We are often asked to explain the differences between Key Person Life Insurance and Life Insurance used to fund a Buy/Sell agreement. While they are both used in the business environment to ease the shock to the business if a partner dies prematurely, they have different purposes. The following is a short explanation of each.
Key Person life insurance is used to protect a business if a key employee dies prematurely. When a key member of the team is suddenly gone, the business may go through a tough time. Clients may be lost, revenue may slack off, credit may be harder to obtain and the remaining employees may be worried that the business will fail and they will be out of a job. If the company owned life insurance on the key employee, the death benefit would provide cash to enable the business to continue operations while a suitable replacement is found. The death benefit proceeds are paid directly to the business and the business can use the money as it deems appropriate. The business can even use the money to buy out the deceased partners share, but it would not be required to do so.
Buy/Sell life insurance is used to fund a Buy/Sell agreement. The Buy/Sell agreement is drafted by an attorney and includes several important stipulations to facilitate the orderly transition of ownership of the business should one of the owners die prematurely. Bad things can happen when a partner dies if no planning had taken place. There can be disputes between the deceased partner’s spouse and the surviving partner over the operation of the business. There can be disputes over the value of the business. There can be disputes about whether to buy or sell at all. As tensions and conflicts mount up, the continued operation of the business is jeopardized.
A funded Buy/Sell agreement eliminates many of the conflicts that arise when a partner dies.
- It fixes the market value of the business.
- It obligates the surviving partner to buy the shares of the deceased partner.
- It obligates the estate of the deceased partner to sell the shares to the surviving partner.
- Provides the cash needed to complete the sale.
A Buy/Sell agreement appropriately funded should be a requirement for every small business with more than one owner.
- Life Insurance premiums are generally not tax deductible business expenses. Therefore, the premiums are paid with after tax dollars and the benefit is received tax free.
- While this discussion centers around business life insurance uses, of equal importance is providing for business continuation in the event one of the partners or key people become disabled. The chances of becoming disabled during ones working career are much greater than the chances of dying prematurely. We should all include a discussion of Key-Person Disability and Disability Buy-Out coverage when talking about business life insurance.