Business Uses of Life Insurance

What is a buy/sell agreement?

Just consider what might happen to the type of business you have if you would die.

• Would your sole proprietorship be liquidated?
• Would your partnership or limited liability company be dissolved?
• Would corporate shareholders face the financial and legal complexities of buying your shares or facing the unknown of a powerful new shareholder?
  
  

How does a buy/sell agreement funded by life insurance work?

Buy/sell agreements may be set up in conjunction with Sole Proprietorships, Partnerships and Corporations. The method for each is a little different. Below you will find a general description of the options available for each type of business.

Sole Proprietorship

If a sole proprietor has a key employee that has the desire to purchase the business in the event of the sole proprietors death, a buy/sell agreement can facilitate the key employee's purchase of the deceased's business. The sole proprietor and the key employee would enter into a buy/sell agreement, and the key employee would purchase a life insurance policy on the life of the sole proprietor. Pursuant to the buy/sell agreement, upon the death of the sole proprietor, the key employee uses the death benefit to purchase the sole proprietors business from his estate.

Partnership

Cross Purchase Plan

In this plan, owners enter into an agreement with one another. To fund this plan, each owner applies for, owns, and pays the life insurance premiums on the other owners.

When an owner dies:

• Life insurance proceeds are paid to the surviving owner(s) income tax free.
• Proceeds are used to purchase the heirs' business interest.
• Heirs receive an agreed-upon payment for their business interest.
• Surviving owner(s) receive an increased cost basis for the acquired business interest.

What is Key Person life Insurance

A good way to ensure that a business will survive if something happens to a top executive is for the firm to consider purchasing life insurance - or "key person insurance" - for its key employees.

Like personal life insurance coverage, key person life insurance pays a benefit to the corporation if that person dies. Businesses typically use the proceeds to make up for lost profits resulting from the key person's death, to hire and train a replacement, and to pay any outstanding debts. While credit insurance and buy-sell agreements frequently help fill this need, key person insurance can be an extra layer of protection.

Here are some questions to ask to determine whether your firm needs key person insurance:

• Who are the profit makers at the company?
• Whose death would affect the business's profitability?
• Which employees does the company depend on for specialized areas such as inventions, research, marketing or sales?
• Has the company recently invested in equipment or expansion, or taken out substantial loans?

How do you set up a Keyperson Life Insurance Policy?

To determine the amount and type of insurance you will need, first ask yourself what you want to happen to your business if something were to happen to the key person. Will the key person be replaced and the business continue? If you are the only owner, will your beneficiaries sell the business? Or, if there are multiple partners, will it be taken over by the remaining owners?

If the business is to continue, the key man will need to be replaced, and the replacement will need time to get up to speed. The amount of coverage you buy should compensate for both the replacement's salary and the period of lower profits during the transition. You can use annual salary as a means of determining how much coverage should be carried. If you think it might take two years for a successful transition, the policy should be written for double the key person's salary.

Once the death benefit amount has been determined, the business would purchase the policy on the key person. The key person would be the insured and the business would be the owner, payor and beneficiary of the policy. Permanent or term life insurance can be used as a key person policy depending on the needs of the business and how much they are willing to spend.

Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice.  Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice.