For small business owners, life insurance can offer many benefits, such as the typical motivation of any potential policyholder: to provide enough money for the family if the primary earner dies.
Just because one person owns a business doesn’t mean it’s worth a lot of money at any one time. Even then, that value is usually not very liquid and can only be realized by selling the business. As a result, surviving family members will be completely dependent on the cash flow generated by the business.
Another great reason a business owner might purchase life insurance is to provide liquidity to pay estate taxes in the event of the policyholder’s death. Estate tax is paid in cash nine months after death. A family may need to use most or all of their available cash, borrowing from a bank or selling a business quickly under duress. Life insurance is often used to avoid these stressful situations.
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On a more personal level, life insurance can be a very effective tool for promoting succession equity when a business owner has one or more children who work for the company and others who do not. Leaving the business to the children involved while making the other children beneficiaries of life insurance makes family members better off both financially and in their relationships.
Co-Ownership Considerations for Life Insurance
Life insurance policies can also play a key role in cases of joint ownership of a business. There are generally two types of sale and purchase agreements. One is a cross-purchase agreement in which business owners purchase life insurance from each other.
This type of agreement is usually designed so that when one of the partners dies, the surviving owner can use the death benefit to purchase the deceased partner’s share in the company from their estate.
Another type of sale and purchase agreement is called a physical purchase agreement, in which the company itself has personal insurance for the co-owners. When one of the co-owners dies, the company receives a death benefit and can use it to purchase the deceased owner’s shares from their estate, but these shares then become treasury shares.
A physical purchase agreement can be useful when there are many partners in the business so that each partner does not need to purchase life insurance for the other partners.
What is considered “fair” in a family varies from family member to family member
Back to the concept of family equity: While business owners who get life insurance usually make it a top priority, implementation of the plan can vary widely. First, you first need to define “fairness” in a particular context. Fairness doesn’t always mean “equal”, and policyholders need to decide what they think is appropriate, rather than letting their beneficiaries decide – who may see the matter differently.
For donors and recipients, fairness is a concept that lives in the mind of the beholder. The key is to make choices that fit your goals. Remember, this is all free for the recipient. This is a gift, not a right.
Individuals are under no obligation to leave any assets to their children, so it is important to emphasize to beneficiaries that anything they receive is given out of love and generosity.
Early communication within the family is key
When clients come to us for advice, our role often includes storytelling. Over the years of working in our respective fields, we have seen multiple situations arise in different home settings. We can provide useful insights from these experiences and provide education on different options and structures.
While each situation has its own unique elements, one general piece of advice we would like to offer is the importance of communicating within the family about your pre-death plans—especially if the plan includes any favorable aspect.
Ultimately, the decisions are yours, and you have been given the right to make those decisions. But if you want your family to get along and spend time together after you’re gone, it’s important to let them know what you plan to do and why. That conversation may also offer perspective that you hadn’t considered before, causing you to change your plans.
Life insurance is a versatile tool that provides liquidity to families who may otherwise be largely illiquid, and meets general spending needs to pay estate taxes and potentially help provide a fair succession.
Especially for business owners, life insurance can provide several benefits, both professionally and personally.
This article was written and expressed the opinion of our staff of consultants, not the Kiplinger editorial staff.You can check advisor records with the SEC (opens in a new tab) or with FINRA (opens in a new tab).