by Karen Murphy, MostChoice.com

Life insurance can be a useful way to transfer your business to a continuing operator upon your death, or to ensure that the death of a key employee does not ruin your company. A child may purchase life insurance on a parent in order to finance the purchase of the parent's business. Likewise, life insurance proceeds can fund a partnership or a corporate buy-sell arrangement.

Providing the cash needed to pay taxes without depleting the business' working capital is another advantage of life insurance. It is also an effective way to meet other financial needs of a business upon the owner's death, such as meeting payroll or covering the cost of the business during the time it takes to settle an estate. 

In addition to providing death benefits, life insurance can provide benefits while the insured is alive, including strengthening the company's credit standing, providing retirement funding and serving as a source of emergency dollars. 

Finally, although insurance premiums are not tax deductible, the proceeds usually are free from income tax. 

Key Man Insurance

The loss of a key person could cost a company a small fortune, from searching, training and replacing the person to the intangible assets that person might represent. 

A key person can be anyone from a business owner to a financial officer or sales manager -- anyone whose departure could seriously cripple your business. The death of a  key person can result in adjusted credit lines, losses to competition, money spent on searching, hiring and training and lower earnings. Cash from a key person insurance plan can help maintain your business until a replacement is found and developed. 

In a key person plan, the business applies for, owns, and is named as the beneficiary of the policy bought for each key person within the business. The premium payments made by the business are nondeductible. Upon the death of a key person, the policy's death benefit is paid to the business, providing cash to cover the financial loss to the business, maintaining the company's credit and paying for a replacement. The plan may also pay the key person's salary to the family for a reasonable period of time. The policy's death benefit is income tax-free.

If the person lives, the cash value of the insurance can provide funds to finance the individual's retirement and can act as a nontaxable reserve for business emergencies. If a person resigns, the cash value of the insurance can serve as a replacement fund to offset the loss of the key person. 

Key-Man insurance is typically built around a permanent life insurance policy, though term life can be had for short-term needs. Premiums may vary, depending on the age, physical condition and health of the key person. 

Experts advise that before purchasing key person life insurance, you should first obtain credit insurance and create a complete business continuation plan. You might consider key person insurance if, after doing this, you still feel you would have a cash-flow problem at the death of a key employee. Five times the employee's annual salary is a general guideline to estimating the key employee's worth, although you could estimate the worth as the employee's salary times the amount of time it would take to find and train a replacement. 

If you have partners, a key person policy may include a buy/sell agreement. In the event of your death, your partners would use the death benefit to buy your share of the company from your dependents. These policies may be of a split-dollar type, where the company and the key person share both the premium costs and the death benefits. In this case, the amount the policy is written for is the agreed-upon buy-out price plus the amount the key person's beneficiaries would receive.

Second-to-Die Insurance 

Second-to-die insurance covers a business owner and his or her spouse or business partner, but pays off only on the second death. The premiums are usually lower than those on a standard individual policy. A disadvantage is that your family or company could need the liquidity before the death benefit is available. Also, if your spouse is on your policy and is also your trustee, the death benefit will be taxed as part of the estate. 

This type of insurance is generally used to fund estate tax liabilities, since it is much less expensive than individual insurance. Using split-dollar with second-to-die insurance enables an individual to have his or her corporation fund the insurance premiums. Many people use the combination of split-dollar and second-to-die insurance as a way to eliminate or reduce gift taxes. This is done in concert with an irrevocable trust. 

Using Insurance to Fund Buy-Sell Agreements

A buy-sell agreement is an arrangement where business owners arrange to purchase the interests of the other owners at a specific price upon certain events, such as death, disability or retirement. Buy-sell agreements thus can establish the value of the business interest for federal estate tax purposes and help ensure that heirs receive full value by guaranteeing the sale and the purchase price. 

A buy-sell agreement funded with life insurance is often the most economical and practical solution when a business owner dies. Life insurance guarantees a specific payout at death, regardless of when death occurs. Because premium costs are lower than the proceeds, life insurance can be the most economical method of prepaying the purchase price of the business. The two most common types of buy-sell agreements are "cross-purchase" and " redemption."

