When a business loses a key person, several things can happen. First and foremost, the business is disrupted as the owners try to assess what has happened and develop a plan of action. This disruption usually causes a drop in sales as the business focus is diffused. As well, sales that have already been made may not be deliverable or may be questionable, causing clients to go elsewhere. Creditors may become concerned and force the company to liquidate assets to pay back loans or, possibly, put it into receivership. Finally, even if the business is able to survive all these factors, it still must replace the skills that were lost, if possible.
Fortunately, the possibility of death or disability of a key person is a contingency that can be insured. Businesses can purchase corporate-owned life insurance on the lives of their key people. If one of these key people dies, the business receives a tax-free death benefit which it can use to meet expenses and repay debts, thereby easing the fears of creditors. The money can also be used as a reserve against the drop in revenue that may occur while the company goes through a period of transition. Finally, the money can be used to pay the costs of replacing the lost skills.
A side benefit for private companies is that the life insurance proceeds can be paid out as tax-free dividends to the owners once the business has recovered. Funds can also be used to provide a $10,000 tax-free death benefit to the spouse of the deceased. As well, an opportunity exists for the key person to take advantage of the tax-deferral capabilities of certain life insurance policies through split dollar coverage.
Disability insurance is also available on key people. The company owns the plan and is the beneficiary of the proceeds. The proceeds, of course, can be used for all the same purposes as proceeds from life insurance plans. The only difference is that the disability insurance proceeds cannot be paid out as tax-free dividends to the owners of the business, nor can they be paid tax-free to disabled employees.
Benefits of Key Person Coverage:
How do you set up a Key Person Life Insurance Policy?
The first factor to consider in setting up a Key Person Life Insurance Policy is to determine how much death benefit is needed. The minimum usually considered is one times the key persons annual income, but other factors need to be considered. What if the business relationships of this person drive half of the company's revenues? How difficult and costly will finding a replacement be? Are there business debts that would place financial hardship on the company?
Once the death benefit amount has been determined, the business would purchase the policy on the key person. The key person would be the insured and the business would be the owner, payer and beneficiary of the policy. Permanent or term life insurance can be used as a key person policy depending on the needs of the business and how much they are willing to spend.
Our Firm can tailor a package to ensure you have the funds to keep your business operating at peak form. Contact us for a free informational meeting.