Life insurance is a tool that many founders underestimate. They may have purchased a basic term policy when they had their first child, or they may be covered by a group life insurance plan through a prior employer that they have never updated. They may vaguely understand that life insurance is important but have not thought carefully about how much they need, what kind of policy makes sense for their situation, or how life insurance fits into a comprehensive estate plan. This is a significant gap, because for founders whose primary asset is illiquid equity in a private company, life insurance is not just a planning convenience — it is often the essential mechanism that makes the rest of the plan work.
The Fundamental Problem Life Insurance Solves
A founder’s family faces a specific financial problem that most people’s families do not: the possibility of inheriting a substantial amount of wealth that cannot be converted to cash quickly or easily. A founder who dies leaving a ten percent stake in a company worth fifty million dollars has left their family a five million dollar asset on paper. But if the company is private, there is no liquid market for that asset. The family cannot sell their shares on a stock exchange. They cannot readily find a buyer who will pay fair value on short notice. They may be subject to transfer restrictions that limit their options further. And the tax bill — estate taxes, if the estate is large enough, and income taxes on distributions from retirement accounts — may be due in cash within nine months of death, regardless of whether the family has any cash.
Life insurance solves this problem by providing a cash payment — the death benefit — that is paid to the named beneficiary promptly after the insured person dies. Unlike the business equity, life insurance proceeds are liquid. They arrive as cash. They can be used to pay estate taxes, cover living expenses during the period while the estate is being settled, replace the income that the founder was generating, or simply provide a financial cushion that gives the family the time to make thoughtful decisions about the business interest rather than being forced into a distress sale.
Term Life Insurance: What It Is and When It Makes Sense
Term life insurance provides a death benefit for a fixed period — the term. Common terms are ten, fifteen, twenty, or thirty years. If the insured person dies during the term, the insurance company pays the death benefit. If the insured person survives to the end of the term, the policy expires with no payment and no cash value. Term life insurance has no investment or savings component — the entire premium goes toward the cost of the death benefit.
Term insurance is typically the least expensive form of life insurance on a premium-per-dollar-of-coverage basis, particularly for young and healthy individuals. A healthy thirty-five-year-old founder can often purchase a twenty-year term policy with a death benefit of one million dollars for a relatively modest annual premium. This makes term insurance the most efficient tool when the goal is simply to provide a large death benefit during a specific period — for example, the years when the founder’s children are young and financially dependent, or the years when the company is in a growth phase and the founder’s income is critical to the household.
For many founders, the primary justification for life insurance during the early years of a company is income replacement: if they die, their family loses not only the value of the equity (which may be illiquid) but also the income that the founder was generating from a salary or S corporation distributions. Term insurance can replace that income stream, providing the family with the financial stability they need while they navigate the longer-term questions about what to do with the business interest.
Term insurance is also commonly used to fund buy-sell agreements between business partners. When two founders agree that the company or the surviving partner will buy out the deceased partner’s interest, they need a mechanism to fund that buyout. Life insurance on each founder’s life, owned by the company or by the other founder, provides the liquidity to fund the purchase at a time when the surviving partner may not have significant personal cash available. This use of term insurance is discussed in more detail in our article on buy-sell agreements.
Permanent Life Insurance: What It Adds and When It Matters
Permanent life insurance — which includes whole life insurance, universal life insurance, variable life insurance, and indexed universal life insurance — differs from term insurance in two fundamental ways: it does not expire (as long as premiums are paid), and it accumulates a cash value inside the policy over time. The cash value grows on a tax-deferred basis, meaning the policyholder does not pay income tax on the growth until they take withdrawals. In some circumstances, the policyholder can take loans from the cash value without triggering a taxable event.
Permanent life insurance is significantly more expensive than term insurance on a premium-per-dollar-of-death-benefit basis. Whether that additional cost is justified depends on the specific planning objectives the insurance is meant to serve. For most founders who need a large death benefit for income replacement and family protection purposes, term insurance is the more cost-efficient choice. But there are specific circumstances in which permanent insurance makes compelling sense for founders.
The most important of these is when the founder’s estate may be subject to federal estate taxes. Under current law, federal estate taxes apply to taxable estates above the applicable exclusion amount, which is substantial but which can be exceeded by founders who have built significant company value. Estate taxes are currently assessed at a forty percent marginal rate on the taxable estate above the exclusion. For a founder who dies with a large taxable estate, the estate tax bill can be enormous — and it is due in cash within nine months of death.
If the estate’s primary asset is illiquid business equity, generating the cash to pay the estate tax requires either selling the business (or a portion of it) at an inopportune time, taking out estate tax loans (which are available but expensive and complex), or having life insurance proceeds available to cover the bill. A permanent life insurance policy that is properly structured can provide a guaranteed death benefit at any age, ensuring that the liquidity is available whenever the insured dies — not just during a fixed term. This is one of the primary reasons that large permanent life insurance policies are a standard tool in the estates of high-net-worth business owners.
