Life insurance in business succession

Business succession planning depends heavily on life insurance, because it supplies cash at exactly the moment an illiquid business creates a need for it.

The three uses

Funding a buy-sell agreement. Proceeds provide the money to buy out a deceased owner's interest.

Without funding, the surviving owners must find the money from the business, from borrowing, or from personal resources — at a moment when the business has just lost an owner.

Key person cover. A policy on someone whose loss would damage the business, payable to the business itself.

This funds the disruption: recruitment, lost revenue, reassurance to lenders and customers.

Estate equalisation. Where a business passes to one child, insurance provides comparable value to the others.

Frequently the only practical way of achieving a fair outcome where the business is most of the estate.

Ownership structures

Which matter for both tax and effectiveness.

Cross-purchase. Each owner holds a policy on each other owner.

The surviving owners receive proceeds personally and buy the interest, which increases their cost basis in the acquired shares — a genuine advantage on a later sale.

The difficulty is the number of policies required, which grows quickly with the number of owners.

Entity purchase. The business owns policies on each owner and uses proceeds to redeem the interest.

Administratively simpler, with one policy per owner, and it does not produce the same basis increase.

For corporations, the receipt of proceeds may also increase the company's value, which can raise the price payable for the interest — a circular effect worth addressing in the agreement.

Insurance LLC arrangements, which hold policies in a separate entity to combine the advantages of both approaches.

The technical traps

Transfer-for-value rules. Where a policy is transferred for consideration, the death benefit can lose its income tax free character.

This arises commonly when converting between cross-purchase and entity structures, or when an owner departs and policies are reallocated.

Exceptions exist, and the rules are technical enough that transfers should not be made without advice.

Corporate alternative minimum tax considerations for some entities, which have changed over time and are worth checking.

Estate inclusion. Where an owner holds incidents of ownership in a policy on their own life, the proceeds are in their taxable estate.

For a business owner whose estate may face tax, holding the policy in an irrevocable trust addresses this.

Notice and consent requirements for employer-owned policies, which must be satisfied before the policy is issued for the proceeds to be received tax free.

Failing to comply is not correctable afterwards, and this catches businesses insuring key employees without advice.

Getting the amount right

The most common practical failure is a policy sized years ago against a business that has since grown.

An agreement requiring a purchase at current value, funded by insurance set at a value from a decade earlier, leaves a shortfall.

Reviewing coverage against current valuation annually, and increasing it as the business grows, is a specific item worth diarising.

Some agreements provide for the shortfall to be paid in instalments, which is a sensible fallback.

Disability, which is more likely

Routinely omitted.

The probability of a long-term disability during working years is higher than the probability of death, and a disabled owner who cannot work and cannot be bought out creates a serious problem.

Disability buyout insurance exists specifically for this, with a definition of disability and a waiting period that need to align with the agreement's terms.

Agreements should define what constitutes disability and who determines it, since disputes on this point are common.

The insurability problem

Worth planning around.

Coverage depends on health, and health changes. An owner who intends to arrange insurance later may find it unavailable or prohibitively expensive.

Which argues for putting cover in place earlier than seems necessary, and for including provisions in the agreement addressing what happens if an owner becomes uninsurable.

General information only, not legal, tax or insurance advice. These arrangements are technical — consult qualified professionals before implementing.