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Life Insurance for Business Succession Planning

November 10, 2020
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Small business owners work extremely hard to get their dream up and running. To increase the odds of it continuing to run successfully for years to come, succession planning is imperative.

What is succession planning?

Succession planning is a process for determining what happens to the business when the owner leaves, whether this is because of retirement, disability, or death. Succession planning is essential so your business partners, employees, customers, and family members who rely on its success aren’t left struggling to figure out next steps.

Succession planning requires careful preparation, discussion, and funding. Insurance products, such as life insurance and disability insurance, are integral to business succession planning. We’ll explain why in this article.

When should succession planning occur?

Succession planning should begin day one. It doesn’t necessarily have to be on paper and funded day one, but the what-ifs need to be acknowledged.

  • What if I die tomorrow?
  • What if I become disabled or mentally incapacitated?
  • What if my family doesn’t want to take over leading the business?

You will need advice and guidance from your accountant and attorney when developing a business succession plan, but let’s discuss these what-ifs to start your planning off on the right foot.

Business Succession Planning: What if I die tomorrow?

According to a Gallup poll, only 30% of business owners have a clear plan for how their business will be managed and who will run it if they were to suddenly pass away. A buy-sell agreement is common in a succession plan.

A buy-sell agreement is a written legal contract between two parties: the business owner and the individual or entity that will take over if the owner is no longer able to. Death is just one event that can trigger a buyout. A buy-sell can also be arranged to plan for disability, retirement, or voluntary leave.

Once triggered, a buy-sell states that the new owner can buy the previous owner’s interest in the business. The sale price is prearranged and documented in the agreement. The funds used are often provided by life insurance and/or disability insurance. Other means of funding a buy-sell include cash installment payments and cash from a loan, but insurance is the recommended method as it’s more affordable and dependable.

A buy-sell agreement is especially important if there are multiple owners. A cross-purchase buy-sell agreement would be appropriate in this case. The multiple owners buy life insurance on one another’s lives and the agreement is structured so that if one of them dies, the surviving owners buy the deceased owner’s interest in the business from the decedent’s estate. If this agreement was not in place, the decedent’s spouse or heir would own interest in the business. This person may not be business-savvy and likely not the best person to take over part ownership. With the buy-sell in place, all owners can be assured that the business remains in their hands.

A buy-sell accomplishes three main things.

First, the business owner can rest assured his or her business and employees will be in good hands if something happens.

Second, the co-owner or other entity/individual who takes over the business knows their professional future is secure.

Third, the business owner’s family will also be provided for financially due to the new owner paying them the prearranged sum of money.

Business Succession Planning: What if I become disabled or mentally incapacitated?

First things first, get a durable power of attorney in place. A durable power of attorney (POA) document allows you to appoint a person to manage your financial and personal affairs if you are unable to do so. Unlike a simple power of attorney, a durable power of attorney remains valid even if you were to become incapacitated.

As mentioned earlier, a buy-sell agreement can also mitigate a disability risk. In this case it’s often referred to as a disability buy-out agreement.

Without a disability buy-out agreement in place, an otherwise healthy and prosperous business could be headed down the road to financial disaster. If you become disabled, not only will the business need to hire someone to replace the duties you can no longer complete, but if you’re still active in the management of the business because you need the income, your business is paying twice.

Funding a disability buy-out agreement is a very similar design to funding a buy-sell agreement but, instead of life insurance, disability insurance is used. A price is still agreed upon in advance, as is the definition of “disability”.

See what you’d pay for life insurance

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​Business Succession Planning: What if my family doesn’t want to take over leading the business?

Many small businesses are family-run. Once mom or dad pass away or retire, the children step up and take over.

But what if your children’s interests lie elsewhere? Or what if not all of the children want to be a part of it?

A buy-sell agreement can help out for the former. If someone other than a family member wants to take over the business, such as a co-owner or an employee, they can enter a buy-sell agreement with you.

Once triggered, the new owner pays your family what your share of the business is worth (this dollar amount is determined in the contract already). The family then relinquishes their rights to the business.

For the latter issue, there is a slightly different solution. But it still involves a buy-sell agreement.

Your business is likely the greatest part of your estate—the estate that your children are set to inherit. But if not all of your children want part in the business, what do you leave for them?

Let’s look at an example.

John Washington owns a successful business. He is married and has two children. His wife, Martha, has been instrumental in the success of the business, but she does not want to be dependent on it as her primary source of income after John’s death. Their eldest son, Lincoln, shares his father’s love for the business, but their younger son, Theodore, has a career in graphic design.

John and Martha’s goals are to:

  • Ensure Martha will be financially secure.
  • Leave the business to Lincoln.
  • Make the inheritances of the two sons equal.

Without business succession planning, if John is the first to die, Martha inherits all of their assets, which includes a business that she does not want. Furthermore, Lincoln would not own a business that he does want.

The issue of equalization really comes into play when Martha passes away. If Martha leaves the business to Lincoln, there will not be sufficient assets for an inheritance for Theodore. If she divides the estate equally between them, Lincoln will have a partner who is not interested in the business and therefore likely won’t be much help in continuing its success.

To complicate the matter further, once the estate passes to children and not to a spouse, it may be subject to estate taxes. So another issue arises. From whose inheritance will these expenses be paid?

If these expenses are paid from the business, there likely would be no business. If they are paid from non-business assets, Theodore would end up with little or no portion of the estate. If the expenses are divided equally between the two of them—which is the likely event—this could cause the ending of the business, the liquidation of family assets, and possibly their home.

To solve this family’s inheritance issues, life insurance can be used.

John Washington should buy enough life insurance to cover at least his interest in the business. The life insurance can fund a buy-sell agreement naming Lincoln the second party to the contract.

Upon John’s death, Lincoln uses the death benefit to purchase the business from his dad’s estate. Lincoln then owns the business, Martha doesn’t need to rely solely on the business for her standard of living, and the estate has cash to help equalize the inheritance to Theodore.

Proper business succession planning requires careful preparation. Work with your accountant, attorney, and financial planner to ensure everything is set up accurately and can be carried out smoothly.

Need life insurance for your buy-sell or collateral assignment for a business loan? Quotacy can help. We work with many business owners and financial planners to help you obtain the life insurance you need.

Start the process by getting a term life insurance quote today. Window-shop in peace without giving up any contact information and know that your information will never be sold. If permanent life insurance is more in line with your needs, we can provide personalized quotes for you. Learn more here: whole life insurance quotes.


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