Download - Bussiness Insurance
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Copyright 2011 Oliver Publishing Inc. All rights reserved 91
Clients want to know:
Do I need business insurance?
After reading this, you should understand:
How businesses are organized
The risks faced by business owners
What types of insurance address business risks
Canada is a nation of small business owners and the number of owner-operated
businesses is truly quite astounding. A large risk that faces the owners of
established businesses is that of business succession. Who will buy the company
when the owner retires? Will the owner get a fair price for the business? What
will happen to the business if the owner dies? How does the business owner
ensure his or her heirs are treated equally?
Small business owners are often unaware of how life insurance or as it is
typically called in a business application, business insurance can be used to
manage these risks.
Business Structures To understand better how to advise a business owner, the agent must understand
the three basic ways a business in Canada can be structured. A business will be
one of the following:
A sole proprietorship;
A partnership; or
A corporation.
Sole Proprietorships
A sole proprietorship is a company owned and operated by one person. It
is unincorporated, and the sole proprietor personally owns the goodwill of the
business, all its assets, and all its debts. This is the riskiest form of business
ownership.
A sole proprietorship is terminated by simply ceasing operations or by the sale
of the business. Ceasing operations is simple and straightforward if the business
truly is owned and operated by only one person and has no ongoing
commitments.
Sole Proprietor A sole proprietor is the owner of an unincorporated business. He or she owns all the assets of the business and is responsible for all business debt.
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92 Copyright 2011 Oliver Publishing Inc. All rights reserved.
However, many sole proprietorships are large companies owned by someone
who has worked long and hard to build the business, and there are employees
and customers to whom the owner feels an obligation. In this case, a sale is
called for. Selling the business will recoup the value the sole proprietor has built
in the business and will satisfy those obligations to others. Proceeds from the
sale could be used to provide an income to an owner who has become disabled
or wishes to retire.
Risks Faced by the Sole Proprietor and His or Her Heirs
The greatest business risk facing a sole proprietor is whether he or she will be
able to find a buyer who will pay a fair price when the time comes to put the
business on the block.
When a sole proprietorship is to be sold due to death of the owner, his or her
spouse or heir must be able to sell the business at a fair price to make up for lost
income and eliminate business debts; otherwise, personal assets can be seized
by creditors to repay such debts.
Some of the risks that can deter a fair sale of the business include:
Potential buyers who detect a fire sale and respond with low offers,
because they realize the need to sell may take priority over getting the
right price.
A spouse or beneficiary of the deceased business owner who may set an
unrealistically high price on the business because of financial need
and/or lack of knowledge about the true value of the business. They
may be unsuccessful, therefore, in finding a buyer.
An owner of a small store typically would be a sole proprietor. The effort devoted to building the business can be lost if there is no plan in place for an orderly transfer of the
business to another owner if the sole proprietor dies or is disabled.
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Why is getting a fair price important for the business owner selling her business?
A To establish business credibility when it comes to negotiating financial matters B A fair price is preferable to a fire sale C The business owner may be counting on the proceeds for future needs D B and C
Partnerships
A partnership is an unincorporated company owned by a group of individuals
who contribute funds towards the business. Every partner is either a limited
partner (basically, an investor) or a general partner (actively involved in the
partnership).
Every partner owns a share of partnership interest, partnership property,
and partnership debt equal to his or her investment in the partnership. A
partnership is terminated by winding-up, dissolution, or the death of a partner. A
partner may choose to depart from the company if he or she is disabled and can
no longer contribute to the company or if he or she wishes to retire.
Risks Facing the Partner
Typically, when a partner leaves a partnership, the other partners step in to
acquire the partnership interest, property, and debt of that partner. The partner
leaving the company risks not receiving a fair price from the remaining partners
for his or her partnership interest.
When a partner dies, there is often a great deal of difficulty for the spouse or
heir to agree on a fair price for the partnership interest and partnership property
with the remaining partners, for the same reasons that a spouse or heir may have
difficulty selling a sole proprietorship. Unrealistic ideas of value may prevail,
and there will be loss-of-income issues to deal with.
Meanwhile the remaining partners run the risk of having the funds available to
make a fair offer, whether to the partner leaving the firm or the spouse or heir. If
the partnership does not have cash on hand, then internal conflict can arise on
how to make the payment.
What do sole proprietors and partners have in common?
A Debts that are personally guaranteed B Businesses that are unincorporated C The need to receive a fair value for their business D All of these answers
Partnership interest Partnership interest is the portion of the partnership owned by the partner. It determines the financial stake the partner has in the firms profits and losses. Partnership property Partnership property is the financial, intellectual or other property brought into the firm by each partner.
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Corporations
A corporation is created in a legal process called incorporation. The legal
process determines the number of shares in the corporation that will be issued
and creates the corporate structure, with a board of directors and officers of the
company.
If the shares are held by fewer than 50 people, the company is a closely held
private company. This type of company is called a Canadian-controlled private
company, or CCPC, when it meets certain requirements. A CCPC gets certain
tax advantages over a public corporation, such as a small-business deduction. A
CCPC may also qualify to be a qualified small business corporation (QSBC), if
certain additional criteria are met. A QSBC has distinct tax advantages for its
share owners, including the owners ability to use the lifetime capital gains
exemption of $750,000 that is available to owners of a QSBC when capital
gains are realized by the sale of QSBC shares.
When company shares are listed and traded on a stock exchange, such as the
Toronto Stock Exchange, the company is a public company.
Values of corporate shares rise and fall with the worth of the company
whether the company is private or public. When there is an increase in share
value from the price paid for the share, then the shareowners benefit from a
capital gain; if the share value drops below the price paid then a capital loss
is received by the shareowners. Shareowners do not personally own assets of the
company and they are not liable for company debt.
A corporation is terminated by sale of all the shares to an acquiring interest or
person, bankruptcy, or a declaration by the board of directors.
Companies listed on a stock exchange like the TSX are public companies. Their share values are widely available. The value of shares of a private company is known only to its shareowners.
Capital gain
A capital gain is received when an investment classified as capital property is sold for more than its adjusted cost base.
Capital loss
A capital loss is received when an investment classified as capital property is sold for less than its adjusted cost base.
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Copyright 2011 Oliver Publishing Inc. All rights reserved. 95
Risks Facing the Corporate Business Owner
Just like sole proprietors and partners, shareowners will want to receive a fair
price for their shares when they are sold. If a share owner retires or is disabled,
the proceeds from the sale of the shares can be invested to provide an income
for the shareowner and his or her family. On the death of the share owner, the
value of the shares will be an important source of funds for survivors to pay
final expenses and provide for ongoing needs.
When a shareholder of a private company dies, usually the remaining
shareholders will want to acquire the shares held by the deceased shareholder in
order to retain control of the company. If the shares become an asset of the
spouse or beneficiary, the remaining shareholders both lose a degree of control
in the company and may find themselves dealing with an inexperienced or
unknowledgeable heir who has an unrealistic idea of the value of the shares.
What risk is unique to the shareowner and is not also experienced by the sole proprietor or partner?
A The need for a fair price B The need to pay business debts C The need to fund a retirement income by the sale of shares D The need to sell shares to recoup value of the business
Two More Business Risks
The Risk of Creditor Seizures
A creditor is a person or party to whom money is owed. It is quite usual for a
business to both owe money to others, and, in turn, be owed money by others. If
the business is a sole proprietorship or partnership, the proprietor or partner will
have debts that are personally guaranteed. When debts are unpaid, creditors can
pursue the assets of the debtor in an effort to be repaid. If the debtor dies, his or
her creditors can sue the estate of the deceased for money that is owed to them.
Life insurance provides two ways to provide protection from the claims of
creditors. One way is by naming an irrevocable beneficiary of the insurance
policy. Another way is to specify certain family members as beneficiaries.
Creditors cannot then seize the benefits of a policy.
