Life insurance as a business tool

How you can use a policy for executive benefits and succession planning.

Many people think about life insurance policies providing financial security for a family who lost a loved one, but they can also function as a strategic business planning tool. Before buying a policy, it’s important to understand how your business can benefit from this type of investment vehicle and what the rules and regulations are for using it.

Executive benefits

One of the most common ways to use life insurance in your business is called key person insurance. A company will take out a life insurance policy on an owner or key employee, with the company paying premiums and naming itself the beneficiary. In the event of this key person’s death, the benefit allows the business to cover expenses like lost revenue, debt repayment and finding a replacement for the position.

Life insurance policies can also be used in businesses that offer deferred compensation plans. Some companies allow highly compensated employees to defer income and receive it later, usually in retirement. The company can buy a policy on that employee and use the policy’s cash value to fund the deferred compensation when it’s due.

Succession planning

If you’re operating a family business, you may plan to pass the company down to future generations. But if your heirs are uninvolved or uninterested in the business, you can consider a life insurance policy to help leave an equal inheritance to your loved ones.

It’s not uncommon for a business owners’ assets to be tied to their company. A life insurance policy can help provide estate liquidity in the event of death which helps to cover obligations, like estate taxes. This is especially important if heirs don’t want to sell the business or ownership interests can’t easily be liquidated.

Business owners may enter into a buy-sell agreement, which defines how ownership interests in a business will be transferred if the owner dies, becomes disabled or retires. In the event of death, a life insurance policy can provide the financial resources to facilitate the transition. The payout can be used by surviving business partners to purchase the deceased owner’s shares, preventing an outside party from acquiring them.

A recent Supreme Court case that involved the valuation of a small, family-owned business established precedence on how life insurance proceeds and redemption obligations should be treated for federal estate tax purposes. Two brothers, who were sole shareholders of the business, entered into a buy-sell agreement that would allow a surviving brother to buy a deceased brother’s shares. But, if the surviving brother declined, the company would be required to redeem the shares using life insurance proceeds. The company redeemed the deceased brother’s shares using $3 million in life insurance proceeds. The estate reported the shares’ values at $3 million, however, the IRS valued the shares at $5.3 million, which was the value of the company plus the $3 million in life insurance proceeds. The IRS argued that the life insurance proceeds should be included in the company’s valuation, resulting in an additional estate tax liability of close to $900,000.

Before buying a life insurance policy, especially if you plan to use it strategically for business purposes, consult with your advisor, tax professional and attorney. Be sure you understand the rules and regulations and are prepared for any potential tax implications. When used intentionally, this vehicle can be a powerful tool in helping you preserve an asset you worked so hard to build.