How Much Life Insurance Does A Business Need? – December 2011
It is common business practice for a company to use corporate owned life insurance in several situations. This article will identify those situations and discuss appropriate amounts of coverage for each of them.
- SHAREHOLDERS’ AGREEMENTS – It is customary for a company with more than one shareholder to have in place an agreement between the shareholders which predetermines a course of action for specific situations. This agreement should include a Buy/Sell provision which deals with how a share interest will be purchased or redeemed in the event that a shareholder relinquishes or wishes to relinquish his or her shares in the company, including the death. The corporation will then insure each of the shareholders to the extent that the provision in the agreement dealing with death is all or partially funded. The same is true for those businesses operating as a partnership, as there should be a partnership agreement with provisions similar to the corporate agreement.
The corporation should own and be the beneficiary of sufficient life insurance on each of the partners in order to meet its obligations to re-purchase or redeem the shares of the deceased shareholder from his or her estate. The Shareholders’ Agreement usually has a method of valuing the shares and this is the appropriate amount for which the shareholder should be insured.
- KEY PERSON LIFE INSURANCE – A company may employ an individual whose active participation in the company is vital to its success. Some of examples of this “key person” , include an individual who is responsible for the sales success of the company’s product; it could be someone who has an intellectual property key to the enterprise’s good fortune; a law firm may have as a partner an outstanding litigator or effective rainmaker. In other words, if the company should suffer financially as a result of the loss of any employee, shareholder or otherwise, then that company has an insurable interest in that individual.
The amount of life insurance coverage that the company would take on that key person is usually determined by an estimate as to how much the company would suffer financially if the key employee were to die. Sometimes this can be an arbitrary number, although the insurance company requires justification for any amount of coverage they would issue for this purpose. In other situations, an analysis is undertaken to estimate the loss to share value due to the death of the employee. A company may want to insure such an individual to provide sufficient funds to attract, train and employ a replacement. Usually, this number would include two years salary in addition to acquisition and training costs.
- LIFE INSURING DEBT – Often a business will make use of bank debt to produce income. This debt may be for normal operating expenses, to make an acquisition vital to the business purpose of the corporation and its shareholders, to pay a dividend to shareholders, or to make a pension contribution for its employees, to name a few. Where the company has borrowed for a business purpose, it is prudent for the firm to insure the lives of the principals so that if there was a death, the loan would be retired. This would protect the working capital of the firm, and would contribute to guaranteeing the financial stability of the company even though it has just lost a key shareholder. Also, many lenders require the shareholders to provide personal guarantees to secure the loan. By life insuring the shareholder in this arrangement, the estate of the deceased is relieved of this burden.
There are some tax advantages for corporations to insure their shareholders to secure debt as well. If the bank requires the life insurance as a condition of the loan (or provides a letter to that effect), a portion of the premium may be tax deductible to the corporation. In order to obtain this deduction the transaction must meet specific criteria as stated in the Income Tax Act. Upon the death of the shareholder, there is another benefit which could accrue to the benefit of the surviving shareholders. Even though the entire proceeds of the life insurance are used to retire the loan, there could be a contribution to what is known as the Capital Dividend Account for an amount up to the insurance proceeds which are used to repay the loan. Capital Dividends can then be paid tax free to the surviving shareholders. In effect, this means that future corporate earnings, retained earnings, or other cash assets can be paid tax free to the shareholders.
The amount of the life insurance required for this use could be equal to the amount of bank or other debt the company has incurred.
These are the main uses of corporate owned life insurance. Other corporate uses for life insurance exist in more sophisticated arrangements. For example, some corporations use life insurance as part of a charitable giving strategy. We can assist you in determining where the needs for life insurance exist in your corporation and how to establish the appropriate amount. Please call us should you wish to investigate the prudent business practice of corporately owned life insurance.