Irrevocable beneficiary An irrevocable beneficiary is a person named as beneficiary that cannot be changed to another beneficiary without the permission of the irrevocable beneficiary.
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When an irrevocable beneficiary is named in a life policy, who has control over major decisions taken by the policy owner?
A The policy owner B The creditors C The irrevocable beneficiary
D The life insured
Loss of the Key Employee
A key employee can be found in a sole proprietorship, a partnership, or
corporation of any size: from Sue, the only painter at Sues Painting, to Bill
Gates, founder of Microsoft. If a key employee dies or becomes disabled, a
business can suffer substantially without the talents of that employee. Not only
is that person no longer contributing to the company, but the company must hire
and train a replacement. This double-whammy can be a devastating blow for
even very large companies.
A key employee may own all, part, or none of the business. How to keep the
company going in the absence of the key employee is a risk for the business in
which the key employee works. On retirement, death or disability, the business
must be able to replace the talent of the key employee with the least disruption
to its affairs.
How Life Insurance Manages Business Risks All forms of life policies term, whole life, Term-to-100, and universal life
are all available for business owners. The difference between business insurance
and personal life policies is the way the business policy is structured in other
words, who the policy owner is, who the insured is, and who the beneficiary is.
Business insurance is based on agreements that have been structured between
the owner or owners and the potential buyer or buyers.
I am a partner in a firm of architects. I applied for and received a life policy to ensure my family would have funds if I died. I named my husband the irrevocable beneficiary of the policy, so that the creditors of the company cannot make a claim against my estate for money that they are owed.
Key employee A key employee is an employee whose contribution to a
company is key to its success.
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If a sole proprietor, partner, or shareholder dies, a buy-sell agreement funded
with life insurance will provide the beneficiary with sufficient funds to acquire
the deceaseds interest in the proprietorship, partnership, or corporation.
A buy-sell agreement will specify price and the terms of payment. It should
be a binding agreement that sets out all terms and eliminates the need for future
negotiation. This means that the seller must sell to the buyer under the agreed-
upon conditions.
An option agreement is a variation on the buy-sell agreement. It gives the buyer
the first option to buy from the seller. No price will be established. If the buyer
does not want or is unable to buy, then the seller can look elsewhere.
There are several ways a buy-sell agreement can be funded with life insurance.
When the business is a sole proprietorship, a cross-purchase agreement is
typically funded insurance that names the buyer of the business as the policy
owner and beneficiary. That money is then used to buy the business from the
heirs of the deceased.
If permanent insurance is used, the cash surrender value in the policy can be
used to pay the owner for the business when he or she wishes to retire. The
policy is sacrificed, but the owner receives a retirement allowance in the form of
the selling price of the business that otherwise he or she might not have had,
while ensuring a future for the business.
Since the prospective buyer of the business is the policy owner and therefore he
or she has paid the premiums on the policy, the proceeds on death will be
received tax-free.
Ive been working as the chef here for 12 years. The guy who owns this restaurant is 62, and he wants to retire. Because we have a whole life cross-purchase agreement, Im going to take the cash surrender value of the policy and be able to buy the restaurant from the owner. Without this insurance policy, Id have to go to the bank for funding. This way Im debt clear.
+ FILE
See file 22 for a case study on how term insurance can fund a buy-sell agreement.
Buy-sell Agreement A contract that specifies the terms that a buyer and seller must meet for the purchase of a business from its seller.
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Choose the answer that best describes a cross-purchase agreement. A A contract that uses life insurance to buy a business
B A life insurance policy between an owner and potential buyer C A life insurance policy on the life of a business owner that names the heirs of the
deceased as the beneficiary D A contract that specifies the value of the business for a future owner
A criss-cross agreement is appropriate when dealing with a partnership. A
criss-cross policy has each partner insuring his or her life and designating the
other partner(s) as an irrevocable beneficiary.
The type of policy used can be either term or a permanent policy. If term, it
should be purchased as a renewable and convertible policy. The reason? So that
permanent life insurance can be put in place regardless of the health of the
business owners.
