The Real Uses of Life Insurance for Small Business Owners

June 13, 2023

As a small business owner, incorporating life insurance into your financial plan is essential. However, life insurance often carries a negative connotation, leaving business owners unsure how to utilize it effectively. 

I've heard countless stories from small business owners who have been pitched various insurance products. Among the most common are cash-value life insurance policies (permanent policies) that appear too good to be true. Sales tactics often involve enticing promises such as tax-free retirement income, the ability to "be your own bank," or an investment with stock returns, but without the risk. 

Are these promises possible? Sure. But with the complexity and over-emphasized illustrations, these “benefits” rarely play out in real life. 

Instead, life insurance should be used for what its intended purpose is – to cover a financial loss. For the family of a business owner, this means providing funds to pay off debts, cover expenses, replace lost income, and ensure financial security. For the business itself, life insurance can help keep operations running smoothly or facilitate a seamless transition of ownership, minimizing disruptions as much as possible.

To navigate life insurance effectively, it's essential to grasp the specific situations and types of policies that are most relevant to small business owners. Understanding these aspects will empower you to make informed decisions and protect your personal and business interests.

Protect your family with personal life insurance

Whether you're a business owner or not, if individuals depend on you financially, life insurance is an essential tool. A personal life insurance policy creates a safety net that replaces lost income, settles outstanding debts, funds your children's goals, and maintains the financial security of your family.

For many entrepreneurs, the absence of a group life insurance policy provided by an employer makes it necessary to seek an independent life insurance policy. Without this coverage, the potential financial burdens on your family in the event of unforeseen circumstances can be overwhelming. 

To determine the appropriate amount of life insurance for your specific situation, a general rule of thumb is between 10 to 12 times your current income. If you'd like to fine-tune this estimate based on your unique circumstances, there are helpful online life insurance needs calculators available. Here’s a good one you can use.

One of the most significant risks entrepreneurs face is being underinsured or having no life insurance at all. Such a scenario would expose your family to substantial financial hardship should anything happen to you. On the other hand, over-insuring is another pitfall to be cautious of. It's not uncommon to encounter situations where business owners are sold excessively large cash-value policies when the actual coverage needs are much lower.

When optimizing the life insurance you need, it's okay to have slightly more personal life insurance than necessary. You just want to be cautious about having an overly excessive amount, as more premiums can strain your cash flow. 

In general, term life insurance fulfills the financial plans of the majority of business owners. This type of policy offers coverage for a specified period, such as 20 or 30 years, and provides flexibility and affordability.

However, there are specific circumstances where a cash value policy might be a suitable option. It's important to note that cash-value policies tend to be more expensive, but they offer a permanent solution as long as premiums are paid. Additionally, these policies accumulate savings, allowing the policy to build cash value over time. One situation that could warrant a cash value policy is anticipating a significant estate tax bill. In such cases, a permanent life insurance policy can be beneficial in providing liquidity to cover estate taxes.

Protect your business with key person life insurance 

Just as personal life insurance provides essential protection for your family, your business also requires a similar level of coverage. This is where key person life insurance, often called key man insurance, comes into play.

Key person life insurance involves the business purchasing a policy specifically designed to ensure the life of an owner or a valuable employee. The primary purpose of this policy is to aid your business in recovering from the unfortunate event of the death of a key individual. In essence, it mitigates the risks associated with losing a person whose absence would significantly impact the value and profitability of the business.

For instance, if the loss of an owner or employee would result in a substantial decline in the company's revenue, a key person policy can provide financial support to keep operations afloat. The insurance proceeds can be utilized to train a new employee, maintain stability by offsetting lost revenue, or continue covering operating expenses.

It's important to note that if you are a sole business owner without any employees, the need for a key-person policy may not be necessary. However, there may be situations where securing such a policy becomes needed or is mandated as collateral for a business loan, even for sole proprietors.

One common question that arises from business owners is whether key person life insurance premiums are tax deductible. Generally, these premiums are paid with after-tax dollars and, therefore, are not tax deductible. However, if the business receives the insurance benefit, it is generally tax-free.

Similar to personal life insurance, key person policies can be either term or cash-value (permanent) life insurance. For small businesses aiming to cover a specific period, term insurance is the most common option. The policy term can align with a key employee or owner's retirement or any other significant milestone for planning purposes.

Alternatively, if your business requires insurance coverage that does not expire, a permanent policy may be more appropriate as long as the premiums are paid.

Determining the proper amount of insurance coverage for a key person can be a complex task. Ideally, the coverage should encompass the estimated loss, severance costs for staff, financial recovery period, and the expenses associated with finding a replacement if something unfortunate happens to the key individual. When used as collateral for a loan, the insurance amount typically matches the loan's value.

Funding a buy-sell agreement

For a small business owner with multiple co-owners or partners, implementing a buy-sell agreement is a crucial step in your strategic planning. Essentially, a buy-sell agreement is a legally binding contract among business owners that outlines the plan for transferring an owner's share of the business.

While a buy-sell agreement doesn't necessarily require an insurance policy, incorporating life insurance can significantly enhance its effectiveness, particularly when owners lack sufficient capital to fund it. 

By leveraging a life insurance policy within a buy-sell agreement, you can create accessible funds that streamline the buyout process.

Within the framework of a buy-sell agreement, the insurance coverage amount should align with the value of each owner's stake. In the unfortunate event of an owner's passing, the insurance policy can provide the necessary liquidity to facilitate the purchase of the deceased owner's share of the business. The resulting cash payout to the family or estate ensures a smooth transition while supporting the financial stability of the business.

There are two primary methods of setting up life insurance within a buy-sell agreement.

Cross-purchase agreement

In this agreement, each partner purchases life insurance on the other partner(s). Should one partner pass away, the death benefit proceeds from the insurance policy are utilized to finance the buy-sell agreement and enable the remaining owners to acquire the deceased owner's share of the business. 

It's worth noting that a cross-purchase agreement can become more complex when there are multiple owners, as each owner must purchase policies on the lives of the other owners.

Entity purchase agreement

This agreement involves the business purchasing the insurance policies on each owner. As the beneficiary of the policies, the business would purchase the ownership share of any deceased owner. This approach is often more practical and efficient when there are multiple owners. 

While premiums for insurance policies used to fund a buy-sell agreement are generally not tax deductible, the benefits received are typically tax-free. 

Both term and permanent life insurance can be reasonable funding options for a buy-sell agreement. Collaborating with your financial advisor and an insurance agent will allow you to tailor the policy to meet the unique needs and objectives of your business.

By integrating life insurance into your buy-sell agreement, you secure the continuity of your business, protect the financial interests of owners and their families, and ensure a seamless transition.

Life Insurance for small business owners

Life insurance is not just another expense—it's a powerful tool that empowers you to mitigate significant financial loss. As a savvy business owner, it's crucial to navigate through the noise and avoid falling into the traps of flashy marketing schemes and self-serving insurance agents. Now that you've gained insight into the right approach and various types of life insurance policies, you can make informed decisions that align with your financial goals.

You're a business owner. You understand the benefits of getting things off your plate. When implementing life insurance in your financial plan, be sure to work with a financial planner who understands the unique needs of small business owners like you. A specialist financial planner can help you craft a team of professionals, including a trusted insurance agent, and collaborate as a team to make sure the policy is aligned with your goals.

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