In the first part of our two-part series on business loan insurance solutions, we introduced the concept of these life insurance plans and how they can provide advantages to businesses of many types. We contrasted unincorporated versus corporate business interests, went over the financial hardships that may be experienced in a business owner’s untimely death, and talked about the many benefits such a plan provides.
In this article, we will delve into the mechanics of a business loan insurance plan and how they work to protect both business and personal assets. Finally, we will provide both a summary and a checklist to give business owners the information they need to make sound financial decisions. As with any business insurance plan, it is important to seek out the expertise of a qualified insurer to find the plan options that meet the specific needs of each individual business interest.
How Do Business Loan Insurance Plans Work?
Business loan insurance policies are economical and efficient methods for protecting critical business (and personal) assets. If a business owner were to die unexpectedly, any outstanding business debt would still need to be repaid, either through remaining business assets or by tapping into personal financial assets.
Let’s take a look at the mechanics of this insurance plan to understand how it works for a given business:
First, like many businesses, the business itself or its owner obtains a business loan or makes arrangements for an open line of credit. Lenders and creditors will require sole proprietor/sole partner businesses to personally guarantee repayment of the debt. Larger companies, such as multi-owner/multi-partner operations or corporations, may still have to provide assurances that the loan debt will be repaid.
To guarantee the funds needed to repay the loan debt in the case of an owner’s unexpected death, the business or business owner purchases a life insurance policy in an amount roughly equal to the outstanding loan. The business or owner pays the premiums on the policy, which are typically non-tax-deductible. For the purposes of this policy, the business is named as the beneficiary or the owner names a specific personal beneficiary, depending on the structure of the company and which entity actually owns the insurance policy. To summarize:
- The insured is the business owner
- The owner of the policy is the business itself or the business’ owner
- The beneficiary is the business or a specified personal beneficiary who is empowered to make financial decisions on behalf of the company.
In many cases, creditors/lenders may require the assignment of collateral benefits of the policy, as their financial interests are at stake.
At the business owner’s death, benefits of the insurance plan kick in. Proceeds from the policy are paid income-tax-free, and are used primarily to pay the outstanding loan debt and any interest that has accrued on the debt. If the policy was assigned to the creditor(s) as mentioned above (collateral benefits), then the proceed payments go directly from the insurer to the creditor(s). If the business is named as the beneficiary, or the owner assigns a personal beneficiary, proceed payments will be made to them for repayment of the loan debt.
Any policy proceeds in excess of the amount needed to satisfy the outstanding debt can be used by the beneficiary to cover any financial needs that may have arisen at the owner’s death. These excess proceeds can often be used to pay for surviving family member expenses or sometimes to indemnify the business against the loss of the owner and his or her experience and skill.
Potential Value of Business Loan Insurance Proceeds
Value of the Tax-Free Insurance Proceeds
There are many advantages to business loan insurance plans. Many companies can benefit from obtaining such an insurance policy to protect their interests and assets from creditors in the event of an unforeseen owner death. There are other benefits, particularly in the value these policies (and their proceeds) represent.
The value of insurance proceeds received tax-free upon the death of the owner can be quite significant, especially when compared to t pre-tax profits or their equivalents. An example to illustrate this value can be useful: imagine a company existing in the 25% tax bracket. With a business loan insurance policy in place, $100,000 of tax-free proceeds from that policy are equivalent to $133,333 in pre-tax profits.
To make this value even clearer, consider that depending on a company’s profit margin, the sales required to reach $133,333 in pre-tax profits can be substantial. A company with a 10% profit margin would have to have $1,333,333 in sales; a company with a 20% profit margin would expect $666,667 in sales, and a company with a 30% profit margin would need $444,444 in sales to reach that $133,333 pre-tax profits number. So, with a $100,000 business loan insurance policy in place, the proceeds from this policy resulting from the death of the business owner could replace $666,667 of sales or receipts that would have to be used to satisfy any outstanding loan debt. This is assuming a 20% profit margin for the example company.
A Checklist and Action Plan for Businesses
Smart businesses protect their assets, no matter the circumstances. Small business owners that carry business debt must also protect their personal assets, as many lenders require personal guarantees of business loan repayment. Business loan protection insurance can provide that critical asset protection. There are three steps business owners should take now, including:
- Selecting the appropriate life insurance policy and policy ownership arrangements to suit the unique needs of the company.
- Establishing insurability of the owner(s) and/or partner(s)
- Arranging for the business to make appropriate premium payments to the insurer.
In the short term, there are additional steps to take to ensure that this valuable and important insurance is ready to protect business assets. These short-term steps include:
Draft and execute a resolution to authorize the purchase of business loan protection insurance if appropriate for the needs of the company and its ownership.
Execute any collateral benefit assignments, particularly if required by lenders/creditors.
Review the issued insurance policy to make sure it meets all needs. Make adjustments with the insurer as necessary.
Finally, companies change from year to year, and their needs will also change. It is a good idea to establish an annual review of all insurance policies, including business loan protection insurance, to ensure they remain current to the specific needs and circumstances of the business and its owners. It is also a good idea for businesses to evaluate their business continuation planning needs, such as establishing a buy-sell plan in case of death or permanent disability of the owner or other key employees.