A look at key person insurance and buy-sell agreements
By Luke Baynes
“If you get hurt and miss work, it won’t hurt to miss work,” former New York Yankees catcher Yogi Berra quipped in a 2002 TV commercial for Aflac individual disability insurance.
But what about the hurt an employer could feel if a key employee gets injured or meets with an unexpected death?
That’s where key person insurance plans and buy-sell agreements come in.
Michael Junga, a Hinesburg-based personal financial representative for Allstate Financial Services LLC, explained the difference between the two business planning tools.
“A buy-sell (agreement) is designed to liquidate and transition ownership of the business,” Junga said. “A key person (policy) is to sustain the business.”
A buy-sell agreement is often utilized by business partners when establishing a company, to avoid a potentially messy estate settlement with a deceased partner’s heirs. While there are myriad permutations to the structure of such an agreement, a common strategy is to have stockholders enter into an agreement to have their estates sell their shares back to the company at death. To finance the repurchase of the stock, the company funds insurance policies on the lives of the shareholders, with the business listed as beneficiary.
According to report materials prepared by Advisys Inc., a financial planning software company utilized by Allstate and other financial services companies, benefits of buy-sell agreements include “an orderly transfer of the operation, management and ownership of the business,” “a mutually agreeable sales price and preservation of business value” and “a value that is binding on the IRS for federal estate tax purposes.”
By contrast, a key person plan is a stopgap solution to provide monetary compensation in the event that an employee critical to the day-to-day operation of a business dies or becomes incapacitated. In either scenario, insurance proceeds can be utilized to ensure that a business continues functioning through the hiring and training process of a temporary or permanent replacement.
As Junga explained: “Usually the business owns the policy, one of the key people is the insured—either for disability, or for life insurance—and the beneficiary is usually the business again.”
Although term life insurance is often utilized in key person plans purely for its death benefit provisions, Junga noted that companies sometimes opt for forms of permanent life insurance, which accumulate cash value that can be used for loan purposes.
“If a business had to go and get a loan at a local bank, it could be 6 or 8 percent for a business loan, or sometimes even worse than that,” Junga said, pointing out that the interest rate on a life insurance loan is normally much lower, or could even be zero.
The Advisys materials report that even though “key employee disability insurance has become a specialty product and providers of this important coverage are becoming more difficult to find,” actuarial data suggests that it is more likely that a person will become disabled than die before the age of 65.
“Insurance claims studies indicate that the odds of becoming disabled for 90 days or longer are much greater than dying during one’s working years,” the report states. It cites data from the Society of Actuaries’ 1985 Commissioners’ Disability Table, which indicates that a business with a 25-year-old employee has a 58 percent chance of losing that person to at least one long-term disability prior to age 65. If a company has two employees in that age group, the probability jumps to 82 percent.
Junga, who observed that “mom and pop situations or family-owned businesses are ideal for key person planning,” summarized the concept in layman’s terms.
“A key person plan is designed for rehabilitative purposes of the business, not to transition the ownership of the business,” he said. “It’s designed as a Band-Aid until things can be operational again at full capacity.”