CHAPTER 9 BUSINESS INSURANCE Just as individuals need insurance for protection so do businesses. Businesses need insurance to cover potential property losses and liability losses. Life insurance also is a useful tool in business. Some of the uses of life insurance include: As a funding method. Life insurance can be used to fund a buy-sell agreement to transfer ownership between partners or stockholders. It can also be used to fund a deferred compensation plan. As a form of business interruption insurance. If a key person should die, a business could suffer a loss of revenue and experience rough financial times. Life insurance on the key employee payable to the business can minimize such an effect. As an employee benefit. Group life insurance can protect an employee and dependents from the financial problems resulting from death. Businesses also may provide disability income insurance for their employees as well as health insurance for their employees and dependents. Businesses are organized in one of three ways. These categories are: Sole proprietorships Partnerships Corporations SOLE PROPRIETORSHIPS With a sole proprietorship one individual owns the business. This will be an unincorporated form of business in which the owner s business and personal assets are one and the same. When a sole proprietor dies, a family member may step in to run the business. If no such person exists, the business may simply close. This is a poor alternative as a running business can be sold for more money. A closed business can be liquidated for the value of trade fixtures and inventory. A more acceptable alternative is to sell the business to a competent employee. A buy-sell agreement should be drafted by an attorney. This document sets forth the agreed upon amount for which the employee will buy the business and for which the proprietor s estate will sell the business. Funding this agreement is the next necessary step. The employee will buy a life policy on the proprietor. The employee is the owner and beneficiary of the policy. The proceeds of the policy will be used to buy the business upon the death of the proprietor. 1
It is possible that the proprietor might wish to retire. In this case, if a cash value policy has been purchased on the life of the proprietor, the employee could surrender it and use the cash values as a down payment on the business. The employee would then need to set up a payment plan to pay for the balance of the purchase price. PARTNERSHIPS A partnership is a legal relationship between two or more individuals who contribute money, time, or talent to carry out a joint business venture and who share in the profits and losses. Like a sole proprietorship, there is unlimited liability on the part of the partners. When a partner dies, the partnership is dissolved. It is imperative that the partners have a binding buy-sell agreement drafted while all of the partners are alive. Under this agreement a deceased partner s interest will be sold to the surviving partners for the price set forth in the buy-sell agreement and the surviving partners have agreed to the purchase for the stated price. The two types of partnership insured buy-sell agreements are the crosspurchase plan and the entity-purchase plan. In a cross-purchase plan each partner buys insurance on the lives of the other partners. The beneficiaries are the surviving partners who use the proceeds to buy out the interest of the deceased. This plan can be cumbersome if there are more than two partners. If there are three partners, each partner needs to purchase insurance on the lives of the two other partners. This means a total of six policies. The entity-purchase plan is used more frequently when there are a number of partners. The entity (partnership) owns, is the beneficiary of, and pays the premiums on the life insurance of each partner. When one of the partners dies, the partnership as a whole purchases the deceased partner s interest. The premiums paid for such business continuation insurance is not a tax-deductible business expense. If permanent insurance is used, the accumulated cash values are listed as an asset on the balance sheet of the partnership and are available as collateral for loans. Cross Purchase Plan Entity Purchase Plan X Y Z Company X Y Z Y Z X Z X Y X Y Z Co. $300,000 $300,000 $300,000 2 Equal Partners of a partnership worth $900,000. Each box worth $150,000
A disability buy-sell agreement can be used should a partner or stockholder become disabled. This agreement is a legally binding contract setting forth the terms under which the disabled person s interest will be bought and sold. Such a plan can arrange to pay the disabled individual periodic payments to buy out his/her interest or it could pay the individual a lump sum to buy out his/her interest. CLOSE CORPORATION A corporation is a group of individuals who get a charter granting them as a body certain of the legal powers, rights, privileges, and liabilities of an individual, distinct from those of the individuals making up the group. A corporation can buy, sell, and inherit property. Unlike a partnership, a corporation does not cease to exist upon the death of one of its owners. In a close corporation only a few people own the stock. When one of the stockholders dies, the remaining stockholders may wish to purchase the stock of the deceased. The buy-sell plan can either be a cross-purchase plan or an entity plan. In a corporate plan, the entity plan is known as a stock redemption plan. The close corporation cross-purchase plan calls for the stockholders as individuals to purchase the interest of the deceased stockholder and for the estate of the deceased to sell the interest directly to the remaining stockholders. The corporation itself is not involved in the agreement. This is similar to the partnership cross-purchase plan in that each stockholder buys insurance on the life of the other stockholders in an amount equal to the purchase price of the deceased s stock. In a corporate stock redemption plan, the corporation is the owner, premium payor, and beneficiary of the policies on the lives of the stockholders. The life insurance proceeds are paid to the corporation. The corporation uses the money to buy the deceased s business interest represented by the stock in the deceased s estate. As with other forms of business continuation insurance, the premiums are not a deductible expense for the corporation. Proceeds on the life policy are received income tax free. KEY PERSON INSURANCE Key person insurance is purchased by a business to protect itself if a key employee dies. The business is the owner, premium payor, and beneficiary of the policy. A key person is an individual who has a unique ability essential to the continued success of a business. The death of individual responsible for the research and development of products could cause a great financial loss for a 3
