It was Benjamin Franklin who wrote, “In this world nothing can be said to be certain, except death and taxes.”
”As a business owner, you probably spend too much time thinking about taxes, and death is a subject you avoid. That’s normal, but the loss of you, a partner, or an important employee could be catastrophic for the company. A common solution is key person insurance, which can help the business remain financially viable while it adapts to the loss.
“Key person insurance creates a financial bridge when someone who contributes the most to running the company or making it profitable is lost,” says Charles Mulford, professor of accounting at Georgia Tech’s Scheller College of Business. “In addition, some policies return anywhere from one to four percent per annum, making them potentially fruitful places to put excess cash.”
Most businesses protect their physical assets, but only 1-in-5 has a key person policy in place. That may change the next time you have a financial dealing with your lender. Typically there is some activity — a loan request, a letter of credit, planning for expansion — that triggers the conversation. In fact, your lender may very likely wish to discuss key person insurance. They want their interest in your business protected, too. Evaluating your key person insurance needs comes down to two considerations: who and how much:
Who. You, as the owner, certainly need coverage; so do your partners, if you have any. You may also want to cover a non-owner employee who is responsible for a large volume of your sales. “Businesses specifically tied to a person’s relationships with their customers lose viability quickly,” says Madigan. Think carefully about other personal traits that could be lost, such as leadership ability, special skills or industry reputation, which help build a company and its value.
How much. Determining the amount of coverage you need isn’t an exact science. It’s not simply a question of how much the person cost the company in salary, but what the total financial impact to the company might be. For example, a 5 percent gross margin requires $1 million in sales to generate $50,000. That star sales person may cost more to replace than you think. The internal disruptions — and there can be many — that occur until a replacement is hired and gets up to speed also have associated costs. Your bank and the underwriters it works with usually have valuation calculators to help you determine those costs.
Your accountant will have to tread the reporting waters carefully, cautions Mulford. “If the premiums, which are not deductible, exceed the cash surrender value, they are considered an expense,” he says. “If the cash surrender value, which grows over time, exceeds the premiums, it’s an investment.” And death payouts are tax-free, except for some C corporations.
So Franklin was mostly right — you can’t cheat death, but with key person insurance you may, just maybe, get a tax break.
