Clients want to know: Do I need business insurance?

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1 lients want to know: o I need business insurance? fter reading this, you should understand: how businesses are organized the risks faced by business owners what types of insurance address business risks anada is a nation of small business owners and the number of owner-operated businesses is truly quite astounding. large risk that faces the owners of established businesses is that of business succession. Who will buy the company when the owner retires? Will the owner get a fair price for the business? What will happen to the business if the owner dies? How does the business owner ensure his or her heirs are treated equally? Small business owners are often unaware of how life insurance or as it is typically called in a business application, business insurance, can be used to manage these risks. usiness Structures To understand better how to advise a business owner, the agent must understand the three basic ways a business in anada can be structured. business will be one of the following: - a sole proprietorship, - a partnership, or - a corporation, Sole Proprietorships sole proprietorship is a company owned and operated by one person. It is unincorporated, and the sole proprietor personally owns the goodwill of the business, all its assets, and all its debts. This is the riskiest form of business ownership. sole proprietorship is terminated by simply ceasing operations or by the sale of the business. easing operations is simple and straightforward if the business truly is only owned and operated by one person and has no ongoing commitments. Other forms nother type of business beyond the scope of this discussion is franchised companies. Sole Proprietor sole proprietor is the owner of an unincorporated business. He or she owns all the assets of the business and is responsible for all business debt. opyright 2009 Oliver Publishing Inc. ll rights reserved 85

2 dvantage LLQP n owner of a small store typically would be a sole proprietor. The effort devoted to building the business can be lost if there is no plan in place for an orderly transfer of the business to another owner if the sole proprietor dies or is disabled. However, many sole proprietorships are large companies owned by someone who has worked long and hard to build the business, and there are employees and customers to whom the owner feels an obligation. In this case, a sale is called for. Selling the business will recoup the value the sole proprietor has built in the business and will satisfy those obligations to others. Proceeds from the sale could be used to provide an income to an owner who has become disabled or wishes to retire. Risks Faced by the Sole Proprietor and His or Her Heirs The greatest business risk facing a sole proprietor is whether he or she will be able to find a buyer who will pay a fair price when the time comes to put the business on the block. When a sole proprietorship is to be sold due to death of the owner, his or her spouse or heir must be able to sell the business at a fair price to make up for lost income and eliminate business debts; otherwise, personal assets can be seized by creditors to repay such debts. Some of the risks that can deter a fair sale of the business include: Potential buyers who detect a fire sale and respond with low offers because they realize the need to sell may take priority over getting the right price. spouse or beneficiary of the deceased business owner who may set an unrealistically high price on the business because of financial need and/or lack of knowledge about the true value of the business. They may be unsuccessful, therefore, in finding a buyer. The need by the spouse or beneficiary to pay business debts. 86 opyright 2009 Oliver Publishing Inc. ll rights reserved.

3 usiness Insurance Why is getting a fair price important for the business owner selling her business? to establish business credibility when it comes to negotiating financial matters a fair price is preferable to a fire sale the business owner may be counting on the proceeds for future needs and Partnerships partnership is an unincorporated company owned by a group of individuals who contribute funds towards the business. Every partner is either a limited partner (basically, an investor) or a general partner (actively involved in the partnership). Every partner owns a share of partnership interest, partnership property, and partnership debt equal to his or her investment in the partnership. partnership is terminated by winding-up, dissolution, or death of a partner. partner may choose to depart from the company if he or she is disabled and can no longer contribute to the company or if he or she wishes to retire. Risks Facing the Partner Typically when a partner leaves a partnership, the other partners step in to acquire the partnership interest, property, and debt of that partner. The partner leaving the company risks: - Receiving a fair price from the remaining partners for his or her partnership interest - Receiving a fair price from the remaining partners for his or her partnership property Partnership interest Partnership interest is the portion of the partnership owned by the partner that determines the financial stake the partner has in the firm s profits and losses. Partnership property Partnership property is the financial, intellectual or other property brought into the firm by each partner. It is essential that a fair price be received by the partner leaving the company because he or she will be responsible for paying his or her share of partnership debts. Inability to do so could result in personal assets of the partner being seized by creditors. When a partner dies, there is often a great deal of difficulty for the spouse or heir to agree with the remaining partners on a fair price for the partnership interest and partnership property for the same reasons that a spouse or heir may have difficulty selling a sole proprietorship. Unrealistic ideas of value may prevail, and there will be loss of income issues to deal with. Meanwhile the remaining partners run the risk of having the funds available to make a fair offer whether to the partner leaving the firm or the spouse or heir. If opyright 2009 Oliver Publishing Inc. ll rights reserved. 87

4 dvantage LLQP the partnership does not have cash on hand then internal conflict can arise on how to make the payment. partnership is the least common type of business organization. What do sole proprietors and partners have in common? debts that are personally guaranteed businesses that are unincorporated the need to receive a fair value for their business all of these answers orporations corporation is created in a legal process called incorporation. The legal process determines the number of shares in the corporation that will be issued and creates the corporate structure with a board of directors and officers of the company. If the shares are held by less than 50 people, the company is a closely-held private company. This type of company is called a anadian-controlled private company or P when it meets certain requirements. P has distinct tax advantages for its share owners including the ability to sell shares tax free if their value is less than $750,000. When company shares are listed and traded on a stock exchange such as the Toronto Stock Exchange, the company is a public company. apital gain capital gain is received when an investment classified as capital property is sold for more than its adjusted cost base. ompanies listed on a stock exchange like the TSX are public companies. Their share values are widely available. The value of shares of a private company is known only to its shareowners. apital loss capital loss is received when an investment classified as capital property is sold for less than its adjusted cost base. Values of corporate shares rise and fall with the worth of the company whether the company is private or public. When there is an increase in share value from the price paid for the share, then the shareowners benefit from a capital gain; if the share value drops below the price paid then a capital loss 88 opyright 2009 Oliver Publishing Inc. ll rights reserved.

5 usiness Insurance is received by the shareowners. Shareowners do not personally own assets of the company and they are not liable for company debt. corporation is terminated by sale of all the shares to an acquiring interest or person, bankruptcy, or a declaration by the board of directors. Risks Facing the orporate usiness Owner Just like sole proprietors and partners, shareowners will want to receive a fair price for their shares when they are sold. If a shareowner retires or is disabled, the proceeds from the sale of the shares can be invested to provide an income for the shareowner and his or her family. On death of the shareowner, the value of the shares will be an important source of funds for survivors to pay final expenses and provide for on-going needs. When a shareholder of a private company dies, usually the remaining shareholders will want to acquire the shares held by the deceased shareholder in order to retain control of the company. If the shares become an asset of the spouse or beneficiary, the remaining shareholders both lose a degree of control in the company and may find themselves dealing with an inexperienced or unknowledgeable heir who has an unrealistic idea of the value of the shares. What risk is unique to the shareowner and not also experienced by the sole proprietor or partner? the need for a fair price the need to pay business debts the need to fund a retirement income by the sale of shares the need to sell shares to recoup value of the business Two More usiness Risks The Risk of reditor Seizures creditor is a person or party to whom money is owed. It is quite usual for a business to both owe money to others, and, in turn, be owed money by others. If the business is a sole proprietorship or partnership the proprietor or partner will have debts that are personally guaranteed. When debts are unpaid, creditors can pursue assets of the debtor in an effort to be repaid. If the debtor dies, his or her creditors can sue the estate of the deceased for money that is owed to them. Life insurance provides two ways of protection from the claims of creditors. One way is by naming an irrevocable beneficiary of the insurance policy. nother way creditors cannot seize the benefits of a policy is when certain family members are specified as beneficiaries. Irrevocable beneficiary n irrevocable beneficiary is a person named as beneficiary that cannot be changed to another beneficiary without the permission of the irrevocable beneficiary. He or she makes all decisions in regards to the policy. opyright 2009 Oliver Publishing Inc. ll rights reserved. 89

