Over the last few weeks, I’ve had a number of conversations with clients about key man insurance. Let me say at the outset that I don’t sell insurance, and have no financial stake in whether any client has coverage or not. The use of such policies, however, may not always fit their intended purpose, especially in smaller companies.
The most common intended purpose of a key man policy is to fund a buy/sell agreement. The benefit payment goes to the company, which in turn uses the proceeds to purchase ownership from the family or estate of the deceased. If it works that way, it’s an excellent planning tool for your family’s security, but there are a number of things that can get in the way.
To begin, the company probably needs the money. If they are scrambling to replace you in the business, partners may be reluctant to part with a cash windfall that can keep them going. In most cases, the insurance company’s responsibility ends when payment is made. The buy/sell is a separate agreement, and enforcing it may require legal action by the bereaved family. In the meantime, the cash is being used elsewhere.
Surprisingly, some policies are in place to buy out a sole owner. A company can’t own all of it’s own stock. Someone else has to have at least minimum ownership, since treasury stock (repurchased by the company) has no voting power. If the buy/sell was put in place for former partners, you may want to revisit both the shareholder agreement and the policy.
Finally, there is the small matter of company debt. The absence of the principle credit guarantor (which applies to most majority owners) will trigger repayment clauses. Lenders are in the business of mitigating loan risk, and credit agreements likely give them first call on any available funds. Unless the company remains on a strong footing, with another guarantor who can step into the primary role, the insurance payout might not be available to either the heirs or the business.
There’s one additional area where the objectives of a key man policy and a buy/sell agreement may not meet. That is in long-term disability. Because most buy/sells lump repurchase terms for death and disability together, many owners forget that the insurance only pays in the first event, and has nothing to do with the second.
There are many approaches to obtaining coverage to secure your family’s financial well-being and/or the sustainability of your business. Although I’m an exit planner, that world of split premiums, whole and universal life, insurance trusts and other, far more arcane structures makes my head spin. All I can advise is if your current broker advertises “auto/home/life” he is not likely the kind of specialist you need. Find someone who is experienced in reviewing shareholder or partnership agreements, and who can tailor a product for your requirements.
Thanks to all the readers who responsed to last week’s survey on energy costs. Just under 69% said either “Falling energy prices are good for my business” or “rising energy prices are bad for my business.” Of course, 14% said the opposite, which just proves my point.
John
Another “Wide Awake Article” – To be advised is to be prepares, and you continually do that.
Always look forward to the next !!!
Thank you
Frank
John,
Agreement that key-man insurance policies should be separate from buy/sell – ownership agreements. Having lived through the unexpected loss of two employees, I would encourage small businesses to look beyond ownership when considering key man insurance as part of their disaster planning process.
Brad
Another type insurance to consider is whole life purchased using Section 79 Insurance.
Allows the company to pay for the insurance ( deduction to the company) owner pays tax on only part of cost, however beneficiary is the stock holders estate ( or wife) .
Company pays for policy , stockholder owns and benefits from it directly.
Can tied funding this to some part of stock valve in the future.
John- My 43 years in the life business has taken me into many areas of practice. The usual KEY MAN POLICY is usually designed for one purpose only.It is to cover the loss of a “Key Man” such as a top salesman that brings in more than 50% of the companies business or an engineer or project manager that a company could not operate or complete a job if they should die. Buy and Sell agreements are usually to cover owners , partnerships or corporations for death or long term disabilities to owners or stock share holders to keep the business from imploding or having to deal with non producing spouses or minor corporate owners.All these plans should be drawn up by a law firm that is experienced in Business Law! not Legal zoom! The last thing is making sure that the agreements are funded with the proper products to meet the contracts specifications in the B&S agreement. I would shy away from Sec 79 plans in funding these agreements and look at the latest IRS rulings on SEC 79 use in business insurance? Comments Welcome! RICH FREELAND CBC
Thanks Richard. I agree that key man policies should be used for critical employees as well. I know dozens of companies, however, where key man covers the owner, who does not function in a sales or client management role, and the owners’ belief is that the benefit will be used to purchase stock from their families. As to the applicable IRS codes, you illustrate my point that such instruments must be carefully constructed by a professional such as you.
A key man insurance policy is different from a buy sell insurance policy. You hit the nail on the head. The purposes are different.
The trick is to get the business owner to planning table. In my 34 years of selling life insurance and disability insurance there is a significant resistance by small business owners to approach the topic. The vast majority of small business owners do not have these plans in place. It is even more critical for family businesses. I completed a large plan for a family business in 2004, the business was started in 1946. Good luck to all the life insurance purveyors out there. It’s a mine field.