When a company is incorporated, a cross-purchase, tax-free dividend
arrangement will provide all shareholders with a fair settlement. The business is
named as the policy beneficiary and receives the insurance proceeds on the
death of the shareholder. The shares of the deceased shareholder will be
transferred to his or her estate. The surviving shareholders then purchase the
shares from the estate, according to the terms of the buy-sell agreement, using a
promissory note for payment. The corporation pays a tax-free capital dividend
in the amount of the life insurance proceeds to the shareholders, who use this
dividend to pay the promissory note.
In a share-redemption arrangement, the business owns policies on the life of
the owners and the business is the beneficiary. When an owner dies, the
business receives the life insurance proceeds and an amount equal to the tax-free
death benefit (i.e., the life insurance proceeds ACB) is credited to the Capital
Dividend Account (CDA). The company then pays out to the deceaseds estate a
tax-free capital dividend for the amount in the CDA. Any payment required
beyond the capital dividends to redeem the shares of the deceased owner are
paid as regular taxable dividends to the deceaseds estate, and the shares of the
deceased are redeemed. Since the shares redeemed are no longer outstanding,
the ownership of each of the surviving owners goes up correspondingly.
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A criss-cross agreement is . . . ?
A A badly written or confused insurance agreement in need of revision B An insurance policy manoeuvre used to insure the interest of all business
partners equally and irrevocably
C An insurance policy designed to provide equal interests to all owners of or partners in a business
D A term-to-100 insurance policy with multiple beneficiaries
Key Person Life Insurance
Key employee insurance, also called key person insurance, is a form of third-
party insurance in which the employer-company is the insured and the
beneficiary, and the key employee is the life insured. If the key person dies, the
insurance proceeds are paid to the business to hire a replacement and provide a
cushion of protection while the business struggles to adapt to its loss. However,
the business may use the proceeds any way it sees fit.
A key employee is usually insured to a multiple of their yearly income. The
person designated as a key employee can be changed by use of a parachute
clause that allows one life to be substituted for another.
Why would a business buy key person life insurance? A To protect corporate performance
B To increase company revenue C To maximize corporate profits D To reduce the importance of the key person in the organization
The Advantages of Life Insurance for Businesses Life insurance is not the only way to fund a buy-sell agreement. Other options
include borrowing the necessary funds, selling company assets, or paying over
time. However, only life insurance has these advantages:
The funds will be available when needed;
The cost of life insurance is lower than other alternatives;
The new owner has no burden of debt from acquiring the business;
Unlike loans, policy premiums are not repaid.
Sharlyn and I are partners in a land-survey business. We have whole life insurance on each other so that, if one of us dies, the other will receive the benefit of the policy. That money will be used to buy the partnership interest from our heirs: Sharlyns mother if she dies, and my wife if I die. If one of us gets hurt on the job and cant work anymore, the cash surrender value of the policy will be used to buy the partnership interest from the other.
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How Disability Income Insurance Manages Business Risks The uses for disability insurance in business are:
Key person disability insurance;
Business overhead expense insurance;
Business disability buy-out insurance.
Key Person Disability Insurance
Key person disability insurance is used to provide a disability benefit to a
business when a person who is key to the business is disabled. There are three
parties to this insurance contract: the policy owner (the business), the person
insured (the key employee), and the insurer.
Disability benefits are paid to the business; the business, in turn, uses the benefit
to provide a salary for a replacement for the key person during a period of
disability. The key persons income may be protected during disability by an
individual or group disability policy.
Premiums for key person insurance are not tax-deductible for the business. They
are an expense that can be budgeted, unlike additional salary and replacement
costs that can be incurred by a business if disability should occur without
insurance in place.
Typically, the benefit period for key person disability insurance does not usually
exceed one year, and the elimination period is very brief, so as not to inhibit the
activities of the business in the absence of the key person.
If a key person is disabled and unable to perform the tasks that make him key to the operation of the business then key person disability can help the business to substitute someone to carry on.
