Business Succession Planning Part 2: How Life Insurance will insure the Life of Your Business

By Nora Dunn on 8 February 2008 (Updated 7 October 2009) 9 comments
Photo: Ul Marga

As a follow up to my first article on Business Succession Planning, there are a number of ways that Life Insurance can be fit into the life of a successful business owner.

There are two basic ways in which a business owner will want to look at Life Insurance for the life of their business:

Buy-Sell Agreement Funding

As referenced in my previous article, if an owner dies in a situation where there are multiple partners (or even as few as two) who own the company, the shareholder's agreement likely has provisions for the deceased owner's shares to be bought by the other owners.

Here's the rub: depending on how the shares are valued and depending on how large the company is, the other owners probably don't have the cash kicking around to buy out the deceased's shares at the drop of a hat. Nor does the company have that kind of dough in the bank.

In fact, many a company has gone bankrupt or into unshakable financial duress due to improperly funded buy-sell agreements and the consequent inability to carry the terms through.

Structuring Life Insurance for Buy-Sell Agreement Funding

The way around this mess is to purchase Life Insurance on the lives of each of the owners. The beneficiaries are the surviving company owners. That way if Bob dies, a life insurance policy on his life will give the other owners the cash to purchase Bob's share of the company. The company remains solvent, and Bob's estate (family) receives the money from Bob's share of the business.

The good news is that depending on how the policy is structured and the type of business, the life insurance premiums are often tax-deductible, and the insurance proceeds are also tax-free. It's a great way to process a relatively small tax-deductible expense with the promise of receiving a relatively large tax-free lump sum of money just when it is needed.

Key Man Insurance (Key Person Insurance)


Business owners are quick to insure the company against the loss or damage of its property on the basis that office equipment and inventory are valuable assets. Such assets, however, may not be as valuable as key employees.

Consider a top salesperson who is unsurpassed at bringing in new accounts, or a manager who handles the day to day operation of the business. Key employees like these are a firm’s most valuable resource.

If a key-person died suddenly, profits could be impacted and there might be considerable costs incurred in recruiting, hiring and training a suitable replacement.

So why insure the life of a key employee? Although it won't replace the work that the key employee did, the extra cash will provide a cushion to:

ARTICLE CONTINUES BELOW
  • Keep the business running
  • Offset expected reductions in sales revenue
  • Find and train a new person to assume the deceased’s role

Believe it or not, when applying for substantial business loans, some banks will actually look for key man insurance depending on the structure of the firm to ensure that an unexpected death won't be the end of the company (and an end of the loan payments).

Examples of key employees would be anybody whose special skills contribute significantly to the bottom line, like:

  • Active business owners
  • Employees who have strong relationships with major customers
  • Employees with specialized knowledge that is hard to replace

Structuring a Key Man Policy

The company purchases a life insurance policy on the employee. Both the owner and the beneficiary of the policy is the company. So if the employee dies, the money goes to the company (tax-free).

Obviously the amount of insurance needed is dependent on the level of value the employee has on the company's operations. Things to consider include:

  • How much would it cost to replace the employee? (including recruitment fees, etc)
  • How much net profit does the employee's work result in?
  • How much would it cost the company if the employee died today?
  • How much can the business afford (or how much is the business willing to afford) for this insurance?

The need and desire for Life Insurance (either Key Man or Buy-Sell funding) will vary from company to company and person to person. It is an intricate situation that incorporates the nature of the business, the needs of the owner(s), as well as their respective family situations. No one piece of the pie can be examined in isolation from the others.

And with so many things, life will continue to change, so periodic re-evaluation of needs (along with a "gut check") is always prudent.

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Guest's picture
Kirk

Great article. So many business owners ignore this aspect of business planning, especially partnerships. I am not a big fan of permanent life insurance for individuals, but this is one area where it is extremely important to get life insurance policies, usually permanent.

Nice job.

Guest's picture
Mark

Nice articles on buy-sell planning and the importance of getting them right; but I'm not aware of any situation in which the premiums are legitimately deductible to the business.

Can you give an instance of when you are thinking the premiums for insurance in the buy-sell arena would be tax deductible?

Regards,
Mark

Guest's picture
Mark

Nice articles on buy-sell planning and the importance of getting them right; but I'm not aware of any situation in which the premiums are legitimately deductible to the business.

Can you give an instance of when you are thinking the premiums for insurance in the buy-sell arena would be tax deductible?

Regards,
Mark

Nora Dunn's picture

Great question, Mark. Tax deductibility is dependant on the country's regulations, in addition to the company's structure (eg: partnership or corporation).

However oftentimes the general rule goes that expenses incurred for the business (which can include insurance premiums) are deductible as business expenses. In Canada this is the case with some buy-sell Life Insurance structures, as well as Key-Man policies. 

I encourage anybody looking into this to check with their accountants about the deductibility applicable to their specific situation. 

Guest's picture
Prasad

A small partnership LLC has two owners and would like to buy life insurance on each other life, as well as on a key employee. The premiums will be paid by the company. Are these premiums tax deductible in USA? I have read articles describing both ways: non-deductible and tax deductible. What's the truth? I appreciate your response.

Guest's picture
Jason Van Steenwyk

Unfortunately, a lot of CFPs, and most freelance writers, know only enough about life insurance to be dangerous.

Life insurance premiums, with a couple of relatively narrow exceptions, are generally not tax-deductible in the United States.

Nora Dunn's picture

@Jason - Thanks for your input. If your reference to CFPs and freelance writers is a dig at me, then I'd also like to let you know that I was an insurance expert as well as a CFP, with more qualifications than I care to mention.

And as you deftly point out, there are a couple of relatively narrow exceptions to the tax-deductibility of life insurance premiums in the United States.

According to the IRS,  the following life insurance premiums are deductible:

"Life insurance covering your officers and employees if you are not directly or indirectly a beneficiary under the contract."

Matters get a little cloudy here, later in the same document:

"If, as a partner in a partnership, you take out an insurance policy on your own life and name your partners as beneficiaries to induce them to retain their investments in the partnership, you are considered a beneficiary. You cannot deduct the insurance premiums."

The question is whether they are referring to the partnership as a business structure, or if the term partnership also extends to shareholders. In Canada and other countries, there is a distinction between a Partnership-structure (with partners) and Corporate-structure (with shareholders).

 

Jason, it would be great if you weighed in on this, since you seem to know about the tax deductibility of life insurance premiums. Please share! What are the exceptions to deductibility of life insurance premiums you refer to?

 

 

Guest's picture

Life insurance of both kinds, Key man and Buy-sell funding are very relative in covering up the possible loss in business acquisition. I certainly agree that key personnel of business entities are their utmost asset that will create a diminishing effect as they die that is why it is very essential to have at least a financial support that will carry on with their loss.

Articles like this are eyeopeners that creates a very substantial thinking for further business assessment. Great job, Nora!

Nora Dunn's picture

Thanks, @Life!