6 dvantage LLQP I am a partner in a firm of architects. I applied for and received a life policy to ensure my family would have funds if I died. I named my husband the irrevocable beneficiary of the policy so that the creditors of the company cannot make a claim against my estate for money that they are owed. Who controls the policy when an irrevocable beneficiary is named in a life policy? the policy owner the creditors the irrevocable beneficiary the life insured Key employee key employee is an employee whose contribution to a company is key to its success. Loss of the Key Employee key employee can be found in a sole proprietorship, partnership, or corporation of any size: from Sue, the only painter at Sue s Painting, to ill Gates, founder of Microsoft. If a key employee dies or becomes disabled, a business can suffer substantially without the talents of that employee. Not only is that person no longer contributing to the company but the company must hire and train a replacement. This double-whammy can be a devastating blow for even very large companies. key employee may own all, part, or none of the business. How to keep the company going in the absence of the key employee is a risk for the business in which the key employee works. On retirement, death or disability, the business must be able to replace the talent of the key employee with the least disruption to its affairs. How Life Insurance Manages usiness Risks ll forms of life policies term, whole life, Term-to-100, and universal life are all available for business owners. The difference between business insurance and personal life policies is the way the business policy is structured in other words, who the policy owner is, who the insured is and who the beneficiary is. usiness insurance is based on agreements that have been structured between the owner or owners and potential buyer or buyers. 90 opyright 2009 Oliver Publishing Inc. ll rights reserved.

7 usiness Insurance If a sole proprietor, partner, or shareholder dies, a buy-sell agreement funded with life insurance will provide the beneficiary with sufficient funds to acquire the deceased s interest in the proprietorship, partnership, or corporation. buy-sell agreement will specify price and the terms of payment. It should be a binding agreement that sets out all terms and eliminates the need for future negotiation. This means that the seller must sell to the buyer under the agreedupon conditions. uy-sell greement contract that specifies the terms that a buyer and seller must meet for the purchase of a business from its seller. n option agreement is a variation on the buy-sell agreement. It gives the buyer the first option to buy from the seller. No price will be established. If the buyer does not want or is unable to buy, then the seller can look elsewhere. There are several ways a buy-sell agreement can be funded with life insurance. When the business is a sole proprietorship, a cross-purchase agreement is typically funded with term insurance that names the buyer of the business as the policy beneficiary. That money is then used to buy the business from the heirs of the deceased. + FILE See file 22 for a case study on how term insurance can fund a buysell agreement. If permanent insurance is used, the cash surrender value in the policy can be used to pay the owner for the business when he or she wishes to retire. The policy is sacrificed, but the owner receives a retirement allowance in the form of the selling price of the business that otherwise he or she might not have while ensuring a future for the business. If the buyer is the policy owner and has paid the premiums on the policy, the proceeds on death will be received tax-free. I ve been working as the chef here for 12 years. The guy who owns this restaurant is 62 and he wants to retire. ecause we have a whole life cross-purchase agreement, I m going to take the cash surrender value of the policy and be able to buy the restaurant from the owner. Without this insurance policy, I d have to go the bank for funding. This way I m debt clear. opyright 2009 Oliver Publishing Inc. ll rights reserved. 91

