Why it is important for small business owners to have life insurance
MARTIN A. SCOTT, CFP®, EA
My firm, Lasting Wealth Principles, does not sell any insurance products, but I still believe that life insurance is a very important wealth protection tool, especially for small business owners. Deciding on the type and amount of life insurance to purchase depends on an individual’s specific financial situation and goals. As I go through the insurance planning part of my financial planning process with small business owner clients, I let them know these three reasons that they should have life insurance: Splitting up an estate equally, Business continuity, Buy-Sell agreement.
Desire to split up an estate equally
A small business owner can use life insurance to make sure members of their family receive equal inheritance amounts. The hypothetical example noted below explains how life insurance could be a financial solution to family members having different objectives.
Sue is the owner of a local restaurant and has two sons, John and Mike. John has never shown any interest in operating a restaurant, whereas Mike has always wanted to be Sue's successor (and keep ownership of the restaurant in the family) ever since he graduated from college. Sue’s restaurant is currently valued at $2 million. In the event of her own death, Sue wants to make sure that both of her sons receive an equal inheritance.
To accomplish this goal, Sue takes the following actions:
Obtains a $2 million life insurance policy and makes John the 100% primary beneficiary.
Consults with her attorney to update her business succession plan to make Mike the 100% owner of the restaurant in the event of her death.
Sue has now accomplished her goal of providing John and Mike an equal inheritance ($2 million value to each son in the event of her death) despite both sons having different objectives.
Business continuity
There are situations where the heirs of a small business owner are not involved with the daily operations of the business meaning that there is scenario of them inheriting a business (if the owner died) that they are not ready to operate. Life insurance could provide adequate funds to these heirs, which would allow them the time to make prudent decisions for the business. The hypothetical example below explains further.
Larry has been a sole proprietor and ran a successful business by himself for over 20 years. His wife, Mary, supports his efforts, but is not involved with business operations. Through the advice of his financial planner, Larry purchases a $3 million life insurance policy and designates Mary as the 100% primary beneficiary. If Larry were to die, then Mary would receive $3 million meaning she would not have to worry about money. Even further, the money gives her the flexibility to hire someone (or a team) to run the company or sell the business without any pressure if that was the better option.
Buy-Sell agreement
This reason applies to the small business owners who share ownership with another person. Basically, the purpose of buy-sell agreements is to provide instructions on what the owners will want to happen with the business if an owner exits the business. Life insurance can be used in these situations as an efficient way to provide funding for a buy-sell agreement. The hypothetical example below provides more clarity.
Melissa and Kathy are equal owners of a healthy smoothie business (valued at $1 million). Due to their hard work over the years and knowing the nuances of running this type of business, they would prefer not to have any of their heirs operating the business in the event of one of them dying. After discussing this concern with their financial planner, they decide to structure a buy-sell agreement, which would make one of them 100% owner of the business if the other person dies. Melissa and Kathy both purchase $500k life insurance policies and list each other as their primary beneficiaries.
So, in the event of Melissa or Kathy dying, two steps would occur:
The surviving business owner obtains $500k (50% of the business value) as the primary beneficiary of the life insurance policy.
Per their buy-sell agreement, the surviving business owner is required to use the $500k from the life insurance policy to purchase the deceased owner's 50% ownership from their heirs.
Not only would the surviving business owner keep full control of the business (with none of the deceased owner's heirs involved), but the heirs of the deceased owner would get the appropriate monetary value (from the deceased owner’s estate).
Evaluating options
Life insurance is not the easiest topic to discuss, but it is such an important protection tool for a small business owner. I explain to all my small business owner clients the importance of life insurance and how it can safeguard the financial future of their family and business. Life insurance also provides peace of mind knowing that if something where to happen, then their family and business would both be taken care of financially.