ENSURING AND INSURING YOUR BUSINESS'S KEY PERSON

Key person insurance and buy-sell insurance are common requirements for many small businesses. The two, in fact, can often be combined in the same policy.

Key person insurance can provide the money which is often needed to keep a small business from foundering when a key person -- usually one of the owners but sometimes a vital employee -- dies. 

Buy-sell insurance provides the funds for surviving shareholders to purchase the shares of a decreased shareholder, usually from the deceased's estate.

Typically, key person insurance and buy-sell funding insurance are involved in small business corporations with two major, active owners. Both the surviving partner and the family of the deceased partner will benefit. Money is available to keep the business going until someone can be found or trained to fill the shoes of the deceased. The surviving partner gets to acquire the business outright. The deceased's estate is assured of promptly getting fair value for its shares in the business firm.

The required amount of buy-sell insurance will obviously be determined by the buy-sell agreement between the shareholders, or partners. As the business grows and increases in value, the amount of insurance should be periodically reviewed.

The required amount of key person insurance should be based on estimates of how much the business would be disrupted by the death of the person, and how long it would take to find and/or train someone who could adequately fill his or her shoes. This might be a few months, or a few years.

Term insurance is sometimes chosen for both key person and buy-sell funding, but permanent or whole life can also be appropriate in some instances.

Everyone benefits from such insurance, but thought should be given as to who should own the policies, pay the premiums, and collect the benefits.

Criss-cross insurance is a common practice.  Shareholder A is the owner and beneficiary of a policy on shareholder B, and pays the premiums, while shareholder B has a similar policy on shareholder A. But because premiums must be paid in after-tax dollars, it could be much less costly if the insurance policies are owned and paid for by the company rather than by the shareholders. Since the corporate tax rate for small businesses is generally less than 25 percent while the marginal tax rate for the shareholders may be 40-50 percent, the net cost of insurance could be cut in half if the policies are owned by the company.

In either case, the spouse or estate of the deceased partner receives prompt payment at a fair value price for its holdings in the business, while the surviving partner is provided with the funds to buy complete ownership of the business.

To see how this works, consider the case of Big O Donuts Ltd., owned 50-50 by Ken and Craig.  Big O owns life insurance policies with a face value of $500,000 on each partner, pays the premiums, and stands to collect any death benefits.  When Ken is killed by a sudden heart attack, his shares in Big O Donuts don't go through his estate, but pass directly to his widow, Betty.  Big O Donuts collects half a million dollars from the life insurance company.  It pays no tax on this money, since the policy was paid for with after-tax dollars.

Under the terms of the buy-sell agreement, Craig is entitled to purchase Betty's shares for eight times the previous year's net earnings, which works out to $460,000.  The company pays a special dividend in this amount to Craig, who uses the money to pay Betty for Ken's shares.  And Big O Donuts and Craig plan to use the remaining $40,000 to open another shop.