8 dvantage LLQP hoose the answer that best describes a cross-purchase agreement. a contract that uses life insurance to buy a business; a life insurance policy between an owner and potential buyer; a life insurance policy on the life of a business owner that names the heirs of the deceased as the beneficiary a contract that specifies the value of the business for a future owner criss-cross agreement is appropriate when dealing with a partnership. criss-cross policy has all partners insuring the lives of each other. Each partner must designate the other partner(s) as an irrevocable beneficiary. criss-cross agreement can be co-owned between the business and the partners or the business and its shareowners. When the premium expense is split between the business owners and the business a split-dollar funding arrangement is said to exist. The type of policy used can be either term or whole life. If term, it should be purchased as a renewable and convertible policy. The reason?: so that permanent life insurance can be put in place regardless of the health of the business owners. When a company is incorporated, a cross-purchase, tax-free dividend arrangement will provide all shareholders with a fair settlement. The business is named the policy beneficiary and receives the insurance proceeds on death of the shareholder. The shares of the deceased shareholder will be transferred to his or her estate. The surviving shareholders then purchase the shares from the estate according to the terms of the buy-sell agreement using a promissory note for payment. The corporation pays a tax-free capital dividend in the amount of the life insurance proceeds to the shareholders who use this dividend to pay the promissory note. This same arrangement is called a corporate repurchase or redemption of shares when the corporation buys the shares instead of the shareholders. Sharlyn and I are partners in a land survey business. We have whole life insurance on each other so that if one of us dies, the other will receive the benefit of the policy. That money will be used to buy the partnership interest from our heirs: Sharlyn s mother if she dies, and my wife if I die. If one of us gets hurt on the job and can t work any more, the cash surrender value of the policy will be used to buy the partnership interest from each other. 92 opyright 2009 Oliver Publishing Inc. ll rights reserved.

9 usiness Insurance criss-cross agreement is? a badly written or confused insurance agreement in need of revision; an insurance policy manoeuvre used to insure the interest of all business partners equally and irrevocably; an insurance policy designed to provide equal interests to all owners of or partners in a business; a term-to-100 insurance policy with multiple beneficiaries. Key Person Life Insurance Key employee insurance, also called key person insurance, is a form of thirdparty insurance in which the employer-company is the insured and the beneficiary, and the key employee is the life insured. If the key person dies, the insurance proceeds are paid to the business to hire a replacement and provide a cushion of protection while the business struggles to adapt to its loss. However, the business may use the proceeds any way it sees fit. If a policy with cash values is used, its cash value can provide a salary during disability, or to guarantee a retirement income via surrender, a loan, or withdrawal (universal life only). key employee is usually insured to a multiple of yearly income. The person designated as a key employee can be changed by use of a parachute clause that allows one life to be substituted for another. + FILE See file 23 for a case study on the use of key person insurance. Why would a business buy key person life insurance? to protect corporate performance to increase company revenue to maximize corporate profits to reduce the importance of the key person in the organization The dvantages of Life Insurance for usinesses Life insurance is not the only way to fund a buy-sell agreement. Other options include borrowing the necessary funds, selling company assets, or paying over time. However, only life insurance has these advantages: the funds will be available when needed, the cost of life insurance is lower than other alternatives, the new owner has no burden of debt from acquiring the business; unlike loans, policy premiums are not repaid. opyright 2009 Oliver Publishing Inc. ll rights reserved. 93

10 dvantage LLQP How isability Income Insurance Manages usiness Risks The uses for disability insurance in business are: - key person disability insurance - business overhead expense insurance - business disability buy-out insurance Key Person isability Insurance Key person disability insurance is used to provide a disability benefit to a business when a person who is key to the business is disabled. There are three parties to this insurance contract: the policy owner (the business), the person insured (the key employee), and the insurer. isability benefits are paid to the business; the business, in turn, uses the benefit to provide a salary to the key person during a period of disability. This permits the business to use the salary that would have been used to pay the key person to hire a replacement. Premiums for key person insurance are not tax-deductible for the business. They are an expense that can be budgeted, unlike additional salary and replacement costs that can be incurred by a business if disability should occur without insurance in place. The benefit period for key person disability insurance typically does not exceed one year and the elimination period is very brief so as not to inhibit the activities of the business in the absence of the key person. If a key person is disabled and unable to perform the tasks that make him key to the operation of the business then key person disability can help the business to substitute someone to carry on. 94 opyright 2009 Oliver Publishing Inc. ll rights reserved.

