Key Man Insurance or Partner Insurance - Got it, so What?

Does your company have life insurance on its key players?  If so, don't dismiss the rest of this article – there are some minefields you may not have thought of.   If not, call an insurance agent today and then use some of these ideas in your conversation.     

In working with closely-held companies, including Chief Executive Boards International members, I find that even those who have "key man" insurance in place many times have not thought through the implications of just who owns the insurance and just who the beneficiary should be.  Many articles and many insurance agents assume the answers to both questions are "the company".   

Not necessarily.  There are actually two major reasons to insure a key player.  One is the traditional "key man" concept, where the insurance is meant to provide enough cash to hire, train and compensate a replacement.   In the case of closely-held companies, this may be an owner or it may also be a senior manager essential to the business, whether he owns shares or not.  In that case, the company as the beneficiary makes sense.    

The second and probably bigger reason for life insurance is to fund the provisions of a buy-sell agreement, providing the cash necessary to buy the shares left in a deceased co-owner's estate.   Call it "Partner Insurance", because the objective is completely different - it's to fund your estate and transfer ownership to your other shareholders.  This case is tricky and full of potential mine fields if not thought through initially and the beneficiaries updated regularly.    I've rarely seen one of these properly configured.  Why?  

Closely examine your company's buy-sell agreement.  You may find, as in many, that there's a provision whereby the company has right of first refusal to buy back a deceased partner's shares at a then-current valuation.  There are hundreds of variations on that theme, but generally those shares are bought back into the treasury, thereby "reverse diluting" the remaining shareholders.   The math becomes tricky. 

Let's say, for example, you're just starting to transition the ownership of your company and you have a 15% partner (someone who's been with you for years - your intended successor/owner) and two 5% partners (key players, with shares mostly for retention purposes), with your holdings at 75%.  At 100 shares outstanding, share ownership would be 15+5+5+75=100.  If the company is the beneficiary and there's enough money to completely buy back (retire) your shares, then the remaining partners' outstanding shares become 100% of the ownership of the company.  Proportionally divided, then, their shares (15, 5 and 5) end up being 60%, 20% and 20% of ownership.   You may be fine with that as far as the lead person is concerned, but what's happened is that the two minor shareholders have each suddenly "inherited" 15% of your company.  Was that your plan or your intent?    Probably not.  What's also happened is, in the case of a typical 67% super-majority requirement on major decisions (such as sale of the company), you've unwittingly handcuffed the majority owner, where either of the other two can block anything he wants to do.   Was that the plan?  You can see the problem.  By the way, the estate gets a step up in basis, meaning that the shares bought back from the company produce zero taxable income for the heirs - either ordinary or capital gains.   Good deal.   Unfortunately, the partners don't get the same deal.   Their basis is still their original investment - whatever they paid for their shares when they bought them. 

What's the alternative?  Depends on your intent.  For this case, let's assume what you really wanted was for your majority and long-time partner to inherit control of the company, keeping the minority shareholders at 5% each.   How would you do that?   Simple.  Make the majority shareholder the beneficiary of your "partner insurance" policy.  In other words, your partner receives (tax-free, it's life insurance) enough cash to buy your shares directly from your estate (which the buy-sell should allow).   This could be a win all around.  Your partner gets the insurance money, tax-free.  Your estate gets a step up in basis on your shares, and then sells them to your partner at that price for no taxable gain.  And your partner, since he paid real money for your shares also gets that amount added to the basis of his shares.   A win all around.  Despite the advantages of this approach, I've never seen a buy-sell initially set up this way.

Variations on this theme could include a small piece of the insurance proceeds for the minor partners, and if the death benefit exceeds the current valuation of the company, you could name your spouse or heirs for the rest.   Granted, this takes some management, updating the beneficiary percentages whenever you update the company valuation.  Among multiple partners, then, these policies need to name the surviving partners as beneficiaries to achieve the intended result in case of death of anyone (also known as a cross-purchase agreement). 

If you dismiss the "partner as beneficiary" option and the company remains the beneficiary, question two is, "What is the valuation of the shares the company is buying back from your estate?"  This is another minefield, particularly if the company is the beneficiary and the valuation process doesn't take insurance proceeds into account.  Let's say your company is worth $4 million and we have a $3 million insurance policy on yourself (to cover your heirs' 75% ownership), with the company as the beneficiary.   That's this week.   This weekend you get hit by a beer truck and expire.   Next week the insurance policy pays off and there's an additional $3 million of cash on the balance sheet.   What's the company worth then?  A capable attorney for your estate would argue it's worth $7 million.  Wow, then we're talking about buying back your 75% stake at a price of $5.25 million.   Where's the other $2 million going to come from?   This problem is a whole lot easier to solve.   Your buy-sell agreement should have a section on valuation.  In that section, simply state something like "for the purpose of valuing a deceased shareholder's shares, any proceeds of life insurance paid to the company will be excluded from the valuation."  One sentence that could save a $2 million dispute, in this sample case.   Note:  Insurance benefits paid to the company may be taxable, adding further complications.     

So, just like the rest of your buy-sell agreement, the insurance component needs to be carefully thought through and various possible scenarios played out.  In my experience, buying the life insurance is an afterthought and almost no thought is given to the beneficiary question - it usually defaults to being the company, with surprising unintended consequences.  

Finally, the purpose of this insurance is to cover a tragic situation.  As such, term life insurance with a top-rated company is the best vehicle.  Ignore pitches that suggest this is also somehow an “investment” and that cash value insurance is appropriate.  Invest the difference in your own company or distribute the money to shareholders.  

As always, check with your own legal, financial and tax advisors to be sure any of these ideas are right for your specific situation.  

If you have other approaches or scenarios relating to buy/sell agreements or key man/partner insurance, click "Comments" below and share them with others.   

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Terry Weaver

CEO

Chief Executive Boards International
http://www.chiefexecutiveboards.com/

TerryWeaver@ChiefExecutiveBoards.com