This article first appeared in Canadian Capital.
The right insurance structure helps companies survive when owners pass on
Consider the situation of a recent client, a successful private software firm wholly owned by a married couple. Although the owners are the prime drivers of the business, they rely heavily on their chief analyst for software development.
Unfortunately, he died unexpectedly three months ago and the company has been struggling to replace him. They are now at risk of losing some customers to competitors, which will in-turn hurt profitability.
This kind of impending financial disaster can be mitigated with key person insurance, which covers people who are so integral to a company’s operations that their sudden absence hinders output.
These policies differ from the typical corporate-owned life insurance that use proceeds to buy out a deceased shareholder’s interest in the company, or fund capital gains tax.
Instead, key person insurance compensates a company for financial losses arising from the death or incapacity of a valued member of the business. Proceeds can be earmarked for:
- A short-term cash infusion to deal with lost revenue or to pay off debts and liabilities.
- Recruiting, hiring, and training a replacement.
- Providing financial support for the key person’s family.
There shouldn’t be any tax on the insurance proceeds, so the company could use 100% of the funds. And while it’s never easy to replace a key person, the funds serve as a buffer while the company works its way through this difficult period.
These policies can also be used to benefit the key person in his or her lifetime. For example, the key person could own the policy, and over-fund it (perhaps using annual bonuses). Naming the company as beneficiary of the base life benefit means the company pays its share of the insurance cost and would receive the base benefit on death.
This could also provide the key person an asset to utilize in future. When he or she retires, the company is removed as beneficiary. The former employee continues to own the life insurance policy and is entitled to both the cash values in the policy and the base life benefit. The proceeds would be available to his or her estate, and the overfunded amount provides an asset for the key person in retirement—by drawing down the cash values, or by using the cash values as security for a loan or for an insured annuity.
Protecting a company is critical but key person insurance can also be valuable for retirement.
By Chris Ireland, Senior Vice-President: Planning Services, PPI Advisory