There are more than 30 million small and mid-sized businesses (SMBs) in the United States. Advisors, many of whom are SMB owners themselves, are integral to helping those entrepreneurs manage both their personal and business finances. We discuss how advisors can add significant value to their clients by thinking outside of the box when helping with key person arrangements and transition planning.

Rethinking key person arrangements

One of the most pressing issues impacting business owners has been attracting and keeping key employees: 65% of small and medium-sized business (SMB) owners cited recruiting and hiring as a challenge when polled by HR organization SHRM.

Having a plan for retaining key talent or dealing with their loss can help business owners mitigate the challenges and stresses of running a business and retain a competitive advantage in today’s marketplace.

As they grow, businesses must protect against the harm that the premature death of a key employee could inflict, including the time and resources spent acquiring and training a replacement as well as lost revenue. To help protect against these risks, businesses generally turn to life insurance — often a simple term policy, as it is usually the least costly and easiest option to implement.

However, cost recovery of a term policy will generally occur only when a covered key employee dies during the term of the policy. Given that only 1%-2% of term policies ever pay a claim, the traditional way of funding a key person arrangement rarely achieves cost recovery.

The benefits of a permanent policy for key person insurance

Compare the shortcomings of term insurance with a permanent policy, which all but ensures that the business will recoup its cost. A permanent policy can be structured to not only mitigate the potential harm arising from the death of a key person, but also to deter the employee from switching companies during his or her tenure.

A business owner concerned about employee retention may also consider entering into an endorsement split dollar arrangement. Under this arrangement, the business will own the permanent policy, pay the premium, and have all rights to the cash value initially.

To encourage the key person to remain employed, the business and employee will agree upon some service requirement duration – perhaps 10 years or 20 years, or a set age or similar metric. Under the arrangement, the business will be obligated to transfer the policy to the employee at the end of the agreed-upon tenure.

Adding value through buy/sell arrangements

We also see advisors defaulting to term insurance to structure buy/sell arrangements, which specify what will happen to a business when certain events occur – usually the death or disability of a business owner. These are key tools for succession planning and business continuity, but advisors should also try to maximize the value of the strategy wherever possible for their clients.

Here, in addition to providing cost recovery, a permanent life insurance policy creates intrinsic value that is lacking in a term policy.

In addition to providing peace of mind against a business owner passing away prematurely, the business could potentially tap the cash value of the permanent policy to jump-start an installment sale with the business owner once he or she decided to leave the business. If structured properly, the cash value can not only be accessed income tax-free, but the untapped portion may remain a corporate asset on the business’ balance sheet.

The policy could also be transferred over to the departing business owner in a process similar to the one outlined above with a permanent key person arrangement.