How Much Life Insurance Does a Business Loan Need?

Ownership, Premiums and Beneficiary in a Loan-Protection Policy

Ownership usually stays with the borrower, which may be the individual or the business entity, while the lender's interest comes from the collateral assignment. For required policies, SBA SOP 50 10 8.1 states that lenders "must ensure that the Applicant/Borrower pays the premiums on the policy."

The deduction question turns on the statute's wording. Under 26 U.S.C. § 264(a)(1), "No deduction shall be allowed for— (1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract."

IRS Publication 334 applies this rule to loans. It states: "If you take out a policy on your life or on the life of another person with a financial interest in your business to get or protect a business loan, you can't deduct the premiums as a business expense."

Under a collateral assignment, the lender is the assignee for the debt, and the business or the owner may remain the named beneficiary of the excess. Whether a taxpayer is "directly or indirectly a beneficiary," and whether an employer-owned contract meets the section 101(j) notice and consent requirements, are questions that need individual review of the contracts involved, by the insurers and a qualified tax professional.

On the death benefit, 26 U.S.C. § 101(a)(1) provides that gross income "does not include amounts received ... under a life insurance contract, if such amounts are paid by reason of the death of the insured," subject to stated exceptions. Publication 334 adds that "the proceeds of the policy are not taxed as income even if they are used to liquidate the debt," a statement that is subject to the exceptions in section 101(a)(1), including the section 101(a)(2) and 101(j) limits described under Important Considerations below. The how business life insurance works page explains the limits on that exclusion.

Key Factors That Affect the Coverage Amount

Several variables shape the business loan life insurance amount.

• Collateral shortfall. In general terms, the gap between what is owed on the loan and the value of the pledged collateral. For 504 loans the SOP gives its own calculation, based on the net debenture and discounted collateral; the example below uses a simple assumption.
• Loan amount versus shortfall. Because the SBA amount follows the shortfall rather than the loan's face amount, a well-secured loan may have a small shortfall or none.
• Declining balance. Repayment reduces the balance and may reduce the shortfall. A level death benefit stays fixed, while a decreasing-term policy is a structure whose death benefit falls over time. Each is a structural option. Whether a lender accepts a declining amount depends on the lender.
• Number of principals. Conventional lenders may set their own approach where several owners are active, since the SOP condition centres on one owner.
• Loan term. The coverage period generally needs to run as long as the lender's requirement does, and lenders set that requirement.
• Lender policy. For conventional loans and for 7(a) Small and Express loans, the lender's written policy may specify an amount, a policy type or an assignment form.

Potential Advantages of Carrying Loan-Protection Life Insurance

Debt that outlives its main earner can fall on whoever remains. Loan-protection coverage may provide several advantages:

• Death proceeds can retire debt that surviving owners, partners or heirs might otherwise repay from personal or business assets.
• A collateral assignment, as described above, limits the lender's claim to the debt and leaves any death benefit above it to the named beneficiary.
• A policy with cash value has a contract feature that the owner may be able to access under the policy's terms. Any such access is subject to the assignment and to the lender's rights.

Important Considerations Before Structuring the Coverage

Costs and complications sit alongside the benefits.

Deductibility. The premium bar covered in the ownership section above is one cost consideration. The business life insurance cost page covers how premiums are set.

Transfer for value. If the policy is later transferred for valuable consideration, for example in a buy-sell restructuring, 26 U.S.C. § 101(a)(2) may limit the exclusion "to an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee." The statute lists exceptions to that limit.

Employer-owned contracts. When a business owns a policy that covers an employee, including an officer, director or highly compensated employee, and is directly or indirectly a beneficiary under it, 26 U.S.C. § 101(j) caps the exclusion at the premiums and other amounts paid. The cap is lifted only if a section 101(j)(2) exception applies and the written notice and consent requirements were met before the contract was issued. An exception alone does not lift the cap, and notice and consent alone do not lift it either.

Lapse. If premiums stop and the policy lapses during the loan term, the lender loses its collateral. That loss may affect the loan's standing under its terms.

Coordination. The insurer acknowledges the assignment, and a lender's form may differ from the insurer's standard form. Forms and procedures vary and are confirmed with both the insurer and the lender.

State law. Assignment rules, free-look periods and other contract rules vary by state.

When to Review the Coverage Amount

A shortfall-based requirement is a moving figure, so certain events typically prompt a fresh look:

• Refinancing or restructuring. A new loan amount or a new collateral position changes the shortfall.
• Large principal paydown. A lower balance may shrink the shortfall.
• Ownership changes. Adding or losing a principal, converting a sole proprietorship to an LLC or corporation, or a partner's departure may change whether the SOP condition is met. The business succession life insurance page covers ownership transitions.
• Collateral value changes. Appreciation in pledged real estate, for example, may reduce the shortfall without any paydown.
• Payoff. When the loan is repaid, owners typically obtain written release of the assignment from the lender and confirm the release with the insurer. They then decide whether the policy still serves another business purpose.

Hypothetical Example: Sizing Coverage to the Collateral Shortfall

This example is hypothetical. It uses round figures and does not represent any reader's result.

Assumptions:

• A Standard SBA 7(a) loan of $500,000.
• The borrower is a single-member LLC.
• The lender values the pledged equipment and receivables at $300,000.
• The lender measures the shortfall as the balance minus the collateral value.

Step 1, at origination:

• $500,000 loan − $300,000 collateral = $200,000 collateral shortfall.
• Under these assumptions, the SOP's requirement is coverage "in the amount of the collateral shortfall," which is $200,000, not $500,000.

Step 2, after five years:

• Assume the balance has fallen to $350,000 and the collateral value is unchanged.
• $350,000 − $300,000 = $50,000 shortfall.

Result. A level $200,000 policy would then exceed the shortfall in this example. A decreasing-term structure could be arranged to track the shortfall more closely, if the lender accepts it. Actual collateral valuations, loan terms and lender requirements vary.