Cross-purchase buy-sell is an arrangement where the shareholders agree to purchase, in proportion to their share of the corporation, the shares of any other shareholder upon an event such as death. The agreement is between the shareholders themselves, not the corporation. In most cases, the shareholders purchase insurance on each other's lives in order to fund the buy-out of a deceased shareholder's shares. 

Advantages:

• Proceeds to the individual shareholders are tax-free
• Purchasing shareholders receive an income tax basis in the purchased shares equal to the purchase price
• Does not cause capital gains on the deceased shareholder's estate

Stock redemption buy-sell is an arrangement whereby the corporation agrees to buy the shares of a shareholder upon an event such as death. The corporation generally purchases life insurance on each of the shareholders in order to fund the redemption of a deceased shareholder's stock. When the redemption occurs, the remaining shareholders' interest in the corporation is increased proportionately, since the interest is split fewer ways. 

Advantages:

• Only one policy is purchased on the life of each shareholder

Income Tax Disadvantages:

• Capital gains treatment on the sale of a deceased shareholder's stock is difficult to achieve if other family members continue to be shareholders 
• No increase in income tax basis for increased share in the corporation
• A portion of the death benefits received by the corporation could be taxed 

Cross purchase method alternatives include the trusteed buy-sell, which is an arrangement where a trust purchases and owns one policy on each shareholder's life. Shareholders have an equitable interest in the trust in proportion to their interest in the corporation. Shareholders pay a proportional share of the premium payments through contributions to the trust. At the death of a shareholder, the trust purchases the decedent's interest. The surviving shareholders receive a distribution of the decedent's business interest from the trust in proportion to their equitable interest in the trust.

Advantages:

• Stepped-up basis, no capital gains treatment and income tax-free insurance proceeds
• One policy per owner

  Disadvantages:

• Unless a partnership, the purchase by the trust of the decedent's contributed premiums are subject to income tax

First-to-Die insurance is a simple and a low-cost alternative to fund a buy-sell agreement, especially when there are three business owners involved. In this case, there is only one policy, which terminates upon the death of the first business owner. The coverage thus is only available to fund a buy-out on the first death. Oftentimes, this is preferable to single life policies that can essentially over-fund a buy-sell agreement. A guaranteed insurability rider purchased with the policy can provide additional coverage to survivors even if they are uninsurable. However, this will reduce the overall savings of a first-to-die policy.

Using Split Dollar Plans to Fund Buy-Sell Agreements

Split dollar funding techniques usually refer to arrangements by which premiums, cash values and death benefits of a regular insurance policy are split by two or more parties. They are considered one of the least expensive and most cost effective methods to help fund a buy-sell agreement or to bring younger owners into a closely held corporation. 

If you have partners, a split dollar plan may help fund a buy/sell agreement. In the event of your death, your partners would use the death benefit from the plan to buy your share of the company from your dependents. The company shares in both the premium costs and the death benefits. In many cases, the policy amount is the agreed-upon buy-out price, plus the amount the beneficiaries will receive. 

There are four different methods of split-dollar funding techniques:

• Collateral assignment -- The employee owns the policy and names a personal beneficiary. The employer pays the nondeductible premiums for the policy. The policy's death benefit and cash value is assigned to the employer as collateral for the employer's interest.
• Endorsement -- The employer owns the policy, and the employee receives a portion of the policy's death benefit. The employee's death benefit portion is the amount equal to the total policy death benefit less the greater of the policy cash value or the premiums paid by the employer.
• Split ownership -- The employee owns the policy, and the employer has specific rights to the policy. The employee's personal beneficiary receives the death benefit in excess of the employer's interest in the policy. The employer's death benefit interest is typically the amount of the premiums paid.
• Sole ownership -- A third party owns and is named the beneficiary of a policy that insures the life of the employee who is a majority stockholder. No assignment or endorsement is used, thus the company has no corporate rights to the policy.

Get a Free Key Person Life Quote