There are a number of ways small business owners can benefit from owning life insurance to protect their business.
As a small business owner, you have probably put your all into your businesses. As a small business owner myself, I understand that your business is your baby and, if you are like me, you will probably do anything you can to protect it and keep Uncle Sam out of your pocket.
Do any of these questions have you shaking your head “yes?”
- Do you have a partner in your business whose services you depend on?
- Do you have a key employee who, if you lost their services, would set you back considerably?
- Do you want a mechanism to attract better talent into you business and give them an incentive to stay with you for the long term?
- Do you want to protect some assets from lawsuit or creditors that you can still access at anytime?
- Do you want a supplemental way to fund your retirement?
If so, you may benefit from owning life insurance.
Note – Life insurance is not a panacea for small business owners!
As this site is all about life insurance I want to tell you that we don’t believe that life insurance is a solve everything solution to all of your problems. It is a great financial tool but life insurance is not a panacea.
What I want to explain in this post are some of the ways life insurance works to solve some problems that business owners like me and you face. It can be used as a complete solution to reach your goals or it can be used in conjunction with other assets and strategies.
What tool you use to accomplish your goals depends on your particular situation. To know if life insurance is right for you it is important to know some of the products unique attributes.
Life insurance offers the following attributes for business owners:
- Life Insurance has ability to turn small premiums in to large benefits in the event of death or disease.
- Life Insurance has the ability to self fund itself in the event of a disability.
- Life insurance death benefits are income tax free and cash values are income tax deferred.
- Life insurance cash values are creditor and lawsuit protected in many cases.
- Life insurance cash values contractually have a guaranteed minimum rate of return (investments do not have any guarantees; this is why life insurance IS NOT AN INVESTMENT, life insurance is insurance.)
- Life insurance premiums can be flexible.
- Life insurance is the only type of insurance that can increase in value as time passes by.
With this, lets take a look at some of the ways that you, as a small business owner, might benefit from owning life insurance for your business.
Life Insurance can be used to fund a business “Buy-Sell Agreement.”
You went into business and you have some partners. Each of you have put your heart and soul into creating an amazing small business. You depend on each other and want to make sure you chose who else could become partners with you.
A problem could occur if one of you passes away unsuspectingly. This is one reason why you have drafted a buy-sell agreement. The buy-sell agreement spells out how each one of your estates will sell the business if this were to happen and it spells out who can buy it. Privately held small businesses aren’t like publicly traded companies whose stock is easily marketable and the odds are the remaining owners will want to know who their new partners will be if there any new partners at all.
Because life insurance has the ability to provide large benefits for small premiums, it works great to create the income tax free lump sum of cash to buy the deceased owners shares from his or her estate.
Term life insurance can work fine to provide the cash needed to buy out an estate in the event of a small business partner passing away. You can get a quick quote to see how much a term life insurance policy would cost by clicking here.
However, what if a partner wants to leave for any other reason and doesn’t die?
If a business has enough cash flow, the owners may choose to use a cash value life insurance policy instead. In doing so, not only do they have the ability to generate the income tax free death benefit, they also are creating a tax deferred sinking fund whose cash value can be accessed to buy out a partner who wants out of the business.
Life Insurance Is Used By Small Business Owners To Protect Against the Loss of a Key Employee
If you have an employee you depend on inside of your business, you may benefit from having a life insurance policy on this key employee.
Life insurance death benefits are designed to compensate the beneficiary for an economic loss they would experience if the insured dies.
A key employee may be a saleperson who brings in millions of dollars per year, a manager who knows your business inside and out or even a contractor you depend on to get jobs done.
Owning any form of life insurance, including term life, is a good way to protect your business for loss. However, key man insurance can be structured to provide other benefits to both the business owner and the employee.
Here are a few.
Life Insurance Can Be Used By Small Business Owners To Attract and Retain Key Employees.
Finding good help is hard. When you find someone who is instrumental in growing and maintaining your business you want to keep them as long as possible. Life insurance can be a tool that helps you do this.
Great employees are marketable. They can go anywhere and get work, even to your competition. To keep them, you need to make them feel appreciated and give them a great compensation package. There are certain rules regarding many of these compensation packages that require a business owner like yourself to provide the benefit to all of your employees, not just key employees.
A Supplemental Executive Retirement Plan (SERP) using cash value life insurance may be the answer.
