Tips for Protecting Your Small Business

So you've realized the American Dream. You have a place of your own, a family and now you don't even have to bow down to "the man" for your hard earned wage. You are a small business owner. However, it doesn't matter if you are a mechanic or a dentist, a beautician or a lawyer, you need to plan for the future to preserve what you have built.

I have life insurance, that is all I need.

While life insurance is important, you need to evaluate whether you are adequately covered. If you are insured for, let's say, $100,000, you may have more than enough coverage. On the other hand, if you owe $100,000 on the mortgage, have two financed cars and your kids are going to private school, you may find that your insurance wouldn't cover very many bills should you meet an untimely end.

Also, consider what your life insurance will be used for. Are your immediate family members beneficiaries? If so, how will that money help to perpetuate your business? While your family may be financially secure, you may be leaving business partners with loans, monthly rent payments, equipment leases and employee salaries that you contributed to before your death. Failing to plan for your business partners can easily put them into a tight financial situation if you were to be suddenly killed or disabled. Consider a cross-purchase plan, in which partners buy life insurance policies on each other. In the event of a partner's death, the insurance benefit is used to pay an agreed upon amount to the deceased family, effectively "purchasing back" the estate's interest in the company.

All of that is spelled out in my will, I don't need a cross-purchase plan.

OK, let's map it out. Let's say John and David own a coffee shop. Each contributes $50,000 to the start up. John is killed in a car accident after a few years of operation. Naturally, John's family would want that $50,000 back since, without John it is impossible for the business to earn that money back for the family. John's family offers to sell their interest in the coffee shop to David, which would make him the sole owner. However, unless David has $50,000 of discretionary cash lying around, he will not be able to afford to pay John's family. Additionally, if John wills his share of the company to his family or to David, that share of the company becomes part of John's estate.

Under a cross purchase plan David has the money to pay John's family. The company doesn't become part of John's estate and is able to change hands without involving probate.

But that leaves the surviving partner with the whole company and no partner AND no additional money, why should he pay for a policy on John if he doesn't even get to keep the cash?

While the monies of this policy funding the cross purchase plan are intended to allow David to "buy out" John's family's interest in the coffee shop, David and John are free to purchase "key person insurance" on one another as well. Insuring the life of another person requires an insurable interest. This is the reason why nurses cannot take out life insurance on their dying patients and run off to Tahiti. While immediate family members automatically have insurable interest (meaning John's wife and children can purchase policies insuring the life of John), David only has an insurable interest as long as he and John have a business relationship. That is, they can insure each other because the future of their business depends upon the continued survival of the other partner.

David can take out another policy on John and have those funds used to help the business make it through the rough times caused by John's death.

Insurance is a scam

Everyone says insurance is a scam until they need it. For some reason, once the insurance check comes in the mail and softens the blow of a major disaster, insurance is a saving grace. In the above example, John and David could be anyone. They could be podiatrists, accountants, car detailers or plumbers. Without planning for the worst (while hoping for the best!) any business person could easily find themselves in a tough spot when the unexpected catches you by surprise.