June 3, 2009

Critical Events, Critical Planning in the Life of a Business

Photo by Uwe Hermann If you own a business, consider this question. Will your bank, suppliers, and employees – and investors – feel more confident or less confident if the death of a key person is followed by a large infusion of cash into the business?

Key people are those who really make the smoke come out of your smokestacks. Who are the key people in your business? How would their death or disability impact your business?

Owners, especially of smaller businesses, are often key persons. But key persons are not always owners.

Consider the value of a sales person who brings new customers to the business. Or the creative talent that creates new products. Or the person who knows just what needs to be done – and who to talk with – to complete your projects.

There are certain critical events in life over which we have little or no control. Death, for example, never seems to come at a good time. If death happens at the “right” time, well, as bad as death is, it’s better than if it happens at the “wrong” time. Death of a key person the day after the company goes public is better than the day before, isn’t it?

The death of a key person can devastate a business – not just financially. Death of a key person can erode confidence in a business. The smaller the business, the greater that loss of confidence. Will it be as successful as it was before the death? Will it struggle? For how long? Will it survive? Can it survive?

Will employees worry about their jobs? Will that make it easier for other companies to lure them away? Will banks and other lenders be nervous? Will suppliers wonder if they’re going to be paid – especially in an economy that is rocky to begin with? Once the downward spiral begins, can it be stopped?

Maybe today would be a good day to look around and take note of the people who are key to your success. What would happen to your company if the timing of the next accident or heart attack was not as “fortunate” as it could be?

And maybe today is a good time to start planning for such a catastrophe.

Let’s go back to the question we asked at the start. If you own a business, will your bank, suppliers, and employees – and investors – feel more confident or less confident if the death of a key person is followed by a large infusion of cash into the business? One reason businesses buy key person life insurance is to help guarantee that continued confidence and dampen feelings of uncertainty.

A few final thoughts.

When you buy key person life insurance, that policy is employer-owned life insurance (EOLI). We’ve talked about EOLI before: as a potential tax trap waiting to happen, questions and answers about the notice and consent rules and an IRS notice about EOLI. Remember you must sign the Notice & Consent form before the life insurance policy is issued. Ignore that rule and the insurance death benefit (other than your cost) will be taxed as ordinary income.

The business should be the owner and beneficiary. It pays the premiums – which are not deductible.

If you plan to transfer the policy to the key person when they retire, you could be creating a deferred compensation plan and must comply with IRC Section 409A.

Money from a key person policy can also be used to buy the person’s interest in the business. That money, assuming everything else is done right, would not be taxed under the EOLI rules.

Different insurance companies have different rules they use to decide how much coverage you can buy. They often use some multiple of the key person’s compensation. That includes not just salary but also perks and benefits. They usually look at all the insurance the business owns on the key person (which can include policies bought specifically for protection of creditors – a policy the bank required when it made a loan, for example).

The more information you can give the insurance company about why this person is important to the business, the more likely you’ll be to get the amount of insurance you’re looking for. Emphasize the person’s experience, successes, background, and relationships with key customers, suppliers, etc as well as compensation. If the person is an owner and compensation is low because they put money back into the business, show the insurance company what other employers pay someone in a similar position.

Your thoughts? Experiences?

Walt