3 Ways to Use Life Insurance to Support Your Business

October 5, 2023 in Business, Insurance

Sheila and Kendra had been best friends since eighth grade. After they graduated from college Sheila suggested they go into business together, and Kendra was all in. Ten years later they were the happy co-owners of a thriving theater arts company. Their partnership was a harmonious blend of talent, ambition and friendship, and they reveled in their shared success.

However, they never imagined – or planned for – the legal complexities that could arise from an unexpected event. And as best friends, they never gave any thought to the legal realities of their partnership. There was no clear exit strategy or business continuation plan in place. Beyond that, there was certainly no discussion of the unthinkable.

Then the unthinkable happened. At the age of just 33, Sheila died in a tragic car accident.

On top of her grief, Kendra, the surviving partner, found herself facing a daunting reality. Sheila’s husband, who had no desire to change careers and join her in the business, was now a single father and the owner of 50% of the theater arts company. To make up for his household’s lost income, he needed Kendra to buy out his half of the business.

This left Kendra in a precarious position. Since she didn’t happen to have a pile of cash sitting around, she would either have to take out a very large loan (assuming she even qualified for one), find a new business partner or sell a business that she loved. The possibility of that last option left Kendra in tears. She had just lost her best friend. She couldn’t face the idea of losing their business, too.

This was a terrible situation… but it didn’t have to be this way.

Life insurance could have secured the business’ future

Many people think of life insurance as something you put in place to provide financial support to your own family after your death. While life insurance certainly can and should be used in this way, there are many other uses for life insurance, too.

If you own a business, there are ways in which life insurance can support it. This includes:

1
Key person insurance
2
Business continuation
3
Financial strength

Let’s explore each of these – what it is, how it’s used and how it could have helped Sheila and Kendra’s theater arts company.

#1: Key Person Insurance

What are “key people”?

Key people are people such as the owners and important members of the management team who play pivotal roles in your business’s day-to-day operations and long-term success. The value that these key people bring can come in various forms, such as:

Technical knowledge – They have specialized skills and expertise that are indispensable to your company.
Experience – Their years of experience elevate your business to new heights, often through innovative problem-solving and strategic thinking.
Customer relations – They have built and maintained strong customer relationships that make your clients feel valued and understood.
Passion – They see the business as “their baby” and are completely dedicated to its success.

To determine if someone is a “key person” in your business, ask the following questions:

How vital is this person to the day-to-day functioning of the business?
What would happen to your business if you lost them?
What would it cost to replace them, in terms of time, money and potential setbacks?

What is key person insurance?

Key person insurance is a life insurance policy that provides financial protection for your business if a crucial employee or officer passes away. Key person insurance offers peace of mind, ensuring your business can weather the storm and continue to thrive even in the face of unexpected challenges.

In the hustle and bustle of entrepreneurship, it’s easy to overlook the potential risks associated with losing a key person. However, as Kendra learned after Sheila’s tragic death, neglecting to protect your business from such an event can have severe financial repercussions.

How does key person insurance work?

Purchase – Your business purchases a life insurance policy for each of the key individuals within your organization. The business then pays the annual premiums (which, unfortunately, are most likely not deductible expenses on your business’ federal income tax returns).
Coverage amount – Be sure to base the policy’s coverage amount on the estimated financial loss that your business would suffer in that person’s absence.
Payout – If the key person dies, then, as the policy holder, your business receives the insurance payout.
Benefit – In this situation, your business will be able to use the payout funds to cover expenses such as hiring and training a replace, offsetting revenue loss or paying off debts.

In Kendra’s situation, the proceeds from a life insurance policy could have been used to purchase Sheila’s half of the business from her husband.

#2: Business Continuation

There are a lot of “what if’s” in a business partnership

In Sheila and Kendra’s case, tragedy came in the form of the death of a business owner. What would have happened if Sheila had survived the car accident, but was so disabled that she could no longer work? Or what if Kendra had to move out of state due to family responsibilities, and therefore needed to exit the business? What if Sheila divorced and, because they lived in a “community property” state, was forced to pay her soon-to-be-ex for 25% of the business (i.e. half of Sheila’s 50% interest in the business). And so forth.

In the world of business partnerships, unforeseen circumstances can cast a shadow over even the most successful ventures.

A Buy-Sell Agreement can address the “what if’s”

A Buy-Sell Agreement is a crucial but often overlooked aspect of partnership planning. Also known as a “business will,” a Buy-Sell Agreement is a legally binding contract between business partners. It addresses vital financial aspects of partnership continuity, including:

Ownership transfer – A Buy-Sell Agreement provides for a smooth transition in the event of a partner’s exit, thereby minimizing disruption to the business’ operations. In the event of a partner’s death, disability, divorce, retirement or other triggering events, the Buy-Sell Agreement outlines how that person’s ownership interest will be transferred.

