Life insurance for self-employed and small business owners

Two problems, not one

Business owners often approach this as a single question and end up solving only half of it.

The household problem is the same one everyone has. If you died, would your family have a shortfall? That is answered with ordinary personal coverage, sized using the method in how much coverage to consider.

The business problem is separate. Would your death create an obligation the business or your co-owners could not meet? That is a different calculation and often a different policy. It is covered in key person and buy-sell coverage.

Someone with a partner in a business and children at home has both problems, and they do not share a solution.

The thing most often missed

Personal guarantees.

Small business borrowing in Canada is frequently backed by a personal guarantee from the owner. Business lines of credit, equipment financing, commercial leases and supplier arrangements all commonly carry one.

A personal guarantee is a personal obligation. If the business cannot pay, the lender comes to you, and if you have died, they come to your estate. The debt does not disappear because the business that incurred it has ended.

This catches families out badly, because the borrowing felt like the company’s rather than theirs.

If you have signed guarantees, they belong in your personal coverage calculation, not the business one. Many owners have not looked at what they signed in years, and that is worth doing.

Self-employed people have no safety net

An employee with group coverage has something, even if it is not enough. A sole proprietor or independent contractor has nothing except what they bought themselves.

That makes the personal policy the entire plan rather than a top-up, and it usually means the amount needs to be larger than an employed person with the same income would carry. See work coverage versus your own policy for what employees are getting that you are not.

Income also tends to be less predictable when self-employed, which is an argument for a term policy with a fixed premium you can budget around, rather than a permanent premium that has to be found in a lean year.

Financial underwriting

For larger amounts, insurers ask for evidence of income, and this is harder for business owners than for employees.

A salaried applicant produces a T4. A business owner may take a modest salary and leave earnings in the company, or take dividends, or have income that swings substantially year to year. Underwriters may ask for tax returns, financial statements, or a notice of assessment.

Two practical points. Have two or three years of records available, since a single year may not represent the picture. And be prepared to explain the structure, because retained earnings in the company are part of your financial position even though they do not appear on a personal return.

Personal or corporate ownership

This is the question business owners most want answered, and it is genuinely a tax question rather than an insurance one.

Personal ownership is simpler. You own the policy, you pay premiums with after-tax personal money, and the death benefit goes to your named beneficiary outside the estate.

Corporate ownership means the company owns the policy and pays the premiums with corporate dollars, which are often taxed at a lower rate than personal income. On death, proceeds received by the corporation, less the policy’s adjusted cost basis, are generally credited to the capital dividend account and can be paid to shareholders as a tax-free capital dividend.

That is a real advantage and it is not automatic. It depends on the corporate structure, on who the beneficiary is, on the policy’s adjusted cost basis, and on the company still existing and being solvent when the time comes. Corporate-owned coverage is also exposed to the company’s creditors in a way a personally owned policy generally is not.

Getting the ownership, the beneficiary designation and any shareholders’ agreement to line up is where this goes wrong. Any one of them out of step can undo the intended result.

This needs an accountant. Anyone recommending a structure here without involving one, or without asking to see your shareholders’ agreement, is working from an incomplete picture.

If the business would simply end

Many sole proprietorships and small operations would wind up on the owner’s death rather than continue. That is fine, and it changes what you are insuring.

The question then becomes what winding up would cost and what would be left. Outstanding obligations, personal guarantees, lease commitments, employee entitlements, and the loss of the income the business produced for the household. That is the number, and it is usually a personal policy rather than a corporate one.

Where to start

Work out the household number first, including any personal guarantees. That is the coverage you need regardless of what happens to the business.

Then look separately at whether the business creates an obligation of its own, which is where key person and buy-sell coverage comes in.

Then, and only then, take the ownership question to your accountant.