Key person, cash value life insurance can be invaluable in indemnifying the financial loss a business faces if a key person dies or leaves the business. Its death benefit can restore a shortfall by providing funds to the business, partners, and/or remaining family members, as well as buy out the interest of the deceased employee’s estate. But that’s only part of the story.
An often-overlooked fact regarding the cash value in key person insurance is how its many potential uses increase a business’s dexterity, giving business owners greater control over their future. It provides businesses options they may not know they have and can provide the funds they currently may not know they’ll need. In short, it allows them to take back control. Faced with uncertainties and challenges of running a business, this is an enormous advantage that merits closer examination.
Term versus Permanent Key Person Coverage
When the need for coverage is for a specific, limited duration, a term life insurance policy may be the correct choice. It may also be the better choice for newer, cash-strapped businesses, as premiums will be more affordable.
Indeed, there are longstanding arguments for buying term:
Buy term and invest the rest
Term can often be converted to permanent insurance
However, those arguments can be countered:
A permanent life insurance policy doesn’t have the timestamp term does (10-, 20-, 30-year)
If conversion is stipulated in the term contract, the client might be limited to certain product choices, and those could be prohibitively expensive
Care needs to be taken to ensure the conversion feature doesn’t lapse
Above all, the cash value itself makes the difference. For businesses that have complex needs and a longer time horizon, a cash value, key person policy can give them a level of flexibility and control not found in term insurance or other financial products.
Covering the Loss of a Key Person
The primary purpose of any key person life insurance policy is the death benefit it provides should the insured pass away. The funds the company receives can help cover the losses and expenses that occur when a key person dies or leaves the business, such as:
A reduction in sales or operations
The cost of hiring and training a replacement
The delay or cancellation of projects
The degradation of important relationships
Paying the balance of a loan
These funds can also help restore value to an owner or partner’s estate. When the insured is the business owner or partner, their death could suddenly make the business less valuable and force a sale. A business that was once worth $20 million, for example, may now be worth only $10 million, leaving a gap in the original estate. In these situations, the death benefit can be used to restore the value of the business which, in turn, allows the family to maintain the value of the estate.
The Value of Cash Value
The potential for accumulated cash value is what transforms a key person policy from pure protection to a flexible business asset. A persuasive case for permanent life insurance can be made if there is cash on the corporate financial statement. It becomes a matter of moving cash from one balance sheet item to another with increased optionality. That access is a strong argument for business owners who may be reluctant to give up ready cash.
The added flexibility can free a business owner to:
Improve Cash Flow
Access to cash is essential for any business. It can keep a business afloat during challenging times, or allow a business to grow. One of the biggest advantages of a cash value, key person policy is the business’s ability to access funds as needs arise. A business can access the accumulated cash via a loan or withdrawal (also known as a partial surrender). [1] The advantages of using the funds within a cash value account versus a bank loan are:
Access for any reason
Continued earned interest, including on the amount borrowed
Favorable interest rates on the loan
No approval process
No additional collateral (beyond the policy itself)
No fixed repayment schedule or deadline
The freedom to access this cash when needed allows the business to essentially act as its own bank. Funds earn interest and grow tax-deferred, and are readily available to cover anything the business may need.
In one particular case, a privately-held company was struggling to cover payroll. Instead of facing a long and complicated approval process of a bank loan, the company chose to borrow the necessary funds from its cash value policy. The ability to access this cash to cover expenses proved critical to the business’s growth as, years later, the business was sold to a public company for $1.8 billion.
Buy Out Shares of Stock
If an owner leaves, the business may lack the funds to buy that person’s share of equity. The cash value inside a permanent, key person policy can be used for this purpose. If the company owns the policy, it will have the option to borrow or withdraw from the cash component, allowing for a buy-back without seeking outside funding.
For example, a company could have the policy structured to allow a loan of $50,000 a year from the cash value to incrementally buy back the stock of a 10% shareholder when he or she retires. As long as the business doesn’t over-borrow, [2] the company could use the funds to pay off the debt at a very low effective interest rate while keeping the policy in force.
Attract, Retain, and Reward Key Talent
Attracting employees, and keeping them, is essential to a business’s success. There are many types of plans targeted to key employees that provide attractive ways to bring them on board and incentivize them to stay. These include:
Executive Bonus Plans (Section 162 Plans)
Supplemental Executive Retirement Plans (SERPS)
Split-Dollar Plans
Cash value policies usually play an essential role in these plans, using life insurance as both a means of funding the plan and providing a benefit (a life insurance policy) to key persons during their time at the company.
Depending on the plan, the employee may be allowed to designate the beneficiaries of the plan, access the cash value, or both. Premiums paid by the company may also be tax-deductible or recouped upon the key person’s death or departure, depending on how the policies are structured.
In addition, these cash value policies can be transferred to key employees for their contribution to the business. This typically occurs when the employee leaves for retirement, with the company bonusing the policy to the individual. The key person retains the death benefit for his or her beneficiaries, and can access the cash value as a source of supplemental, retirement income. Unlike qualified plans, the cash value of a permanent policy does not have contribution limits, withdrawal penalties, or age restrictions.
As a general rule, once ownership transfers from the employer to the employee, the value of the policy becomes taxable to the employee and tax-deductible for the employer.
Multiple Uses in a Single Source
A key person, cash value policy can be used in multiple ways as a business’s needs evolve. The benefits of a policy can attract top talent, and then provide coverage in the event of the key person’s death. Meanwhile, a business can access the cash value to cover expenses, if needed. Eventually, the same policy can be transferred to the insured when he or she retires.
This multi-use of a key person policy was demonstrated in the case of a construction company that held a permanent policy on a 10% owner, whose share was initially worth $4 million. The company spent $100,000 a year for 10 years to fund the policy, naming the business as the beneficiary and providing protection to the business in the event of the owner’s death.
Years later, when this person retired, the business was able to reward his contribution to the business by transferring the policy to him. Once the policy was transferred, he was able to name his own beneficiaries, as well as access the policy’s cash value, which had grown to $1.3 million. These funds became supplemental income for his retirement, and an asset in his estate.
Cash value, key person insurance is an asset that a business can leverage to minimize its risk and help ensure longevity. It provides the flexibility to adapt to the new challenges and opportunities that are inevitable in today’s dynamic economic environment. Working with an experienced financial professional can help businesses select the right policy to meet their needs.
[1] Withdrawals from a permanent policy that exceed paid premiums may be taxable.
[2] Loans and partial withdrawals will decrease the death benefit and cash value and may be subject to policy limitations and income tax.
This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. To determine what is appropriate for you, please schedule a time to talk with us. Information obtained from third-party sources are believed to be reliable but not guaranteed.
The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that neither M Financial Group, nor TRC Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither M Financial Group, nor TRC Financial should replace those advisors.
All examples are hypothetical and for illustrative purposes only.
Cash value accumulation is determined by the policy contract, is not always guaranteed, and is subject to withdrawals.
An insurance policy’s financial guarantees are subject to the claims-paying ability of the issuing insurance company.