Here is how a SERP could work:
- Your business takes out a life insurance contract on your key employee’s life.
- You agree to pay the key employee $x dollars per year if they stay for a negotiated period of time.
- While they work, you reposition money and fund the life insurance contract. The money you use is after tax money.
- The cash value of the life insurance creates a sinking fund that is growing tax deferred.
- The cash value of the life insurance could be used in the future to pay the promised benefit to the key employee.
- The cash value can be used by you, the business owner at any time because you control the policy.
- The death benefit of the insurance policy can be used to pay the key employees estate and/or compensate the business for the economic loss of his or her services should they pass away while employed.
- When the key employee starts receiving their promised retirement benefit, the cash value can be used to pay the benefits. These payments are tax deductible to the business.
- The life insurance death benefit can be structured to provide an income tax free lump sum of cash that can repay the company the benefits it provided the key employee.
SERP plans are non-qualified and can therefore be offered to only the employees you choose. In addition, there can be a vesting schedule associated with a SERP placing a type of “golden handcuff” on the key employee providing incentive to stay on board with you and your company.
The death benefit from life insurance make a SERP appealing because it can effectively create a tax arbitrage on this benefit allowing your business to recapture a chunk of its cost. The tax deductible benefits paid to the employee are replaced by the tax free death benefit of the life insurance.
A Split-Dollar arrangement is another way you could use life insurance to compensate and retain a key employee.
Like a SERP, a split dollar arrangement using life insurance is another way you could attract and retain your key employees.
Unlike a SERP where your business owns the life insurance policy, a split dollar arrangement can put the ownership of the life insurance policy with your key employee or your business. You two agree to split the premium requirements to fund the policy over a negotiated period of time and share in its benefit.
Here is how a split dollar plan using life insurance works for retaining key employees:
- A written agreement is taken out between your business and your key employee. It specifies who owns the policy and the rights each party has to the death benefit and cash values. It also outlines what the employee needs to accomplish to keep the plan in force.
- A life insurance policy is taken out on the life of the key employee.
- Premiums are paid into the policy as agreed upon and your business and employee enjoy the benefits the plan creates.
Why use a split dollar plan using life insurance to attract and retain key employees?
- Allows key employee to obtain valuable life insurance coverage they may not obtain on their own.
- Allows your business to be financially compensated if the key employee passes away.
- Split dollar life insurance plans can be used to recruit, motivate and retain key employees.
There are a number of ways to structure a key man life insurance. If the key employee is uninsurable, other assets like annuities can be used.
Check out how a major university used split dollar life insurance to motivate and retain one of its highest paid employees by clicking here.
How Small Business Owners Can Use Life Insurance To Fund Their Retirement.
Using life insurance inside a 401(k) profit sharing plan
Business owners can buy life insurance inside of their 401(k) profit sharing plans and use pre-tax money to buy life insurance protection.
When they do this, the death benefit received by the policy beneficiary is 100% income tax free less the cash value in the policy which is taxable as current income when withdrawn. for example, if you had a $1,000,000 life insurance policy with $100,000 of cash value, your beneficiary would receive $900,000 income tax free and the $100,000 would be taxed at their marginal tax rate just as any other money would be in an inherited traditional retirement account.
Using life insurance as a supplemental retirement plan for business owners
You have a business and it is generating great cash flow. You want to start setting some money aside that is outside of your business, is creditor protected and you can access at anytime if you need it.
Cash value life insurance like whole life and universal life can be a great place to store cash, earn a decent rate of return and protect its value from lawsuits and other creditors should your business experience difficulty.
Personally, I have a very good friend who was worth millions. His business flourished for 20+ years generating $100’s of millions of dollars in profits. He continually invested in his business and those investments continued to grow his empire….until one day everything came crashing down. He lost everything and was left with nothing in his 60’s.
Life insurance isn’t an investment. It is insurance. Because of its creditor protection and liquidity provisions it is a strong candidate for a business owner to store excess cash in. That cash can eventually be used to create a tax-free cash flow in retirement through withdrawals and loans.
In addition, life insurance has a self-completion feature if a policy owner becomes disabled. The life insurance company will continue to fund a life insurance policy if the policy owner becomes disabled allowing the cash value to grow without any additional contributions by the policy owner.
Contact us if you would like to discuss how we can help you protect your business and accomplish your financial goals by clicking here.