Most business owners like to think of their team as extended family. As such, business life insurance should not be overlooked or undervalued. It might not be the most inspiring of entrepreneurial to-dos, nor is it the most time-sensitive compared to a high-stakes proposal or a tight deadline on a project; however, it is an absolute “must have” for any responsible business owner.
Take a few minutes to read or even skim this article to see if you are making any of the following mistakes that leave so many businesses vulnerable to potential financial distress down the road.
Quick Article Guide:
1. Thinking Personal Life Insurance Covers the Business
2. Not Earmarking Funds to Pay Out a Deceased Owner’s Share
3. Not Covering “Key” Employees
4. Purchasing the Wrong Type of Coverage
5. Not Buying Enough Coverage
6. Cutting an SBA Loan Deadline Too Close
7. Writing Off Insurance Premiums
8. Not Reviewing the Policy Periodically
9. Going Straight to a Big Insurer
10. Work with a No-Cost Broker
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The life insurance policy you might have already bought to protect your family does not provide any protection for your business if you die, especially if there are several owners in your company. To ensure that your business has sufficient funds to operate after your death or the death of one of your business partners, you will need what’s called a buy-sell agreement. A buy-sell agreement with life insurance is a legally binding contract between insured owners outlining how the assets and equity in a business will be divided if an owner dies.
If an owner in your company dies, a buy-sell agreement can provide tax-free cash to help the surviving owners carry on and keep the business in operation, without having to liquidate or sell assets in order to “buy out” the deceased owner’s share from their surviving family.
Put simply, a buy-sell agreement helps to keep the family of a deceased owner out of the business, facilitating a smooth sale in which the deceased owner’s family is compensated while the business is positioned to move forward appropriately.
There are two main types of buy-sell agreements:
“A document that allows a company’s partners or other shareholders to purchase the interest or shares of a partner who is deceased, incapacitated or retiring. A cross-purchase agreement is used in business continuation planning. The document outlines how the shares can be divided or purchased by the remaining partners, such as a proportional distribution according to each partner’s stake in the company.”
Stock Redemption Plan
“A binding agreement that is implemented by the owners of a business to facilitate the orderly transition of a business interest in the event of the death, disability or retirement of a business owner.”
Deciphering Between the Two
In a cross-purchase agreement, the owners typically pay for life insurance policies on each other, which means the paperwork can add up quickly in cases where there are three or more owners. In a stock redemption plan, the business is both the owner and the beneficiary of the policies. A stock redemption plan is usually ideal for a business with more than two owners.
To learn more about both types of buy-sell agreements, visit our previous articles:
In addition to policies on the owners, your business should also consider buying “key person” life insurance on your integral staff, such as executives, salespeople, and long-tenured administrative professionals.
Key person insurance covers your business for:
- The business income loss caused by the sudden death of an employee with specialized skills
- The time and resources needed to interview potential replacements
- The time and resources needed to hire and train the chosen replacement
- Any clients that could be lost during this transitional period
To learn more about key person life insurance please see our article here.
Many business owners set up the wrong type of buy-sell agreement for their particular situation, or they buy the shortest term life insurance policy available. Don’t view life insurance for your business as a checklist item—take the time to realize why it’s important and what level of protection a given policy will provide. Treat life insurance like you would any other high-level business decision. Do plenty of research, ask questions, and consider the options carefully.
Before finalizing a cross-purchase agreement or stock redemption plan, be sure that the total coverage matches (with room for growth) the value of your business as defined by one of the following formulas:
Assets minus liabilities
What a buyer is willing to pay for the business, often based on “comps”
Capitalization of Earnings
Based on annual earnings and forecasted future earnings
If there is a discrepancy between Book Value and Market Value, the decision usually defaults to Market Value, as this figure is typically higher and minimizes the risk of being underinsured.
When purchasing key person life insurance, you can get a ballpark face amount based on how many years your business would likely suffer if the key person died unexpectedly, multiplied by the key person’s annual compensation (salary, commissions, benefits, and bonuses).
Life insurance companies will typically allow you to insure up to 10 or 15 times a key person’s total compensation including all bonuses. For most businesses, 5-10 years of the key person’s compensation will be sufficient and affordable. If their compensation fluctuates, calculate an average from the past three years.
If you’re applying for an SBA (U.S. Small Business Administration) loan, you might have noticed that you must secure your loan with life insurance. Don’t save this for last!
Understand that from first call through approval, life insurance can take up to 8 weeks to finalize. If you put yourself right up against your loan application deadline, you might be forced to purchase a non-medical policy, which will cost you more than a policy with a medical exam. We can always go back later and replace your non-medical policy with a more cost-effective option, but you can save a sizable sum of money by starting your life insurance shopping early and taking a medical exam.
Learn more about securing life insurance for an SBA loan here. If you need life insurance to fund your SBA loan in a hurry, please see our article; “Best No-Exam Life Insurance Companies 2016.” Some of the top-rated life insurance companies we work with may be able to approve your insurance policy in less than a week.
Ask your agent about a collateral assignment. Since the balance of an SBA loan reduces over time as you make payments, a collateral assignment allows the insurance company to pay your lender what they are owed, and then pay the remaining funds to your surviving family.
If you already have enough life insurance to protect your family, you may want to consider purchasing a life insurance policy that will allow you to decrease the amount of coverage you carry as your loan is paid off. Some life insurance companies will actually allow you to decrease your coverage once a year, and this strategy can save you up to 40% on the cost of your coverage. To learn more about decreasing term life insurance, please see our article here.
Thinking of writing off your life insurance payments as business expenses? We recommend consulting with your CPA or tax adviser first. Although you have the option to designate your insurance premiums as expenses, doing may make the proceeds of the insurance policies taxable. Being taxed on a life insurance payout can significantly decrease the money your business receives.
If your business is growing, your business’s life insurance should reflect the increase in value. Its best practice to review your business life insurance with your agent every 2 to 3 years. If your business is growing rapidly, you may want to review your business policies on an annual basis. Doing so will also give you a chance to make sure your business, business partners, and their beneficiaries are adequately covered.
It might be comfortable to go to a big-name insurance company for your business life insurance, but most of these companies do not specialize in home and auto insurance, not life insurance. Many of the big-name insurance companies like State Farm and Allstate spend almost a billion dollars a year on advertising and these costs are passed down to the consumer. Additionally, their agents are “captive” which means they are only able to sell life insurance policies with the company they work for.
Working with an independent no-cost broker will allow you to compare rates from dozens of companies to make sure you receive the best policy available. At JRC we work with over 40 top-rated life insurance providers to help maximize your options and savings. You might still end up with a policy from one the largest life insurance companies like Prudential or MetLife, but these “A+” rated companies do not advertise heavily and this allows them to charge a lot less for their insurance policies.
JRC is a one-stop shop for your personal and business life insurance needs. We are owner-operated and our agency is nationally licensed. Our agents do not have quotas or daily sales goals, we are here to provide the personalized attention you deserve. Give us a call today, toll-free at 855-247-9555, or request a free quote online using the button below. In just a few seconds you’ll be able to compare rates from dozens of companies.
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