+ FILE
See file 23 for a case study on key person insurance
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Copyright 2011 Oliver Publishing Inc. All rights reserved. 101
Business Overhead Insurance
Overhead expenses are the cost of doing business. Business overhead expenses
continue even when the business owner is disabled. To keep the business going
during such an absence, the business itself can be protected by a business
overhead policy. This kind of policy is typically available to a very small
business with a maximum of about ten employees, where the business is
completely dependent on the owner for revenues (e.g., the owner/operator of a
truck; a dentist operating a clinic; etc.)
A business overhead policy covers overhead expenses only. They include
salaries for employees, rent, utility bills, existing business debt, and many other
expenses incurred in operating the business. The policy does not cover salary for
the business owner, payments on new debt taken on by the company, furniture,
equipment, and merchandise. The business owner, who is typically the prime
revenue-earner of the business, protects himself or herself through a personal
disability income policy.
There are two parties to this contract: the business and the insurer. The business
is the policy owner, the insured, and the beneficiary. The benefit period for a
business overhead policy ranges from six to 36 months. The elimination period
is zero days for an accident claim and between 14 and 90 days for a sickness
claim.
Settling a Claim for Business Overhead Insurance
Business Overhead Insurance is a reimbursement plan that requires receipts be
submitted as evidence for a claim. There is a policy maximum, and qualifying
expenses are reimbursed to that maximum. For example, if a sole shareowner of
a business takes out a $5,000 Business Overhead Insurance policy and then
becomes disabled, he may submit up to $5,000 per month in business expenses
for reimbursement. If his actual business overhead was $7,000, the $2,000
difference between the policy coverage and actual overhead would not be
insured.
If, however, the claim was less than the amount insured, lets say $3,500, the
$3,500 would be reimbursed, and the difference between the amount insured
and the amount of reimbursement, $1,500 ($5,000 $3,500), may be put into
reserve to extend the benefit period of the policy.
Taxation of Benefits
Benefits paid by the insurer to the business are taxable, because the premiums
are tax-deductible. However, allowable business expenses may be deducted.
WATCH
Business Overhead Insurance
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Disability Buy-out Insurance
Disability buy-out insurance can be used in those businesses that have buy-sell
agreements in place to ensure a smooth transition between business owners. The
buy-sell agreement is a contract that determines the conditions under which a
business will be sold and bought by an employee, a partner, another shareholder
in the business, or the business corporation itself. One aspect that the agreement
will cover is the value of the business.
If an owner/partner/shareholder dies, his or her share is purchased from the
heirs or survivors with life insurance, according to the terms of the buy-sell
agreement. If an owner/partner/shareholder is disabled, his or her share is
purchased from the disabled owner/partner/shareholder with disability buy-out
insurance, according to the terms of the buy-sell agreement.
Settling a Claim for Disability Buy-out Insurance
Disability buy-out insurance is usually paid as a lump sum, instead of as a
monthly benefit. The lump-sum payment from a Canadian insurer can provide
between $500,000 and $1.5 million after a 12- to 24-month elimination period.
A company such as Lloyds will provide up to $50 million per person.
It is wise if the definition of disability used in an agreement is determined by the
insurer, so as to reduce the potential for strife between partners who might not
be able to agree on what constitutes a disability and also when the disability
actually exists. A mandatory buy-out clause states when the disabled must sell.
This is called the trigger date and is usually one to two years after total disability
can be confirmed.
The insurer will require substantiation for the amount of insurance being
purchased. This can be satisfied by providing copies of the balance sheet and
income statement for the two years prior to the application. The business must
also have been established for more than two years.
Its been my lifelong dream to own a golf course. Last year I made my dream come true when I bought the Highlands. Ive taken advantage of both individual and business disability insurance to protect my business and me. To make sure I will always have an income, I have a personal disability income policy. To protect my right-hand man, Ralph, a key person disability policy will pay a benefit to the business if Ralph is unable to work.
WATCH
Disability buy-out insurance