Life insurance for business owners: Should you have it?

Life insurance provides financial security for your family if you were to die prematurely. When you’re a business owner, however, there are more people counting on you. From your business partners to your employees, a life insurance policy can play a pivotal role in the continuity of your business.

“More often than not, people are the largest asset in a company,” says Jacob Kujala, senior product manager for U.S. Bancorp Investments. “As a business owner, there’s an important financial dynamic to your value. Having life insurance makes a lot of business sense.”

Types of life insurance for business owners

Tom Nicoski, senior vice president and product manager for U.S. Bancorp Investments, says life insurance for business owners provides two main benefits.

Buy-sell agreement life insurance

“A buy-sell agreement is beneficial if a business owner has a partner and would prefer not to work with the partner’s family members if the partner passes away prematurely,” says Nicoski. “Life insurance proceeds can be used to purchase the business shares from the deceased partner’s estate.”

Key person life insurance

Life insurance can also be used to provide cash for the business if a key person were to pass away. “The insurance proceeds provide a financial cushion while the business works through the loss of the individual’s contributions to the business,” Nicoski says.

While business owners often purchase life insurance for buy-sell and key person reasons, Kujala says policies with those specific names don’t exist. “Key person and buy-sell agreements are risk mitigation and succession planning strategies that use traditional forms of life insurance,” he explains.

Owners can purchase a policy that funds a specific outcome they’re trying to achieve or can potentially use a policy to fund multiple objectives. For example, the company may take out a policy that includes key person insurance for $1,000,000. Three quarters of that policy could be used to offset the financial loss to the business if the employee passes away, and the remainder could go to the key person’s spouse as a salary continuation.

Term policy or permanent policy?

One decision to make is whether to choose a term policy that covers a certain period, or a permanent policy that has a cash value aspect to it. Deciding which is best will depend on several factors, most importantly the policy’s intended use. Other factors include business’ cash flow, total amount of coverage desired, age and health of the insureds.

Permanent insurance policies have several benefits for long-term planning. “The business might use a permanent policy as a vehicle to grow some liquidity that can be used down the road as a bonus for a partner or for future projects,” says Nicoski.

Permanent policies also offer tax advantages. “Unlike other investments that can be owned by a business, life insurance enjoys tax-advantaged growth and distributions,” says Kujala. “Cash value that grows inside of a policy is tax deferred. When money is distributed from the policy, the beneficiary can access the cost basis first and the gain afterwards. And if they take the gain out as a loan, that is not taxable. If taking policy loans above cost basis, it’s important to monitor the policy against lapse in order to maintain the tax efficiencies.”

Term insurance policies, on the other hand, are often used for buy-sell arrangements in the early stages of a company’s existence, says Nicoski. “Term policies are the least expensive way to insure an individual for a set period of time, allowing business owners to reinvest revenue back into the business during its growth years.”

Other considerations for life insurance for business owners

• Riders: Policies can include riders such as death benefit accelerations for long-term care or disability waiver of premium. With the long-term care rider, a policy owner can use policy death benefits while living to help offset the cost of a chronic care event. With disability waiver of premium, all or a portion of the insurance policy’s costs can be waived to reduce expenditures while still allowing for needed insurance coverage.
• Beneficiaries: Kujala suggests that business owners work with tax and legal advisors when choosing beneficiaries. “For key person policies, the business is going to want to be the owner of the policy,” he says. In other situations, like buy/sell planning, the partner(s), the business itself, or a trust could be the owners and/or beneficiaries of the policy. “Without proper ownership and accounting, you can lose one of the biggest benefits for life insurance and the death benefit could become taxable. It’s important to get tax and legal professionals involved,” Kujala adds.
• Buy-sell value: The appropriate face amount of your policy is generally determined by the strategy for which you're using it. Nicoski says if you're creating a buy-sell agreement, you'll need to get a business valuation. “Have the valuation done regularly,” he says. “When you start your business, it may be worth a million dollars. Five years later, the business could be worth four million. You’ll want to get more coverage.”
• Key person value: Nicoski suggests determining the financial impact the person provides the business as well as how long it would take to replace that individual and get them up to speed.

Both Nicoski and Kujala say that consulting a financial advisor can help you navigate the process. “An advisor can open up different discussions and identify risks that the business owner might not have been thinking about,” says Kujala. “Trusted advisors, CPAs, and attorneys can help strategize concepts that address those risks. The advisor is uniquely qualified to help the owner determine the policy type that best matches up with the strategy. They may also help the business owner find the premium dollars to fund their policies, too.”

Would your business benefit from life insurance? Learn about life insurance options from U.S. Bancorp Investments.