How can business owners use life insurance to their advantage?

Coverage provides companies more than just financial protection

How can business owners use life insurance to their advantage?

Life & Health

By Mark Rosanes

Life insurance is often considered a critical type of cover, helping grieving family members soften the financial impact of losing a loved one. With the right policy, this form of protection can aid families in paying off loans and debts and provide them with the monetary means to meet daily living expenses.

But there are several layers to this kind of coverage and this type of financial benefit is just one of its many elements. Business owners can also purchase life insurance inside their corporations, allowing them to protect their business interests and provide continuity at the time of their death.

Corporate ownership of a life insurance policy, however, has its share of advantages and drawbacks – and depending on how it is managed, this form of cover can play a crucial role in helping a business move forward.  

How does life insurance for business owners work?

Corporate-owned life insurance can be tailored to meet the different needs of a business. Policies generally fall into two categories, with each type working differently.

1. Term life insurance

As the name suggests, business-owned term life insurance provides coverage for a specific period or “term,” typically five, 10, or 20 years. Premiums stay the same for the duration of the term and are relatively less expensive compared to those of permanent life insurance.

This type of policy is often used during working years, providing financial benefits when the business owner dies. The funds can be utilized to replace lost income and cover liabilities.

2. Permanent life insurance

Permanent policies offer guaranteed lifetime coverage and come in many forms, including whole, participating, and universal life insurance. Apart from financial protection, permanent life insurance provides a tax-deferred investment component – which is subject to a limit – and a cash value element that builds up over time and can be used as collateral if a business decides to borrow. 

If the policy is voluntarily terminated before maturity or death, the insurance company pays the policyholder the cash surrender value. Permanent life insurance plans often play a key part in estate planning, allowing businesses to accumulate value long-term and cover estate taxes.

How can businesses use life insurance to their advantage?

There are several instances where companies can use business-owned life insurance to their benefit. These include:

1. Funding buyout agreements

A buy-sell life insurance agreement is designed to protect a business in the event a co-owner dies. In such an agreement, the death benefit is used to fund buy-sell transactions. Typically, the benefit amount depends on a relative portion of the company’s value. If there are two co-owners, for example, the death benefit will be 50% of the business’s worth. The money is then given to the late owner’s family, while their stake goes to the surviving partner.

A buyout agreement often happens when the remaining owners are not interested in having the deceased’s family stay involved in the business and the family likewise shows no interest in doing so.   

There are several ways a buy-sell transaction goes. These include using the proceeds to redeem shares or paying a capital dividend to fund a personal purchase of shares from the deceased’s estate. To avoid confusion and potential conflict later, the buyout process – including the intended use of the life insurance benefits and the capital dividend account – should be documented in the co-owner's agreement.

2. Key employee insurance

This type of protection is essentially a life insurance policy that covers a vital team member and provides financial benefit to the company at the time of the employee’s death. It is particularly useful for small businesses that rely on specific workers for critical tasks. The payout is intended to provide monetary support as the company goes through a transition period to find and train a replacement.  

3. Estate equalization

Business owners can also utilize life insurance if they want to pass along a company with multiple beneficiaries to a single family member. The process, called estate equalization, allows them to bequeath the entire business to one family member while still leaving something for their other dependents.

According to brokerage firm Life Insurance Canada, estate equalization operates this way: “The business owner takes out a life insurance policy worth the value of the business and names the other dependent (who isn’t inheriting the business) as beneficiary. If there are more children, additional life insurance policies worth the same amount can be purchased. This life insurance strategy also generates more wealth for the next generations, doubling or tripling the business owner’s estate value when they die.”

4. Rewarding key employees

Business-owned life insurance can be strategically used to improve employee experience and retain valuable workers. Companies can do this by rewarding key employees with a life insurance contract. This works with the business owners putting workers’ bonuses towards a permanent life insurance policy, giving them access to a death benefit and the policy’s cash value. 

What are the drawbacks of taking out corporate-owned life insurance?

Taking out life insurance under a corporation exposes business owners to potential drawbacks. Limited liability partnership BDO Canada listed five risks businesses can face when investing in corporate-owned life insurance policies:

  • Risk of capital losses eroding the amount of life insurance proceeds that can be paid out tax-free to shareholders
  • Exposure of life insurance proceeds to creditors of the company
  • Coordination with other post-mortem planning
  • Permanent life insurance does not have the liquidity of marketable securities
  • Policies may affect the company’s ability to claim the lifetime capital gains exemption (LCGE) on their shares

How much life insurance do business owners need?

Life insurance needs of businesses can vary significantly depending on a range of factors, including the cost of replacing a key person, taxes incurred upon the death of the owner, ongoing business expenses, and outstanding loans. To work out how much coverage a company needs, the owners should get in touch with an experienced insurance professional. 

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