Life insurance for business owners

A closely held business creates insurance needs that personal coverage does not address, and the arrangements involve legal structure as much as insurance.

Buy-sell agreements

The central issue for any business with more than one owner.

If an owner dies, their interest passes to their estate — potentially to a spouse or children with no involvement in or knowledge of the business.

The surviving owners may find themselves in partnership with someone who wants to be bought out, or who wants a role, or who wants to sell to a third party.

A buy-sell agreement provides that on defined events, the interest is purchased at a defined price by defined parties.

Life insurance funds the purchase, which is the practical problem — surviving owners rarely have the cash to buy out a substantial interest.

The structures

Cross-purchase. Each owner holds policies on the others and buys the deceased owner's interest personally.

Advantages: surviving owners receive a basis increase in the acquired interest; proceeds are received by individuals.

Disadvantage: the number of policies grows quickly with the number of owners. Four owners require twelve policies.

Entity purchase, or stock redemption. The business owns policies on each owner and redeems the deceased owner's interest.

Advantages: fewer policies, simpler administration, one premium payer.

Disadvantages: surviving owners generally do not receive a basis increase; corporate-owned policies have specific tax considerations including potential alternative minimum tax implications for some corporations and the employer-owned life insurance notice and consent requirements.

Hybrid and trusteed arrangements, which attempt to combine advantages and add complexity.

The choice has significant tax consequences and should be made with a tax professional and an attorney, not by an insurance agent alone.

Valuation

The agreement must specify how the interest is valued.

Options include a fixed price updated periodically, a formula, or an appraisal process.

Fixed prices go stale. Formulas can produce results nobody intended as the business changes. Appraisals cost money and take time.

Whatever the method, review it regularly. An agreement valuing the business at a figure set eight years ago is a source of dispute rather than a solution.

Note also that the valuation in a buy-sell agreement may be relevant for estate tax purposes, subject to specific requirements for it to be respected.

Key person insurance

Coverage owned by and payable to the business, on an individual whose death would materially harm it.

The purpose is to fund the disruption: recruiting and training a replacement, lost revenue during the transition, reassuring lenders and customers, and providing working capital.

Lenders frequently require it as a condition of business borrowing.

Note the employer-owned life insurance rules: notice must be given to the insured and consent obtained before issue, and specific requirements must be met for proceeds to remain income tax-free to the business.

Failing these requirements makes proceeds taxable, which is a substantial and avoidable error.

Executive benefit arrangements

Split dollar arrangements, in which an employer and an employee share the costs and benefits of a policy.

The tax rules changed substantially some years ago and these arrangements are now structured under specific regimes. They are complex and require professional design.

Deferred compensation funded with life insurance, where the business informally funds a promise to pay future benefits.

The insurance is a business asset, not a dedicated fund, and the employee is a general creditor.

These arrangements are subject to specific tax rules on deferred compensation with significant penalties for non-compliance.

Personal coverage for business owners

Separate from business arrangements and frequently overlooked.

Business owners often have personal guarantees on business debt, which survive them and can reach the estate.

They may also have illiquid wealth concentrated in the business, which creates an estate liquidity problem — taxes and expenses due in cash, with assets that cannot readily be sold.

Personal life insurance, frequently held outside the estate in a trust, addresses both.

Disability, which is the larger risk

Buy-sell agreements frequently address death and omit disability, which is statistically more likely during working years.

A disabled owner who cannot work but retains their interest creates exactly the problem the agreement was meant to prevent.

Disability buy-out insurance funds a purchase on long-term disability, and the agreement should define disability, the waiting period before triggering, and the purchase terms.

Business overhead expense insurance is a related product, covering fixed business costs — rent, salaries, utilities — while an owner is disabled, which keeps the business operating.

The review discipline

These arrangements go stale faster than personal ones.

Review after any change in ownership, any material change in business value, any change in the tax law affecting the structure, and at least every few years.

Confirm that policies remain in force, that ownership and beneficiary designations match the agreement, and that the funding is adequate for the current valuation.

Underfunded buy-sell arrangements are common and are discovered at the worst moment.

General information about insurance and business planning, not insurance, legal or tax advice. These arrangements involve complex tax and legal rules. Consult a qualified attorney, tax professional and licensed advisor.