understand and explore these ideas before buying a policy, so you can be intentional about integrating life insurance strategies into a holistic business plan.
Life insurance solutions for business are often unexplored by the general public. That being said, if you own a business, especially a partnership, these policies can make or break the lifestyle of an entrepreneur and their family, let alone the business itself.
Insuring Key Employees
Arguably, the most common way business owners utilize life insurance is to insure key employees. This is a very practical way to bolster the financial stability of your company if a key employee dies. The death benefit payout on a life insurance policy may not completely offset the hard and soft costs incurred when you lose a key person, but it can help mitigate the financial pain.
Equalizing Estate Distributions
When dealing with a closely held family business, life insurance can be used to make sure your heirs receive equitable inheritances. There are many ways to structure an equitable framework, but for illustrative sake, let’s look at a simple example.
Assume you own a successful business and have three kids; one works for the family company and the other two do not. Upon your death, you want each child to receive a roughly equal estate distribution. So, you structure a life policy that gives the employed child shares in the company while providing the other two with a cash death benefit payout.
Funding Buy-Sell Agreements
For many closely held companies, life insurance is an integral part of their succession plans. It provides a way to fund a prearranged buyout transaction if a business owner dies.
For example, imagine a privately held company with nine equal-share owners. A term life policy is purchased on the life of each partner based on the current value of their share of the company, and the other eight owners are specified as beneficiaries. If an owner dies, the others will use the death benefit to buyout their position and continue to operate the company with the new, consolidated ownership structure.
That said, if the company grows and appreciates in value, the term life insurance may be inadequate. To address this likely development, permanent life policies can be purchased to provide additional death benefits in a flexible fashion.
An alternative to the above scenario is an entity purchase agreement, where the subject company owns insurance policies on the lives of the various owners. When one of the owners dies, the company receives the death benefit and uses it to buy the deceased owner’s stake from their estate. This approach is most useful when a company has many different owners.
Paying Off Debts
Another common reason a business owner may purchase life insurance is to provide liquidity to pay off debts at death. Obligations of focus usually include commercial real estate mortgages, multi-purpose operational loans and estate taxes. Ultimately, the goal is to utilize life insurance to prevent heirs from experiencing the assumption of any existing or death-related liabilities.
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How Much Life Insurance Do Business Owners Need?
The amount of life insurance your business needs depends on the intent of the coverage. This can vary widely from one company to the next, but the following guidelines are generally applicable.
How To Determine Amount of Coverage
- If you are focused on key personnel coverage, consider how much money your business would need to cover the costs of losing the personnel.
- If you are focused on paying off debts, consider the amount of your liabilities.
- If you are focused on funding a buy-sell agreement, the coverage should approximate the fair market value of the business, which will grow over time (ideally).
Ultimately, the goal of business life insurance is to ensure your company (and family) can comfortably move forward without you. Given the importance of this objective, no corners should be cut when planning. It may be beneficial to consult with a reputable financial advisor to determine how life insurance can help optimize your business.
Are There Drawbacks to Business Owners Having Life Insurance?
Like any financial decision, buying corporate life insurance can have drawbacks. Most notably, life insurance premiums and investment losses can erode the capital of a company, resulting in less shareholder value.
Additionally, permanent life insurance policies can expose a company to excessive opportunity cost and illiquidity. Well-capitalized companies are often better served by investing in traditional financial securities, such as publicly traded stocks and bonds.