If there’s a divorce, is the divorcing partner required to buy out his or her spouse? Is that spouse required to sell? In the case of debilitating disability, is the disabled person required to sell? If not, how will the other person be compensated for the fact that the disabled person is no longer doing their share of the work? What if the disability is just temporary?
If one partner wants to retire and the other does not, how will that be handled? If both partners want to retire, what is the succession plan? If one partner dies, will the remaining partner have the right to buy out the deceased partner’s heirs – even if these heirs have a desire to join the business?

A Buy-Sell Agreement can address ownership transfer in all of these “what if” scenarios and more. In this way the Agreement can ensure that the surviving partner retains control of the business and everything is done in an equitable manner.
Fair valuation – All of these “someone buys out the other person’s interest” or “we sell the business” situations require an agreement as to what the business is worth. A Buy-Sell Agreement defines a fair and predetermined valuation method for determining this. Agreeing on this in advance prevents disputes about the business’ worth and ensures a fair process that benefits all parties involved.
Sale to a third party – In cases where the remaining partner will not be purchasing the ownership interest, a Buy-Sell Agreement can provide a framework for a third-party sale.
Protection for heirs – A Buy-Sell Agreement can ensure that if a partner dies and their heirs will not be participating in the business, these heirs receive fair compensation for their loved one’s ownership interest.

Life insurance can be used to fund a Buy-Sell Agreement

A Buy-Sell Agreement must also establish funding mechanisms to facilitate the transfer of ownership. Where will the money come from? If you don’t address this issue, you can end up in a situation where it is not financially possible to implement the plans that everyone had agreed upon.

Quite often the answer to the funding dilemma is life insurance.

Life insurance is a common tool used to provide the necessary funds to buy out a partner’s share in the business. In this case you need to be sure to purchase a policy that will provide enough funds (in the case of a partner’s death) or cash value (for situations such as disability or divorce) to cover the anticipated financial needs.

#3: Financial Strength

Isn’t life insurance just for mitigating risks?

When it comes to managing your business’ financial health, insurance is not just about protection against loss. Few business owners realize this, but you can also use life insurance as a powerful tool to strengthen your business finances. Here’s how…

Collateralize loans

One of the most significant benefits of life insurance for business owners is that it can be used as collateral for a loan. Rather than having to put up personal assets (such as your home) as collateral, you can use a whole life or universal life insurance policy instead. In this case, the cash value that builds up in the insurance policy can be used to guarantee payment should you be unable to repay.

Collateralized loans often have lower interest rates and/or are available for larger loan amounts than those that are not collateralized. The long-term savings from a lower interest rate can be substantial!

Using life insurance as collateral can also increase your credit worthiness overall. Because you are now viewed as being more financially stable, you are more likely to be able to obtain a loan from a top lender that offers better rates. Without collateral, your only option may be to obtain funds at a much higher interest rate from a loan shark or subprime lender.

Life insurance can strengthen your business’ financial position

Beyond securing loans, life insurance can also strengthen your overall financial position. When you have life insurance in place, this adds to the strength and stability of the business. It provides…

Risk mitigation – Because life insurance creates a financial safety net for your business, this in and of itself puts your business on a stronger financial footing. For example, as discussed above, when you use life insurance as key person insurance, if a key employee dies the payout can help ensure that your business continues to thrive.
A source of operating funds – Whole life or universal life insurance policies (also known as permanent life insurance policies) build cash value over time. You can access this cash value through policy loans or withdrawals, and use the funds for business investments or emergencies.

If Kendra and Sheila’s business had purchased life insurance policies, after using the proceeds from the policy on Sheila’s life to purchase Sheila’s half of the business, Kendra could have used the cash value in her own policy to cover the costs of recruiting, hiring and training someone to do Sheila’s job.
Funds to pay estate taxes – Depending on the details of the situation and the current status of our ever-changing tax laws, if you die, your heirs may have to pay estate taxes on the value of your business. You certainly don’t want them to have to sell the business in order to come up with the money to do this! Life insurance proceeds can provide the money needed to cover the tax liability, thereby helping to ensure a smooth transition of your business to your heirs.
Confidence to others – Having life insurance in place can instill confidence in investors, partners and key stakeholders, because it reduces risk and demonstrates your commitment to the long-term success and stability of your business. All of this enables these people to see your business in a different light or through a different perspective.

By strategically incorporating life insurance into your financial planning, you can unlock new opportunities for growth and secure a brighter future for your business.

Conclusion

If you’d like to explore how life insurance can meet your business’s unique needs, please don’t hesitate to reach out to me. This is one of my areas of expertise. As a financial advisor and fiduciary with a focus on working with women business owners, I’m here for you. Let’s talk!

It is easy to set up an appointment with me to talk about your needs and questions. Just click on “Schedule a Call” to find a time convenient for you.