Virtually every business owner will tell you it takes more than one person to build up and maintain a profitable business. In fact, it is likely that several “key employees” have contributed to the success of any given operation. However, while a business owner may be careful to make sure that he or she is adequately insured, the need to protect the business against the loss of key employees is often ignored or disregarded, which is a mistake.
Fortunately, there is a relatively painless way to help safeguard the business. Appropriately enough, it is commonly referred to as “key person” insurance.
Typical situation: A company takes out a life insurance policy on someone whose presence is considered crucial to the business operation. In some cases, the proper insurance protection for the business can mean the difference between solvency and bankruptcy. The life insurance proceeds from the policy could be used for any or all of the following purposes:
- finding, hiring and training someone to take the place of a deceased worker;
- paying bills to maintain the company’s good credit rating;
- paying off business loans, which lenders may demand after the death of an owner/officer; or
- making up for the loss of revenue caused by the subsequent disruption to the business.
Who should be covered by a key person policy? Start with the owner and president of the company (who might also be the founder). The rest of the group depends on the type and size of the business. For example, it may be worthwhile to insure a crackerjack salesperson, a creative talent or an indispensable manager.
Are the life insurance premiums tax-deductible? No. However, when the key person dies, the business receives the proceeds of the policy tax-free. In addition, the life insurance proceeds are not generally part of the key person’s estate. But if he or she is the sole or controlling shareholder, the proceeds may be taken into account for determining the value of the stock for estate-tax purposes.
Finally, as long as there is a legitimate business reason for the insurance, the business should be able to avoid any accumulated earnings tax problem.
What happens if the key person leaves the firm? Generally, there are three options: The company may (1) sell the policy to the ex-employee as a fringe benefit, (2) transfer the policy to another key person or (3) surrender the policy for its cash value.
With savvy planning, you should be able to cover all the insurance needs of the business, including any appropriate life insurance policies. Consider this an important aspect of the business-planning process.
For further information on the above article or any business advisory services, contact Michael D. Machen, CPA, CVA at (334) 887-7022 or by leaving us a message below.
