Workplace

Although life insurance can be confusing for many business owners, it is extremely important in times of need. A properly designed life insurance policy can keep a family business operating, pay the mortgage and estate taxes, and provide an income for a spouse and family. A poorly designed life insurance policy can add to the costs of the estate and result in extra estate taxes or cause the insurance proceeds to be sub­ject to creditors. Therefore, you should review some of the important aspects of your policy now, before your family is forced to do it for you.

Amount of coverage

The type of life insurance policy is not as important as the amount of coverage. Many company owners buy their life insurance coverage based on how much they can afford in premium and not by using a formula.

The amount of coverage for an individual or officer of a company can be determined by adding all debt obligations, mortgages, expected income loss because of lost sales or job opportunities, and any amount needed to fund income arrangements for families.

For example, if you are the sole owner of a company and owe $500,000 on the company credit line, $500,000 on the mortgage, have sales of $1 million and want to pay a $50,000 salary benefit to your family for 10 years after your death, you would need a minimum of almost $2.5 million for life insurance. If there are other assets in the estate, there may need to be additional coverage to pay the estate tax liability.

Types of coverage

It seems there are new types of coverage developed daily, but the basic premise still is to buy the correct amount first and then match the additional benefits to your budget.

Term coverage is pure coverage and often is used to cover large needs during short time periods when there is a limited budget for coverage. Permanent, cash value policies are used to fund longer-term obligations, such as estate taxes or employee benefits, where the coverage will need to be guaranteed until the death of the insured. The cash values are used to help offset future increases regarding insurance costs associated with many permanent policies. Permanent policies range from traditional or whole life coverage to universal life coverage, which uses a complicated interest-based formula to determine the return on the cash value. Relatively new to the scene is variable universal life coverage, which uses a mutual fund approach to determine returns on cash values.

Ownership and beneficiary

Policy ownership is one of the most important aspects of having a life insurance policy but usually is the least understood. If ownership is not set up correctly, the tax-free death benefit can become subj­ect to income taxes, estate taxes and creditors of the estate when it should be subject to none of those things.

Basically, a policy owner should be the same as the insured if the purpose of the coverage is to pay off obligations due upon the insured's death. The beneficiary should be the spouse or business. If the coverage is for a business, consider a split-dollar program that will allow the business to pay premiums while the death benefit can be split from the business and go to the family or other beneficiaries.

If a policy is owned by a corporation and the corporation also is the beneficiary, the death benefit may be subject to corporate taxes, estate taxes and creditors' claims. Most corporate loan coven­ants have provisions that no money can be paid to the shareholders unless the debt is satisfied, thereby prohibiting any of the death proceeds to flow to other shareholders or family members. A policy owned by a corporation also can increase the value of the corporation, causing the buy-sell agreement to be underfunded and the buyout to fall apart when the family of the deceased needs the money most.

A serious purchase

Unlike any other corporation asset, life insurance can provide instant liquid cash when it is needed most—upon the death of a key employee in the company. Buying a policy should be taken seriously, and maintenance is needed.

Consult your attorney and insurance agent about the correct policy design to fit your specific needs, and review the policy regularly. Waiting to review life insurance policies until after the insured's death can cost the company and family a lot of money and create headaches if not done properly.

Brian Heckert is president of PENFlex Services Inc., a business consulting firm with offices in Nashville, Ill., and Peoria, Ill.