A Guide to Life Insurance for Business Owners

Thang Truong
Thang Truong
Updated on:

Business owners have so many things to worry about; finding health care insurance, paying taxes, economic uncertainty, finding good employees. You could be forgiven if you forgot about life insurance, or just kept putting it off. 

As a small business owner, you occupy a unique position. Not only does your family count on you, your employees and business partners do as well. That’s why small business owners really need two types of life insurance policies: personal life insurance and business life insurance.

Why do Business Owners Need Personal Life Insurance?

Small business owners need personal life insurance for the same reason everyone does: to provide for your family if something were to happen to you. Could your family get by financially without your support? You’ll need personal life insurance for two reasons:

  • Income replacement
  • Collateral coverage

Income replacement will provide for your loved ones after you die. They can also use the money to pay off a mortgage, pay for college, or supplement your widow or widower’s retirement. 

Collateral coverage is how your family will pay back the loan if you took one out to start the business. Oftentimes, people need to put up collateral to qualify for a loan. If you put your home up as collateral, you don’t want to risk losing it to the bank if you die. Your family will be grieving your loss; you don’t want them to grieve the loss of the home you shared as well.  Personal life insurance will ensure this won’t happen.

Why do Business Owners Need Business Life Insurance?

Your business partners count on you just as much as your family does. That’s why you’ll need business life insurance as well as personal life insurance. You’ll want to know about key person insurance and buy-sell agreements to protect your business.

>>MORE: Understanding Indexed Universal Life Insurance: Is it Good for Retirement Planning?

Key-Person Insurance 

According to the iii, a key person is someone whose knowledge and skills significantly contribute to a business’s income. Losing this person would cause the business to lose money. 

The business pays for the policy on the key employee and receives the death benefit if the key employee dies. Then the small business can use the tax-free death benefit to pay off debts, look for a replacement employee, or pursue specialized training for other employees. 

>>MORE: Tax Benefits of Life Insurance: Compare With Other Retirement and Investment Options

Term or Permanent Insurance for the Key Employee?

Term insurance can be appropriate for key-employee insurance. For example, if you know your business partner plans to retire in twenty years, a 20-year term key-employee policy should work. Term insurance is much less expensive than permanent insurance, so this can be a cost-effective way to protect your business.

Permanent insurance is much more expensive. However, if you or your partner plan to run the business until death, permanent insurance might be worth the cost since you can’t predict when you’ll die. The cash value account can be used to in case you need quick access to cash.

Buy-Sell Agreements

If own your small business with a partner, what happens to the business if they die? A buy-sell agreement states what happened to their half of the business if they die. The buy-sell agreement allows the other partner to buy their shares. Life insurance can provide the money to do that. 

Frequently, partners in a small business enter into a cross-purchase agreement. This is a buy-sell agreement that both partners have on each other. If one dies, the other one gets the death benefit and uses it to buy their half of the company.

For example, if two partners, A and B, own a small business worth $20 million. They would buy 2 permanent life insurance life policies. A holds a policy worth $10 million on B and B holds a policy worth $10 million on A. If A dies, B will receive $10 million death benefit, tax free, from the policy and offers to buy shares of A in the business from A’s family. The same process happens if B dies.

If there are more than three partners running the business, you can use an entity-purchase agreement instead. This allows the shares of the deceased person to go back to the business. 

>>MORE: Why is Whole Life Insurance Not Worth it?

Business Succession Planning

Simply put, what will happen to your business in the event of your death or your partner’s death? Life insurance can help smooth the way, allowing the living partner to make all of the decisions that the partner’s used to make together. This allows them to make critical decisions regarding finances. 

It’s worth it to discuss what will happen to your business if one of the partners dies. If there are more than two partners, the remaining partners can disagree on what direction to go in, and the business can fail. Business succession planning is a complex topic, beyond the scope of this article. But if you own a business, you’ll want to look into it. 

>>MORE: Understanding How Variable Universal Life Insurance Works

How Much Life Insurance Should Business Owners Get?

For the key-employee life insurance, you’ll need to calculate what impact the key-employee’s death will have on the bottom line. This could be difficult, as some of what your partner contributes is non-quantifiable. If they happen to be in charge of sales, you could estimate how much money they bring in. 

There are many ways to calculate how much key-employee insurance you need, but Entrepreneur makes it simple: buy as much as you can afford.

Last Thoughts

Small business owners need both personal and business life insurance. It’s important to sit down with a financial advisor to figure out what and how much life insurance you’ll need. The good news is that once you’ve purchased business and personal life insurance plans, you don’t have to think about them anymore. You can just enjoy the peace of mind that comes with being prepared for any eventuality.

Thang Truong

Thang Truong covers small business insurance and small business success at BravoPolicy. He is a licensed P&C insurance agent. Previously, he held product leadership positions at realtor.com, Capital One, NerdWallet, and Mulberry Technology. He holds a MBA degree from UC Berkeley - Haas School of Business.

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