company. A key person insurance policy could help offset losses experienced by the company until a suitable replacement can be obtained. As the company owns the policy, it is considered to be a company asset. The death benefits or the cash values of such a policy can be used for a number of business purposes. The four primary purposes for key person insurance are: Business indemnification Key person insurance compensates the business for financial losses experienced due to death of an essential employee. Reserve fund When permanent insurance is used, it builds cash values. This appears on the company s balance sheet as an asset. This is called a living benefit of life insurance as it provides a cash reserve fund for the business during the lifetime of the key employee. Business credit The death of a key person can adversely affect a business s credit. Having key employee insurance can guarantee the repayment of a loan on the death of the key employee. Consequently, this can enhance the credit standing of a company. Favorable tax treatment The proceeds from the policy are not taxable to the business and the cash values in the policy accumulate tax deferred. Premiums, however, for key person insurance are not tax deductible. SPLIT DOLLAR INSURANCE Split dollar insurance should not be thought of as a type of insurance, but rather as a manner of buying insurance. In a split dollar insurance policy the ownership rights and death proceeds are split between an employer and an employee, or between a parent and a child. The employer pays the part of each year s premium that at least equals the increase in the cash value. The employee pays the remainder of the premium. When the increase in cash value equals or exceeds the yearly premium, the employer pays the entire premium. If the employee dies while still working for the employer, a beneficiary of the employee s choice receives the difference between the face value and the amount paid to the employer (the greater of the cash value or the total of all premiums paid by the employer). During employment, the employee s share of the death benefit decreases. If the employee were to leave the employment of the employer, the employer has the option to surrender the policy in exchange for a return of all premiums or to sell the policy to the employee for the amount of cash values. Split dollar policies are one of two types. In the endorsement method, the employer owns all policy privileges. The employee s only right is to name a beneficiary and choose a settlement option for the distribution of proceeds. With the collateral method, the employee owns the policy. The employer s contributions toward the premium are regarded as a series of interest-free loans 4
that equal the yearly increase in the cash value of the policy. The employee assigns the policy to the employer as collateral for the loans. When the employee dies, the loan amounts are deducted from the face value of the policy and the remaining proceeds are paid to the beneficiary. Split dollar plans are not qualified plans. They are simply a way in which a financially capable person or entity can help another person purchase insurance. An employer can decide which employee he/she may wish to help in this manner. In helping an employee finance the cost of insurance, an employer is better able to hold onto a key employee. DEFERRED COMPENSATION A deferred compensation plan is an arrangement whereby an employee or business owner defers a portion of current income such as bonuses until a later date. This is a nonqualified plan so the company can choose among its employees or owners who may participate in the plan. As a nonqualified plan, it does not receive favorable tax treatment. However, when the company pays the deferred compensation to an employee, a deduction is allowed for the benefits paid. The employee will be responsible for tax on the amount of deferred compensation. As this is usually after retirement, the employee is frequently in a lower tax bracket. Life insurance is frequently a funding vehicle for deferred compensation plans. An amount deferred is used to purchase a cash value life policy. The cash values in the contract can be used to supplement retirement income. Should the employee die prior to retirement, the life proceeds will be paid to the employee s beneficiary. Other life insurance products used in funding deferred compensation are disability income policies and annuities. The promise of the deferred compensation ties a participating employee to the company. Should the employee choose to leave the employment prior to retirement, the deferred compensation will be forfeited. SALARY CONTINUATION PLAN A salary continuation plan is an additional fringe benefit that is funded by the employer. This plan can be between an employer and employees or between a business and an independent contractor. The employer agrees to pay the employee or the employee s assignee payment at retirement, disability, or death. The plan is normally contingent upon continued employment or association (e.g. providing consulting services) with the employer. Life insurance is one of the funding methods used for salary continuation plans. 5
REVIEW QUESTIONS 1. Which of the following is/are forms of business insurance? 1. Key person insurance 2. Funding a buy-sell agreement 3. Group benefits for employees 4. Industrial life insurance A. 1 & 3 B. 1, 3, & 4 C. 1, 2, & 3 D. All the above 2. Key person insurance: A. Protects a key employee. B. Protects the heirs of a key employee C. Protects the company for which the key employee works. D. All of the above. 3. Which of the following is not used in buying out a deceased business partner s interest? A. Cross-purchase plan B. Buy-sell agreement C. Split dollar insurance D. Entity-purchase plan 4. Which forms of insurance products might be used to fund a deferred compensation plan? A. Life insurance B. An annuity C. Disability income D. All the above 5. XYZ Company has a plant manager who is integral to the functioning of the plant. If he were to die, production would suffer and a search for a competent replacement could take a period of time. To offset losses the company might experience, the company should purchase: A. Salary continuation insurance B. Key person disability insurance C. Entity purchase insurance D. Key person life insurance 6