Business Owner Insurance Solutions

Business insurance is essential for protecting companies from the financial impact of losing key employees, facilitating ownership transitions, and maintaining operations during an owner's disability. The CFP exam tests your understanding of these insurance solutions, their tax implications, and when to recommend each type. This section covers key person insurance, buy-sell agreement structures, business overhead expense insurance, and disability buy-out insurance.

Key Person Insurance

Key person insurance (also called key man or key employee insurance) is life insurance purchased by a business on the life of an employee whose death would cause significant financial harm to the company. The business owns the policy, pays the premiums, and is the beneficiary of the death proceeds.

Who Qualifies as a Key Person?

A key person is typically someone whose skills, knowledge, relationships, or leadership are critical to the company's success. Common examples include:

Valuation Methods for Key Person Coverage

Determining the appropriate coverage amount requires estimating the financial impact of losing the key person. Three common valuation methods are used:

1. Multiple of Compensation Method

Multiply the key person's annual compensation by the number of years needed to replace them or recover from their loss (typically 5-10 years).

Example: Key executive earns $200,000 annually. If replacement and recovery is estimated at 7 years: $200,000 x 7 = $1,400,000 coverage.

Limitation: Assumes the employee's value equals their compensation, which may understate their true contribution.

2. Percentage of Revenue/Profits Method

Calculate the revenue or profits attributable to the key person and multiply by the recovery period.

Example: Sales manager generates $2 million in annual revenue with 15% profit margin ($300,000 profit). Recovery period of 5 years: $300,000 x 5 = $1,500,000 coverage.

3. Cost to Replace Method

Estimate the total cost to recruit, hire, and train a suitable replacement, including:

• Executive search firm fees (typically 20-35% of first-year salary)
• Signing bonuses
• Training and onboarding costs
• Lost productivity during transition

This method often provides a baseline or minimum coverage amount.

Tax Treatment of Key Person Insurance

Section 101(j): Employer-Owned Life Insurance (EOLI) Requirements

The Pension Protection Act of 2006 added IRC Section 101(j), which applies to employer-owned life insurance contracts issued after August 17, 2006. Compliance is mandatory for death benefits to remain income tax-free.

Notice and Consent Requirements (Before Policy Issuance):

The employee must receive written notice and provide written consent acknowledging:

1. The employer intends to insure the employee's life
2. The maximum face amount for which the employee could be insured
3. Coverage may continue after the employee terminates employment
4. The employer will be a beneficiary of death proceeds

Annual Reporting Requirement:

Employers must file IRS Form 8925 annually, reporting:

• Number of employees insured under EOLI contracts
• Total insurance amounts
• Consent documentation status

Consequences of Non-Compliance:

If notice and consent requirements are not met, the death benefit is taxable as ordinary income to the extent it exceeds total premiums paid. This can turn expected tax-free proceeds into a significant tax liability.

Exam Tip: Section 101(j) Exceptions

Even with proper notice and consent, death benefits are tax-free only if the insured falls into one of these categories at death OR within the 12 months before death:

• An employee of the applicable policyholder
• A director of the employer
• A highly compensated employee (top 35% of compensation)
• A highly compensated individual (5% owner or compensation exceeding $160,000 in 2025)

Buy-Sell Agreements

A buy-sell agreement is a legally binding contract that establishes how a business owner's interest will be transferred upon death, disability, retirement, or other triggering events. Life insurance is commonly used to fund these agreements.

Types of Buy-Sell Agreements

Entity Purchase (Redemption) Agreements

In an entity purchase agreement, the business agrees to purchase the deceased owner's interest, and the remaining owners' percentage interests increase proportionally.

Advantages:

• Fewer policies required (only one per owner)
• Business pays premiums with company dollars
• Simpler administration with multiple owners
• Cash value becomes a business asset

Disadvantages:

• No basis step-up for surviving owners—their cost basis in their shares remains unchanged
• Connelly case impact: Death benefit proceeds may be included in business valuation for estate tax purposes
• Future sale may result in higher capital gains for surviving owners

Number of Policies Formula:

Entity Purchase: N policies (where N = number of owners)

Example: A business with 4 equal owners needs only 4 policies—one on each owner.

Cross-Purchase Agreements

In a cross-purchase agreement, each owner agrees to purchase a proportionate share of a deceased owner's interest directly from the estate.

Advantages:

• Stepped-up basis for surviving owners—basis equals purchase price paid
• Death benefit proceeds not included in business valuation
• Lower capital gains on future sale of business
• Insurance proceeds not subject to business creditors

Disadvantages:

• More policies required as owners increase
• Premium disparities if owners have different ages or health conditions
• Individual owners pay premiums with after-tax dollars
• Administrative complexity with multiple policies

Number of Policies Formula:

Cross-Purchase: N x (N-1) policies (where N = number of owners)

Example: A business with 4 equal owners needs 4 x 3 = 12 policies—each owner owns 3 policies on the other owners.

