Life insurance is a wealth protection tool that many people use for financial planning, but it is particularly important for business owners. Mr Martin A Scott, Founder and Financial Planner of Lasting Wealth Principles, says the type and amount of life insurance depends on the business owner's specific financial situation and goals, but having it is important for three reasons.
You want to split up your estate equally
Life insurance can be an effective tool to make sure members of a business owner's family receive equal inheritance amounts. The following example provides more clarity on how life insurance could solve an issue of family members having different objectives.
Mark is the owner of a consulting business and has two sons, Bob and Charles. Bob has never shown any interest in consulting, but Charles enjoys it and would like to be Mark's successor. Charles doesn't want ownership of the business to leave the family and wants to grow it even further. The consulting business is currently valued at $3 million.
In the event of his own death, Mark wants to make sure that there are no disagreements between his sons, and both receive an equal inheritance. To accomplish this goal, Mark takes the following actions:
- He obtains a $3 million life insurance policy and makes Bob the 100% primary beneficiary.
- He updates his business succession plan, which now makes Charles the 100% owner of the consulting business in the event of Mark's death.
These two actions by Mark accomplish the primary goal of providing Bob and Charles an equal inheritance ($3 million value to each son) in the event of his death. It also creates a situation where both sons would be okay with the result given their objectives: Bob does not want to be involved with the business, whereas Charles wants to be the owner and continue its growth.
Your heir won't want to run the business
In many cases, the heirs of a business owner are not involved with the day-to-day operations, which means they could inherit a business that they are not equipped to operate if the business owner died. In this type of situation, life insurance could provide a sizable amount of money to heirs and allow them the time to make sound decisions for the business. Take the following example.
Mike operates a solo business practice and is married to Beth, who is not involved with the business operations. In the event of his death, Mike knows that Beth has no interest in running the business. He purchases a $2 million life insurance policy and designates Beth as the beneficiary. If Mike dies, then Beth would obtain a large sum of money from the life insurance policy.
As a result, her financial stress would be alleviated, and she could take the appropriate amount of time to sell the business without any pressure or hire a team of employees to operate the business if that was the better option.
You have a buy-sell agreement
In situations where a business has multiple partners, buy-sell agreements are generally structured to provide instructions on what is to occur if a partner exits the business. Life insurance is an efficient way to fund a buy-sell agreement. Take the following example.
Susan and Lisa equally own a real estate business that they started together years ago. Their success has resulted in the business being valued at $4 million. In the event of one of their deaths, they would like to avoid a situation where either of their heirs get involved with the business operations.
To make sure this doesn't happen, they structure a buy-sell agreement, which makes one of them the 100% owner of the business if the other person dies.
Additionally, Susan and Lisa both purchase $2 million life insurance policies and list each other as their primary beneficiaries. In the event of one of them dying, the other person obtains $2 million (50% of the business value) as beneficiary of the life insurance policy.
Their buy-sell agreement instructs the surviving business owner to purchase the deceased owner's 50% ownership from their heirs. The $2 million from the life insurance policy provides this cash needed for this buyout.
As a result, the surviving business owner keeps full control of the business with none of the deceased owner's heirs being involved, and the heirs get the appropriate monetary value from the deceased owner's estate.
This is an abridged version of an article which appeared on Business Insider.