Why the Owner of the Policy Matters as Much as the Beneficiary
Most people focus on who is named as the beneficiary of a life insurance policy — who will receive the death benefit. This is certainly important. But the ownership of the policy is equally important, and it is an aspect of life insurance planning that founders frequently overlook.
Under federal estate tax law, if you own a life insurance policy on your own life at the time of your death, the death benefit is included in your taxable estate. This can seem counterintuitive: you might think of life insurance as something that benefits your family, not something that swells your taxable estate. But from a tax perspective, the right to control the policy — including the right to change the beneficiary, borrow against the cash value, or surrender the policy — constitutes an incident of ownership, and that ownership is what causes the death benefit to be included in the estate.
For a founder with a relatively modest estate, this may not matter much. If the estate is well below the federal exclusion amount, the inclusion of the life insurance proceeds in the estate does not produce any additional estate tax. But for a founder with a large estate — particularly one built primarily on private company equity — having a ten million dollar life insurance policy included in the taxable estate can produce a four million dollar additional estate tax bill that the family must pay in cash.
The solution to this problem is an irrevocable life insurance trust, commonly known by its acronym ILIT. An ILIT is a trust that is established specifically to own one or more life insurance policies. Because the trust owns the policy — rather than the insured — the insured has no incidents of ownership, and the death benefit is excluded from the insured’s taxable estate. The death benefit passes to the trust at the insured’s death, where it is held and distributed to the beneficiaries in accordance with the trust’s terms, free of estate tax.
Establishing an ILIT requires careful planning. The trust must be irrevocable, meaning you cannot change it or take assets back. Premiums on the policy are paid by making gifts to the trust, which are then used by the trustee to pay the insurer. Those gifts must comply with gift tax rules, including the annual gift tax exclusion. And if you transfer an existing policy into the ILIT rather than having the trust purchase a new policy, there is a three-year lookback rule: if you die within three years of transferring the policy to the trust, the death benefit will still be included in your estate for tax purposes. For this reason, it is generally preferable to have the ILIT purchase a new policy from inception, rather than to transfer an existing policy.
How Much Life Insurance Do Founders Actually Need?
Determining the right amount of life insurance requires analyzing what the insurance is meant to accomplish. There is no single formula that applies to every founder, but the analysis typically considers several categories of need.
Income replacement is typically the largest component for founders with families. If you are generating a salary or business income that supports your household, your death will eliminate that income stream. The amount of insurance needed to replace that income depends on the income amount, how long the income would need to be replaced (typically until your youngest child is financially independent), and the expected investment return on the insurance proceeds. A common rule of thumb is that the death benefit should be ten to twelve times the founder’s annual income, but this figure should be refined based on the specific family’s circumstances.
Debt coverage is another component. If the founder has personally guaranteed business debt, has a mortgage, or has other significant personal liabilities, the life insurance should be sufficient to cover those obligations so that the family is not forced to liquidate other assets to satisfy them.
Estate tax funding is a separate calculation for founders with large estates. The estate tax liability should be estimated based on the expected value of the taxable estate at the time of death, and a separate insurance policy — ideally held in an ILIT — should be sized to cover that liability.
Buy-sell funding is yet another component for founders with co-owners. The insurance on each founder’s life that is used to fund the buy-sell agreement should be sized to reflect the current value of the founder’s equity interest, updated periodically as the company’s value grows.
The total amount of life insurance that a founder needs may be substantially larger than they might initially guess, particularly once estate tax exposure and buy-sell funding are factored in. Working with both a financial planner and an estate planning attorney to determine the right amount and structure of coverage is an important step that should not be left to the life insurance agent alone.
The Coordination Imperative
Life insurance is most powerful as an estate planning tool when it is coordinated with all of the other elements of the estate plan. The policy ownership structure should account for estate tax planning. The beneficiary designation should be consistent with the distribution plan in the will and trust. The amount of coverage should reflect the current valuation of the business and the current amount of family debt and income replacement need. And if the policy is funding a buy-sell agreement, the amount and ownership structure of the policy should be consistent with the terms of the agreement.
Founders should review their life insurance coverage whenever there is a significant change in their personal or business circumstances: a major increase in the company’s valuation, a new funding round, a new child, a divorce, a change in the estate tax law, or the formation of a new business partnership. Life insurance policies that were adequate when they were purchased can become seriously inadequate as the business grows and the founder’s estate grows with it.
Life insurance is not a set-it-and-forget-it component of an estate plan. It is a dynamic tool that requires periodic attention to remain effective. But when it is properly sized, properly owned, and properly integrated with the rest of the plan, it is often the piece that makes everything else work — providing the liquidity that allows the family to hold the business interest, the cash to pay the estate tax, the funding for the buy-sell, and the income replacement that gives the family time to make good decisions rather than forced ones.