Hybrid (Wait-and-See) Agreements

A hybrid agreement combines features of both entity and cross-purchase structures, allowing flexibility to decide which method to use when a triggering event occurs.

How It Works:

• The agreement gives the business the first option to redeem the departing owner's shares
• If the business declines (in whole or part), remaining owners have the right to purchase
• This flexibility allows tax optimization based on circumstances at the time of the event

Advantages:

• Maximum flexibility to optimize tax treatment
• Can adapt to changing tax laws and business circumstances
• May use single policies owned by the entity with cross-purchase backup rights

Disadvantages:

• More complex drafting requirements
• Uncertainty about final structure until triggering event
• May require more policies for full flexibility

The Connelly Supreme Court Case (2024)

In Connelly v. United States (2024), the Supreme Court ruled that life insurance proceeds used to fund an entity purchase agreement increase the company's fair market value for estate tax purposes. This decision has significant implications for business succession planning.

Key Facts:

• The Connelly brothers owned Crown C Corporation
• An entity purchase (redemption) buy-sell agreement was funded with $3.5 million in life insurance
• When Michael Connelly died, the IRS argued the insurance proceeds should be included in the company valuation

The Ruling: The Court held that the $3.5 million death benefit increased the company's value by that amount, resulting in over $1 million in additional estate taxes for the deceased owner's heirs.

Planning Implications:

• Cross-purchase agreements avoid this issue because insurance is owned by individuals, not the business
• Entity purchase agreements may need restructuring or additional planning
• The estate tax exemption is scheduled to decrease by approximately 50% after 2025, making this issue more significant for many business owners

Business Overhead Expense (BOE) Insurance

Business overhead expense insurance is a disability insurance product that reimburses a business owner for fixed operating expenses if the owner becomes disabled and cannot work.

What BOE Insurance Covers

Key Features

Benefit Period: Typically 12-24 months (shorter than personal disability insurance)

Elimination Period: Usually 30-90 days (shorter than personal disability insurance)

Benefit Amount: Based on documented monthly overhead expenses, up to policy limits

Reimbursement Basis: Benefits are paid based on actual expenses incurred, not a flat monthly amount

Tax Treatment of BOE Insurance

Example: A business owner pays $2,000/year in BOE premiums (deductible). If disabled, they receive $5,000/month in benefits (taxable income). However, those benefits pay for $5,000 in business expenses (deductible), resulting in no net taxable income.

Who Needs BOE Insurance?

BOE insurance is most valuable for:

• Solo practitioners (physicians, attorneys, accountants, dentists)
• Small business owners without partners to cover operations
• Professionals with significant fixed overhead costs
• Business owners whose personal disability policy does not cover business expenses

Disability Buy-Out Insurance

Disability buy-out insurance funds a buy-sell agreement when a business owner becomes totally disabled rather than dies. This coverage addresses a significant gap—the probability of a long-term disability before age 65 is greater than premature death for most working-age adults.

How Disability Buy-Out Works

1. Business owners establish a buy-sell agreement that includes disability as a triggering event
2. Disability buy-out policies are purchased on each owner
3. If an owner becomes totally disabled, an elimination period begins (typically 12-24 months)
4. After the elimination period, benefits are paid to fund the buy-out
5. The disabled owner's interest is purchased according to the buy-sell agreement terms

Key Features

Tax Treatment

Planning Considerations

Valuation: A current, accurate business valuation must be established and updated periodically. The buy-sell agreement should specify the valuation method (formula, fixed price, or annual appraisal).

Coordination with Life Insurance: The buy-sell agreement should address both death and disability. Life insurance funds death buy-outs immediately, while disability buy-out policies have longer elimination periods.

Elimination Period Alignment: The elimination period should be long enough to differentiate temporary from permanent disability, but not so long that the disabled owner faces financial hardship. Business overhead expense insurance can bridge this gap.

Business Insurance Comparison Summary

Exam Tip: Buy-Sell Agreement Selection

When recommending buy-sell structures on the CFP exam:

• Choose cross-purchase when: basis step-up is important, fewer than 4 owners, owners can afford premiums personally, or avoiding Connelly estate tax issues is a priority
• Choose entity purchase when: many owners make cross-purchase impractical, premium equality is desired, or simplicity is paramount
• Choose hybrid when: maximum flexibility is needed or tax optimization at time of triggering event is desired

Remember the policy formulas: Entity = N; Cross-Purchase = N x (N-1)