What Are Business Uses of Life Insurance?

Life insurance extends beyond individual financial planning to serve as a tool for businesses of all sizes. Companies face risks that can impact their operations, financial stability, and long-term viability. Life insurance helps mitigate these risks by providing financial resources. It offers protection that ensures continuity and resilience when unforeseen events occur. Businesses can address potential disruptions, safeguarding their future and supporting strategic objectives.

Protecting Against Key Person Loss

The unexpected loss of a key individual can disrupt a business. Key person insurance, sometimes called “key man” or “key employee” insurance, protects a company from financial repercussions arising from the death or incapacitation of an owner, a top executive, or another employee whose unique skills or knowledge are important to the business. This person’s absence could lead to financial losses, operational challenges, or even business closure.

With key person insurance, the business owns the policy, pays premiums, and is the designated beneficiary. If the insured key person dies, the company receives the death benefit. These proceeds cover costs such as offsetting lost revenue, recruiting and training a suitable replacement, paying off business debts, or maintaining credit lines. The funds provide financial stability during transition, reassuring investors and customers about continued operations. This insurance is relevant for small businesses where the owner or a few individuals drive a significant portion of the company’s value and operations.

Facilitating Business Continuity and Ownership Transfer

Life insurance is a component in facilitating business continuity and ownership transfers, particularly through buy-sell agreements. A buy-sell agreement is a legally binding contract among co-owners or between an owner and the business. It outlines how ownership shares will be handled upon a triggering event, such as an owner’s death, disability, or retirement. This agreement ensures an orderly transition and maintains business stability.

Life insurance provides liquidity to fund these agreements. In a “cross-purchase” method, each owner purchases a life insurance policy on the other owners, paying premiums and acting as the beneficiary. If an owner dies, the surviving owners receive the death benefit and use these funds to purchase the deceased owner’s shares from their estate. Alternatively, in an “entity purchase” or “stock redemption” method, the business itself purchases life insurance policies on each owner, serving as the owner, premium payer, and beneficiary. Upon an owner’s death, the business receives the death benefit and uses it to buy back shares from the deceased owner’s estate. This approach provides immediate cash for the transaction, prevents shares from falling into unintended hands, and offers financial security to the deceased owner’s family.

Supporting Executive Compensation and Retention

Businesses use life insurance within executive benefits packages to attract, retain, and reward key employees. These arrangements offer advantages for both the company and the executive. One common approach is an Executive Bonus Plan, often referred to as a Section 162 Plan. In this setup, the company pays a bonus to the executive, who then uses this bonus to pay premiums on a life insurance policy they own. The bonus is deductible to the company as a business expense, and it is considered taxable income to the executive. The executive owns the policy and can access its cash value tax-deferred, and the death benefit is income tax-free to their beneficiaries.

Another method involves using life insurance to informally fund Non-Qualified Deferred Compensation (NQDC) plans. NQDC plans involve a company’s promise to pay future benefits to executives. The cash value of a corporate-owned life insurance policy can serve as an asset to help the company meet these future obligations. The company owns the policy, and the cash value grows tax-deferred, providing an internal funding source. Split-Dollar Arrangements involve an agreement between the company and the executive to share the costs and benefits of a life insurance policy. These arrangements can be structured in various ways, such as the employer owning the policy and the employee being taxed on the economic benefit of the coverage, or the employee owning the policy with the employer loaning funds for premiums. Split-dollar plans offer flexibility in allocating premiums, cash value, and death benefits, helping to provide attractive benefits to executives while allowing the employer to recoup their costs.

Securing Business Debts

Life insurance serves as a mechanism for securing business debts, providing reassurance to lenders and protecting the business’s financial stability. Lenders require life insurance as a condition for granting business loans, particularly for small businesses or those where the owner’s continued involvement is important to the company’s ability to repay the debt. This requirement ensures the loan will be repaid even if a principal or key individual passes away unexpectedly.

The process involves a “collateral assignment” of a life insurance policy. The business or the individual borrower obtains a life insurance policy, and the lender is named as a partial beneficiary or assignee up to the outstanding loan amount. If the insured individual dies, the death benefit proceeds are first used to pay off the remaining loan balance, with any excess funds going to the policy’s other named beneficiaries. This arrangement strengthens the business’s creditworthiness, making it easier to access capital for operations, expansion, or other needs. It protects the business from unpaid debt and provides a clear repayment mechanism for the lender.