11 usiness Insurance usiness Overhead Insurance Overhead expenses are the cost of doing business. usiness overhead expenses continue even when the business owner is disabled. To keep the business going during such an absence the business itself can be protected by a business overhead policy. business overhead policy covers overhead expenses only. They include salaries for employees, rent, utility bills, existing business debt, and many other expenses incurred in operating the business. The policy does not cover salary for the business owner, payments on new debt taken on by the company, furniture, equipment, and merchandise. The business owner who is typically the prime revenue earner of the business protects himself or herself through a personal disability income policy. There are two parties to this contract: the business and the insurer. The business is the policy owner, insured and beneficiary. The benefit period for a business overhead policy ranges from six to 36 months. The elimination period is zero days for an accident claim and between 14 and 90 days for a sickness claim. Settling a laim for usiness Overhead Insurance usiness Overhead Insurance is a reimbursement plan that requires receipts be submitted as evidence of the need for a claim. There is a policy maximum, and qualifying expenses are reimbursed to that maximum. For example, if a sole shareowner of a business takes out a $5,000 usiness Overhead Insurance policy and then becomes disabled, he may submit up to $5,000 per month in business expenses for reimbursement. If his actual business overhead was $7,000, the $2,000 difference between the policy coverage and actual overhead would not be insured. If, however, the claim was less than the amount insured, let s say $3,500, the $3,500 would be reimbursed and the difference between the amount insured and the amount of reimbursement, $1,500 ($5,000-$3,500), would be put into reserve to extend the benefit period of the policy. Taxation of enefits enefits paid by the insurer to the business are taxable because the premiums are tax-deductible. However, allowable business expenses may be deducted. opyright 2009 Oliver Publishing Inc. ll rights reserved. 95

12 dvantage LLQP isability uy-out Insurance isability buy-out insurance can be used in those businesses that have buy-sell agreements in place to ensure a smooth transition between business owners. The buy-sell agreement is a contract that determines the conditions under which a business will be sold and bought by an employee, a partner, another shareholder in the business, or the business corporation itself. One aspect that the agreement will cover is the value of the business. If an owner/partner/shareholder dies, his or her share is purchased from heirs or survivors with life insurance according to the terms of the buy-sell agreement. If an owner/partner/shareholder is disabled, his or her share is purchased from the disabled owner/partner/shareholder with disability buy-out insurance according to the terms of the buy-sell agreement. Settling a laim for isability uy-out Insurance isability buy-out insurance is usually paid as a lump sum instead of as a monthly benefit. The lump-sum payment from a anadian insurer can provide between $500,000 and $1.5 million after a 12 to 24 month elimination period. company such as Lloyd s will provide up to $50 million per person. It is wise if the definition of disability used in an agreement is determined by the insurer so as to reduce the potential for strife between partners who might not be able to agree on what constitutes a disability and also when the disability actually exists. mandatory buy-out clause states when the disabled must sell. This is called the trigger date and is usually one to two years after total disability can been confirmed. The insurer will require substantiation for the amount of insurance being purchased. This can be satisfied by providing copies of the balance sheet and income statement for the two years prior to the application and that the disability buy-out does not exceed the amount of life insurance on the life of the owners/partners/shareholders. The business must also have been established for more than two years. 96 opyright 2009 Oliver Publishing Inc. ll rights reserved. It s been my lifelong dream to own a golf course. Last year I made my dream come true when I bought the Highlands. I ve taken advantage of both individual and business disability insurance to protect my business and me. To make sure I will always have an income, I have a personal disability income policy. To protect my right-hand man, Ralph, a key person disability policy will pay a benefit to the business if Ralph is unable to work. Finally for the business itself, I have a business overhead insurance policy.