While originally designed and still used primarily to replace a deceased breadwinner’s income, life insurance is also an integral component of sound business planning. Although there are numerous uses, this essay will briefly describe the role of life insurance in the following business settings: key-man, buy-sell, executive bonus, and split dollar.
Many small to mid-size businesses are the result of one person’s vision and drive. If that person were removed from the equation, the business might flounder or even fail. As a result, many small to mid-size firms procure a life insurance policy on that person, with the business as the beneficiary. That way, should the key person die, the business would have the requisite cash to calm creditor’s nerves and either a) conduct an executive search for a successor or b) negotiate a sale of the business on more favorable terms than might otherwise be attainable.
Additionally, lending institutions will often require life insurance on the key person as a condition of the loan, with themselves named as beneficiary.
A buy-sell agreement is used when there is more than one owner of the business, and it stipulates what will happen should one of the owners die. A simple example using two partners would require the deceased’s estate to sell, and the surviving owner to buy, the deceased’s share of the business, usually with a formula to determine the price. Without the buy-sell agreement, the survivor could find herself in business with her ex-partner’s spouse.
Life insurance is used to provide the funds required to execute the terms of the buy-sell. Each partner procures a policy on the other, with himself as the beneficiary. That way, if one partner dies, the survivor will have the funds necessary to complete the buy-out.
Executive bonus is an employee perquisite, whereby the employer will buy a life insurance policy for the executive. The employee owns the policy, and can name the beneficiary. The premium is reportable as income, so the employee is responsible for the tax on it, although the employer can bonus that as well.
Split-dollar is the sharing of a life insurance premium between two parties, usually an employer and employee. The employee is normally only responsible for a nominal amount, and the employer funds the balance. Pursuant to a written agreement, the employer will be repaid its entire investment in the policy, either as a beneficiary to the policy or at the employee’s retirement.
This is obviously a very elementary introduction to each concept. Much has been written (entire books!) on each topic, and usually the employer’s CPA and/or attorney is involved in reviewing and/or providing input to the transaction. As always, please call or email with specific questions or comments.