Life Insurance for Business Owners: Key Person, Partner Protection and Buy-Sell Planning

Start with the question, not the policy

Most business owners carry property and liability coverage without thinking twice. Fewer have planned for the loss of a person. Yet in a small company, one owner or one employee can hold the client relationships, the technical knowledge, or the signature on the bank loan.

Life insurance does not solve those problems by itself. What it can do is put cash in the right hands at the moment a business is most fragile. The planning work is deciding whose hands, how much, and under what written agreement. Our business protection page gives an overview. This article goes through the mechanics.

Key person coverage

A key person is anyone whose death would cause a measurable financial setback to the business. It might be a founder, a top salesperson, a lead engineer or a chef.

With key person coverage, the business applies for the policy, owns it, pays the premiums and receives the death benefit. The insured person must consent. The proceeds can be used to:

• Replace lost revenue while the business adjusts
• Recruit, hire and train a successor
• Pay down debt or reassure lenders and suppliers
• Fund an orderly wind-down if continuing is not realistic

There is no single formula for the amount. Owners often look at the person's contribution to profit, the cost and time to replace them, and any debts tied to them. Insurers will ask for financial justification for the amount requested.

Buy-sell funding

A buy-sell agreement is a contract among owners that says what happens to an owner's interest after a triggering event such as death, disability or retirement. It typically sets who may or must buy the interest and how the price is determined.

An agreement without funding is a promise that the surviving owners may not be able to keep. Life insurance is a common funding tool for the death trigger because the money arrives when the obligation does.

Cross-purchase

Each owner agrees to buy a deceased owner's share. Each owner usually owns and is the beneficiary of a policy on every other owner. With two owners that means two policies. With several owners the number of policies grows quickly, and some businesses use a trust or a separate entity to hold them.

Entity purchase

The business agrees to buy back, or redeem, the deceased owner's share. The business owns one policy per owner and is the beneficiary.

The last row matters more than it looks. The structure can affect the surviving owners' tax basis, and how company-owned insurance proceeds are treated when the business is valued can affect estate taxes. These are questions for an attorney and a CPA who know your entity type and your state. Some businesses use a hybrid, sometimes called a wait-and-see arrangement.

Partner protection in plain terms

Buy-sell planning protects three groups at once. The surviving owners keep control and avoid an unplanned partner. The family of the owner who died receives cash for an interest that may otherwise be hard to sell. Employees, customers and lenders see continuity.

Without a funded agreement, a surviving spouse may inherit an ownership stake in a business they do not want to run, and the remaining owners may have no money to buy it. Neither side is served well by that.

Loans and personal guaranties

Many small business loans are backed by an owner's personal guaranty. If the owner dies, the debt does not disappear. The lender may look to the business, the estate or a surviving guarantor.

Some lenders require life insurance on an owner as a loan condition, often with a collateral assignment that gives the lender a claim on the proceeds up to the balance owed. Even when a lender does not require it, it is worth listing every debt that carries a personal guaranty and asking whether your family would be exposed. Term life is frequently used here because the need has an end date that matches the loan.

Succession

Succession planning answers who will own and who will lead. Insurance can support it in a few ways:

• Funding a purchase by a family member or key employee
• Providing an inheritance for children who are not active in the business, so the active child can receive the company
• Giving the business cash to retain key employees through a transition

For needs with no end date, some owners look at permanent life insurance. Cash value policies have their own costs and risks, which we explain in Indexed Universal Life Explained Without the Sales Pitch.

Employer-owned life insurance: notice and consent

When a business owns a policy on an employee, which can include an owner who is also an employee, federal tax rules under Internal Revenue Code section 101(j) apply to contracts issued after August 17, 2006.

At a high level, death proceeds from an employer-owned contract may be included in the employer's income to the extent they exceed the premiums and other amounts paid, unless the notice and consent requirements are met and an exception applies. Before the policy is issued, the employee must:

1. Be notified in writing that the employer intends to insure their life and of the maximum face amount
2. Give written consent to being insured and to coverage possibly continuing after employment ends
3. Be informed in writing that the employer will be a beneficiary of the death proceeds

The exceptions relate to the insured's status, such as being a director or highly compensated employee, or to how the proceeds are used, such as paying them to the insured's family or using them to buy an ownership interest. Policyholders report these contracts each year on IRS Form 8925.

The key point is timing. The paperwork must be done before issue. It is a small administrative step with large consequences if missed, so involve your CPA and attorney at the application stage.

Common mistakes

• An agreement signed years ago with a valuation that no longer reflects the business
• Policies whose ownership and beneficiary do not match the agreement
• Coverage amounts never updated after growth, new partners or new debt
• Relying on group coverage that ends when employment ends, a topic covered in Is Life Insurance Through Work Enough?
• No plan for disability or retirement, which are more common triggers than death

Build the team first

Business coverage sits where insurance, tax and contract law meet. A sound process usually involves an attorney to draft the agreement, a CPA to advise on tax and valuation, and an insurance professional to find coverage that matches the documents. An independent brokerage such as Cornerstone Capital can help with the third part.

Eligibility, premiums and availability depend on age, health, underwriting, state and carrier. This article is educational. It is not legal, tax or investment advice. Work with your own attorney and CPA before acting.