Life insurance for business owners: a multipurpose tool

Any advisor who counts a business owner among their clients knows that telltale look, the one that says, “I already have too much on my plate running a company to worry about long-term planning stuff.”

All too frequently, the day-to-day concerns of running a company push vital business planning and big-picture strategic decisions to the back burner. Indeed, two-thirds of business owners lack a formal succession plan, including 7 in 10 business owners over age 50, according to the 2014 U.S. Trust Insights on Wealth and Worth Survey from Bank of America Private Wealth Management.

As much as business owners tend to focus on the seemingly more urgent near-term demands of running a company, sometimes they need to be reminded how important long-term business planning is and how valuable life insurance can be in that context.

“As the owner of a company, you have to make sure your business is protected from certain risks, and that you’re protecting your assets by taking care of your best employees,” says Elaine B. Eisner, co-founder of the Eisner Gohn Group, an insurance planning practice. “Life insurance is really good at providing that kind of protection for business owners.”

Protecting what the business owner built

Versatile as it is, life insurance is an indispensable strategic tool:

• For business owners,

• For its utility in business continuity/succession planning and estate planning,

• As a form of compensation to attract and retain talent, and

• As a means to protect employers against the loss of key employees.

For entities with more than one owner, such as partnerships, often the first order of business is protecting one another from the loss of one partner due to disability, death or retirement, says Hank N. Mulvihill, Jr., principal at Mulvihill Asset Management in Richardson, Texas. Here’s where advisors and their business owner clients often turn to buy-sell agreements underpinned with life insurance.

In some cases, such as with professional firms (legal, engineering, consulting, dental, etc.) a group of partners or senior executives cross-insure one another. So if one of them dies, the remaining partners in the group use the tax-free proceeds to buy that person’s stake in the firm (rather than the stake transferring to the person’s heirs, whom the other owners may not want as a partner).

Permanent life insurance also plays a large role in business succession planning, whereby the successor owners of a company are the beneficiaries of a policy that insures the life of the existing owner. When the existing owner dies, the successor owners use policy proceeds to acquire the company. Family-owned businesses often employ this type of maneuver, says Raymond Benton, principal of Benton & Associates in Denver, Colo.

The aforementioned strategies most commonly involve permanent life insurance that is either owned by the partners or the entity itself. Universal life with fixed premiums tends to work best for companies seeking cost assurance, Mulvihill says. In other instances, a well-funded whole life policy makes sense.

“If you’re looking for cash value to fund a retirement buy-sell agreement, it’s worth looking at a custom whole life contract or an over-funded universal life contract,” says Eisner.

For businesses that are highly cyclical or otherwise prone to cash flow fluctuations, a UL policy with flexible premiums can make the most sense, she adds. Meanwhile, businesses that can’t afford to pay the premiums on a permanent policy might look to a more affordable term life policy.

Key person planning

After business owners and/or partners protect themselves with buy-sell agreements, the next level of planning involves protecting the company from the loss of a key executive, such as a top revenue producer or a person who is otherwise indispensable to the organization because of their expertise, business connections, etc.

Companies who have such a “key person” — an owner or otherwise — often purchase a life insurance policy on that person, so if he or she dies, the life insurance policy “provides capital to help stabilize the company and give it operating cash while it finds a replacement for that person,” says Benton.

Life insurance is also a useful and highly tax-efficient tool for companies with an employee stock ownership plan (ESOP), Mulvihill points out. The company may purchase some form of permanent life insurance for key-person coverage to protect against the risk of the company not being able to cover its ESOP repurchase obligations.

Handcuffs and other talent-retention tools

“After you take care of the risk with owners and key staff,” says Mulvihill, “then you go to the goodies” — bonuses and other forms of compensation built around life insurance.

In a tightening labor market, it’s becoming more difficult for companies to attract and retain talent. Compensation programs built around life insurance are a potentially powerful way for small and mid-sized companies to compete for talent with larger, better-capitalized businesses.

For example, Eisner explains, a company may establish an executive bonusing arrangement whereby the company takes out a life insurance policy on a valued employee. Usually either the employer pays policy premiums (which are tax-deductible if the technique is executed properly) or shares premium responsibility with the employee (a split-dollar arrangement). Eventually that insurance policy — she generally favors a custom whole life contract for situations such as these — “should create a fairly robust tax-free income stream for a period of years during [the executive’s] retirement.”

These kinds of compensation arrangements are appealing “because they give the owner of a small to mid-sized business golden handcuffs to retain their most valued people,” Eisner says, and because “they are very easy to administer.”