Life Insurance For Small Business Owners is more important than you might think. You insure your home and your car, why wouldn’t you protect your business with life insurance?
There are many ways for a business owner to protect his or her business but many people overlook small business life insurance. They believe as long as they have a personal life insurance policy their business will survive. This type of thinking is often wrong. If you own a small business, you have put a tremendous amount of sweat equity into growing your business.
If you were to suddenly die, would your business survive?
A personal life insurance policy helps your family cover living expenses and pay off any debt. Business life insurance keeps your business operating even if you are not there. In many cases, the business may be worth very little without the owner or partners to keep the business running. There are several ways to protect your business with life insurance:
Business Continuation Life insurance
A business continuation policy is much different than owning a personal policy. This type of policy protects the business in the event of premature death of a business owner or partner which may result in the business being sold or liquidated. Often business continuation consists of a Buy-Sell Agreements.
The Buy-Sell Agreement is the most popular continuation plan for a small business or corporation. It requires surviving business owners, key employees, or in some cases the business itself to purchase the interest of the deceased business owner or partner. The agreement is a legal document drafted by an attorney and funded in most cases with life insurance.
There are a different types of agreements to fit businesses of all types and sizes:
Cross Purchase Agreement
This type of agreement involves the business owners, partners or even shareholders to buy life insurance policies on the lives of each co-owner, but not on themselves. The amount of life insurance purchased is equal to their individual share of the net worth of the business. Each co-owner usually pays the annual premiums on the policies they own and each owner is the beneficiary.
Cross Purchase Agreements are usually designed to be used for small businesses with no more than four owners. Why? Because of the complexity of multiple policy ownership. More than 4 owners would result in a numerous amount of policies. For instance, a corporation with just four owners would need a total of 12 life insurance policies, each owner would buy a policy on the other three partners (4 x 3 = 12).
How it works: If one of the owners or partners were to die, proceeds would be paid to the surviving owners to a) fund the business with cash or b) pay off family members for the deceased owners portion of the business. It provides a clear description of how the deceased owner’s heirs will sell their interest to the remaining owner(s). This ensures the continuity of the business and makes sure the family does not have any controlling interest of the business.
Entity Purchase Agreement
The Entity agreement is sometimes also referred to as a stock redemption agreement. Specifically for corporations and not partnerships, it obligates the business entity to buy out the interest of the deceased owner, and the estate of the deceased owner is obligated to sell.
In an entity purchase buy-sell agreement, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and the business is the owner and the beneficiary of the policies.
How it works: When a shareholder/owner suddenly dies, the corporation buys the deceased owner’s shares from the surviving heirs with life insurance proceeds. The buyout price has already been agreed to previously and is reflected in the amount of life insurance purchased. The deceased owner’s heirs receive immediate cash at fair market value for their business interest. Stock redemption plans are easier to manage when there are multiple partners since only one policy per owner is needed.
Wait and See Buy-Sell Agreement
This agreement allows a business or corporation to combine features from both the Cross Purchase Agreement and the Entity Purchase Agreement. The business can buy policies on each owner or shareholder or the individual co-owners can purchase policies on one another. In other words, a Wait and See Agreement uses a combination of both methods if the business owners agree to the continuation plan.
How To Determine The Amount Of Buy-Sell Funding
The amount of insurance coverage needed to fund the agreement is determined by the owner’s share of the business, and the overall value of the business itself. Once the value of the business is appraised, you can determine the amount of coverage to purchase on each owner. Here are a few methods of business valuation:
Market Value: The market value of a business is whatever someone is willing to pay for the business. In other words, the fair market value or price someone is willing to pay for the asset.
There are many factors that go into fair market value such as type of business, sales, liabilities, location, property and so on. Market value can fluctuate vastly over time, and is significantly influenced by the business cycle.
Book Value: Book value of a business is determined like the net worth of an individual. When determining book value, the sum of the liabilities or debt is subtracted from the amount assets the business owns. The book value is normally calculated with the help of a Certified Public Accountant or Financial business analyst. It is a better way to value a business than market value if the business owns significant real estate holdings and equipment.
Advantages of Using Life Insurance for Small Business Owners
- Life insurance proceeds are generally income tax free
- Creates immediate cash to fund the buy-sell agreement at death
- Cash proceeds are paid quickly ensuring the business will keep operating
Disadvantages of Using Life Insurance for Small Business Owners
- Premiums are paid with after-tax dollars and are not tax-deductible
- Proof of insurability required. Owners must be in good health to qualify for a policy
- Ongoing obligation to pay premiums and keep the agreement funded
- Different ownership percentages require different amounts of insurance.
- If the owners ages vary widely, younger owners will have to pay higher premiums on the lives of the older owners
1. Keep in mind, premiums for the policies must be paid or the insurance could lapse. Also, the amount of insurance should be reviewed regularly to make sure the coverage meets the value of the business. The insurance coverage may need to be increased or even decreased depending on the value and profitability of the business.
2. The financial stability of the insurer should be checked periodically to make sure the company will be in business long term to pay claims and obligations. This can be done by checking the financial rating agencies such as A.M. Best, Standard and Poors, Moody’s and Fitch.
In addition to Buy-Sell agreements, life insurance for small business owners includes: