Small Business Owner's Guide to Protecting your Family and Small Business

Running a business is complex, and unfortunately it results in additional legal and financial risks to your family. Your personal and business lives are inextricably linked and that means you need a plan that addresses both your business and personal assets to truly protect your family. If you’re not properly protected, your entire financial plan can be derailed in a moment. This guide will go over a basic blueprint to help you understand the basic steps to protecting your family and small business.

Protection Planning is a critical yet often ignored part of any small business owner’s financial plan. Typically, small business owners like to focus on the exciting parts of a plan – like reducing taxes or investing money into new projects. However, what happens if the money stops? If the worst were to happen, your grand plans don’t matter and you’re back to square one.

At its core, protection planning is about preventing a situation like that from occurring.

So, what steps can you take to protect you, your family, and your small business? Ironclad Wealth Management breaks down protection planning into three main categories:

1. Income Based Risks
2. Asset Based Risks
3. Business Risks

Each category is complementary and equally as important. A plan can fail if any part is ignored. Let’s break these down and review what you need to protect your small business and family.

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Income Based Risks

Income based risks are categorized as risks or actions that can reduce or stop your income. Income based risks are infrequent, but are devastating when they occur.

Step 1: Disability Protection

The first major risk that you face as a small business owner is a health event that results in your being unable to work and produce income. Health events like this are twice as likely as death for the average American.

In this scenario, you are effectively retired early with additional health costs. If you’re reading this and you’re 35, 45, or 55 – ask yourself “could I retire today?” If the answer is no, you need a plan to protect you and your family.

So, what happens in a health event like this? Let’s look at a few different scenarios for a small business owner earning $500,000 per year.

When you’re disabled, you lose your most valuable financial asset – your ability to earn income. As you can see above, the income loss is so substantial that it’s borderline impossible to self-insure the risk, especially early in your career.  In addition, you probably face increased medical expenses at the same time.

What options do you have to protect your small business and your family in this scenario?

• NOT Health insurance (covers medical expenses, but DOES NOT replace income)
• Social Security – is based on your earnings record and has a low maximum, you must have worked 5 out of the last 10 years, and it has a long approval process. You can estimate benefits here.
• Group Disability Policy – must have multiple employees and benefits are not as good as an individual policy.
• Individual Disability Policy – harder to get than group but has the best benefits.
• Business Profits - You build a business that can run without you being involved in the daily operations and you continue to receive business profits.
• Self-insurance – your investment assets are sufficient for you to “retire early” if needed.

At the end of the day, the absolute best option for every business owner is to have a business that generates income while not having to rely on the business owner to operate. In that scenario, your income would continue with a dip while the new manager begins to understand and operate the business.

However, that is not possible for many business owners. If you’re a solo entrepreneur, you are critical to a technical process, the key salesperson, or don’t have the team who can handle the business on their own, you won’t be able to utilize that option.

If that’s the case, your best option is a disability policy. Put simply, a disability insurance policy replaces your income while you are unable to work. These benefits typically max out at 60% of your income (which is much higher than SSDI) and the benefits are tax-free if you don’t write off the premiums as a business expense.

Here’s how we think about disability policies:

Essentially, you are giving up some of the best-case scenario’s upside, to protect the worst-case scenario’s downside when you buy a disability policy. In this scenario, you give up $10,000 of your income to guarantee that your income doesn’t go below $300,000 in the event of a disability. In the case of a small business owner with a business and family to protect, I know which one I would choose.

We recommend the following for small business owners trying to protect their income:

1. Create a business independent from the daily efforts of the business owner
2. Self-insure with investment assets
3. Individual Disability Policy
4. Group Disability Policy

If you can’t achieve 1 or 2, you most likely need a disability policy. There are also disability policies that provide several months of your expenses to help you find a new manager. If you think your business could operate after a 6-12 month adjustment period, a policy called a “Business Overhead Expense” policy may help. Disability policies can be complicated, but with the right guidance you can find a solution that solves your health risks and protects your business and family.

For a deeper dive into disability insurance, check out our disability insurance blog here.

Step 2: Protecting Against the Risk of an Early Death

The second major risk to your family and business is death. While death is something that no person’s family can emotionally prepare for, it is something that can be prepared for financially. Modeling and preparing for the worst to happen is key for any small business owner seriously invested in protecting their family.

As with disability, death results in what is effectively an early retirement for those you have left behind. Your income stops and the assets that you have left behind are what is available to live on.

When you pass away, your family has a few options to generate income:

1. Continue to operate the business.
2. Sell the business.
3. Live off personal salary/income.
4. Live off other investment assets.
5. Live off insurance proceeds.

To determine the best option for you and your family, the first questions you need to answer are how much your current living expenses are, how much income your family would have if something happened today, and how long would they need to replace your income.

Here is an example of how much someone with $10,000 a month of living expenses may need:

Once you’ve determined how much you need, you can then determine if there are any assets you have that will allow your family to offset the amount needed. This could come in the form of a spouse’s salary continuation, investment assets, or the value of the business once sold. Keep in mind, if you pass away without a plan your business may be sold for a significantly lowe value than you would otherwise expect.

Here's how this may look:

As you consider ways to better calculate this number, you need to remember that some of these assets are reserved for retirement and may need to be excluded when calculating this figure. Other assets may also be worth less than normal – like your business without you running the ship. While you don’t want to over insure yourself, you definitely don’t want to underestimate your insurance need and leave your family and business at risk.

Here’s how I would go about thinking about life insurance to protect my family:

1. Calculate the total need by talking to either a financial planner or using https://lifehappens.org/life-insurance-needs-calculator/
2. Determine if there are other sources of income available that lower my need.
3. Subtract #2 from #1 and determine how much insurance I need.
4. Review quotes for insurance with a financial planner/insurance agent.

If you follow these steps, you will be well on your way to protecting your family and the value of your small business in the event of your death.

If you’d like to review a more detailed blog on life insurance for small business owners, check out our deep dive here.

Asset Based Risks

While the income-based risks may be the largest risks that you face, asset-based risks are more common and need to be considered as a part of any financial plan. In the case of a business owner, operating a business exposes you to increased liability. Planning before anything happens is the only way to protect you and your family.

Step 3: Emergency Fund

An emergency fund is the most basic building block of not only a protection plan for a small business owner, but the financial plan itself. Above all an emergency fund must be safe and liquid. This means that it is invested in assets that won’t reduce in value and that you can access the funds when needed. At its core an emergency fund allows you to absorb unexpected financial shocks without having to incur high-interest rate debt. Having a secure foundation allows you to take more risks and put the rest of your money to productive use.

There are two general rules for emergency funds:

• Single Income Earner – for families with one income, the general rule is 6x your monthly expenses in liquid assets.
• Dual Income Household – for dual income households, the general rule is 3x your monthly expenses.

However, these general rules don’t always meet the personal, financial and psychological needs of small business owners. In some cases, we use a third benchmark to plan for clients’ emergency fund needs – the "sleepwell" number.

While it may be nice to think of the emergency fund as a simple formula – 3x or 6x your monthly expenses. That sometimes misses an important part of any emergency fund – the ability to give you confidence to take risks. Sometimes, this requires more than 3x-6x your monthly expenses. When we say “sleepwell” we mean a number that when you see it in your bank account reduces stress, lets you sleepwell at night, and gives you confidence to take risk.

Once you have found your emergency fund number, you won’t want to keep the funds in a checking account that pays little to no interest. Remember, you want these assets to be both safe and liquid. There are two places that our clients keep their emergency fund:

• A brokerage account where you invest in money market/treasury bill funds
• A high-yield savings account (typically online digital banks will offer higher rates than your traditional big banks)

Finding and funding the right emergency fund is a boring, yet critical step in a small business owner’s protection plan.

Step 4: Health Insurance

The second risk to your assets is a health event. As we discussed earlier, a health event has the potential to reduce or stop your income. At the same time, significant medical bills may overwhelm your emergency fund if you are underinsured. If you don’t have health insurance, you are giving up control of your finances. Health insurance is the first line of defense from health-based risks.

When you start your own business, you typically lose health insurance that you carried as a W-2 employee. Once this happens, small business owners typically get health insurance from one of a few sources:

• Their spouse’s employer plan
• COBRA insurance for a short time after you leave your employer
• A group plan they set up for their own employees
• An individual plan through the ACA exchange
• A non-ACA compliant plan

In its purest sense, ACA compliant health insurance is a way of converting the unknown costs of medical care into a capped annual amount.

Without health insurance, you are on the hook for all your medical treatments. With health insurance you will pay your premiums, deductible, copays, and eventually you may reach your max out of pocket. While you’re still paying for quite a bit, and it feels like it’s entirely too complicated (it definitely is!) , it’s a much better situation than paying for the unknown balance of an unexpected medical issue.

While it may be tempting to try and skirt the rules with non-ACA compliant coverage or ignore health insurance entirely, you are essentially giving up control over your finances when you do this.

Here’s a quick comparison:

If we all knew the future, we would only hold insurance for the years we need to and would never have to worry about paying unnecessary premiums. However, we don’t know when a health event will happen and to properly protect ourselves, health insurance is a must.

Because of this, the only options that we view as untenable are non-ACA plans or not carrying any insurance at all. Whether you use your old employer’s plan, your spouse’s plan, or an individual ACA plan, carrying coverage that caps your annual spending is a must.

Step 5: Home and Auto Insurance

The most common asset-based risk that you face is liability derived from automobile and home accidents that you are liable for. Compared to other risks, the answer to a home and auto accident is straightforward because you are legally mandated to have home and auto insurance. The real question with home and auto insurance is where you set your deductible, and the liability amounts that you select.  

We typically recommend that your home and auto insurance be sufficient to allow you to purchase an umbrella policy. This typically requires policy limits of $250,000/$500,000. A home & auto agent will be able to design these quotes for you.

Step 6: Liability Coverage

In certain cases, home and auto coverage may be insufficient for potential liabilities brought against you. An umbrella policy covers the excess risks covered by accidents that you are liable for. Typically, liability insurance is much cheaper than home and auto coverage. However, you must have home and auto coverage before you can buy umbrella coverage.

We typically recommend that clients have an umbrella policy that is equal to their assets that could be subject to a claim or judgment.

Step 7: Estate Planning

While life insurance can help replace your income in the event you pass away, a properly designed estate plan is a crucial piece of any protection plan.  Without a will, you leave your family to go through probate and if you both pass away, you leave the courts to appoint guardians for your children. Properly designed estate documents are critical to your family and small business being protected.

A basic estate plan contains at least 3 documents:

1. A will
2. A power of attorney
3. An advance healthcare directive

Once you have these three documents in place, you are well on your way to having a good plan. However, there are some complicating factors that may necessitate trust-based planning.

1. If you own property in several states
2. If you work in a highly litigious field
3. If you believe you may be subject to the estate tax
4. If you have a child, special needs or otherwise, who will need care after your passing.

If you are subject to any of these areas (and there are several other complications to consider) then it may make sense to invest in trust planning. For the purpose of protecting your family and small business, one interesting thing to note is that proper trust planning may segregate some of your assets from the claims of your creditors if you give up sufficient control.

All in all, our recommendation is this – create your basic estate plan, keep it up to date, and if your situation becomes more complicated, invest in speaking to an estate planning attorney to design a more comprehensive plan.

Business Risks

While the risks that we discussed earlier in this blog felt like personal risks, they are risks that can affect both you and your small business. The next set of risks are business-specific risks. And like the more personal risks, they can just as easily affect your personal life and family.

Every business is subject to its own unique risks and there is no way to capture your business specific risks in a blog. However, there are several key risks that most businesses face. We will cover the most common areas and how you can address each risk.

Step 8: Business Structure

There are several ways that you can structure your small business. The reason why this is important is that depending on how you set the business up, you may be personally liable for business claims.  

If you are a sole proprietor, meaning you have not set up an LLC, partnership, or corporation you have unlimited personal liability for the claims of the business. This means that every business action has the chance to directly impact you and your family. It doesn’t get more interconnected than that. A sole proprietorship is most common for those who got started part-time or who fell into business. If that’s you, you should consider updating your entity structure.

Luckily, there are several types of business structures available that limit your personal liability. LLC’s, S-Corps, and C-Corps all limit the claims to the business itself. This means that you can only lose your investment in the business and the business’ assets in the event of a judgement against your business.

Partnerships are slightly more complicated. General partners have unlimited personal liability and limited partners’ personal risk is limited to their investment in the partnership.

There is really no reason for you to operate as a sole proprietorship and subject you and your family to the liabilities that your small business may generate. It is impossible for me to tell you which type of business structure would be best for you in this blog, because there are several tax ramifications in addition to the legal ramifications. However, I can confidently say that you should elect to structure your business in a way that minimizes your personal liability.

Need a guide on how to setup a small business in Georgia? Check out our blog here.

Step 9: Business Insurance

The most common risks that you face as a small business owner often add an additional level of stress to the operation of your business. These can often be mitigated by insurance. These are common occurrences like:

• An employee being injured on the job
• A client suing you for faulty work (even if it was done well!)
• A customer being injured at your workplace

Even the best run and most well-intentioned small businesses can be sued or subject to legal claims. The only way to maintain control over your finances and life is to insure the risks that are insurable.

There are several types of business insurance that you may need to purchase including, but not limited to:

• General liability
• Worker’s compensation
• Errors and Omissions Coverage
• Malpractice insurance
• And more

While it may sound like quite a bit of coverage and quite a bit of premium, many of these policies’ premiums are based on revenue and company size. So, while you are smaller, the premium will be less than for other companies.

We would recommend that you speak to a property and casualty agent that specializes in small business coverages to better determine which coverages are needed. We have referrals if requested.

Step 10: Partners – Operating and Buy-Sell Agreements

If you have one or more partners in your small business, you also face additional risks that should be accounted for. While almost all small business partnerships start with the best of intentions, divorce is a fact of life. Unfortunately, a business divorce can be just as ugly as a real divorce.

There are several documents that should be maintained to help minimize any future issues with a business partner – not only for you, but for your family.

The first and most critical document is the operating or shareholders’ agreement. An operating agreement is the governing document for your business operations and procedures. If there are any disagreements, the rules laid out in the operating agreement will govern the dispute. If there is no operating agreement, you fall back on your state’s default rules and it will be subject to court interpretation.

The second document that I find commonly neglected in a business is the buy-sell agreement. A buy-sell agreement dictates the rules for transferring your shares to another party – whether that be a sale, after death, or after disability.

Oftentimes, the buy-sell is done at the inception of a business as part of the operating agreement and then never thought about until a partner passes away. I cannot stress enough how much potential trouble this places you and your family in.

If you pass away without an updated buy-sell agreement, your family may be forced to sell at a lower value than is fair or it may result in onerous terms – like being paid out over 10 years with a low interest rate as an example.

If you don’t know what’s in your buy-sell agreement, or you don’t have one, take this as your sign to have one created.

Oftentimes, operating and buy-sell agreements are set up at the inception of a company and then ignored. However, proper maintenance as your business grows is essential to protecting yourself and your family from potential business disputes.

Our recommendation would be to have a lawyer draw these agreements up and review the agreements at least annually with your business partners to determine if changes are needed.

Step 11: Key Employee Risk

As your business begins to grow, you will most likely begin to hire people for roles that you don’t have time for or simply cannot do. This is a good thing because it means that you are building a true business that isn’t wholly reliant upon you.

However, it does mean that you are in a position where you need to protect your revenue and time. As a result, you need to incentivize and retain your employees to prevent and minimize business disruptions.

Outside of compensation, benefits become a tool to retain these employees. We categorize employee benefits into two categories:

• Mainline benefits
• Key Employee benefits

Mainline benefits are benefits accessible to all employees. They form the baseline of what your key employees expect when you extend them an offer, or they are considering another employer. These include things like:

• Health insurance
• 401(k) benefits
• Vision/dental insurance
• Group disability

While you may view these benefits as a burden, offering them as baseline for your employee is the first step in retaining the employee.

Once you have your mainline benefits in place and your business is operating well, you can offer specific, exclusive benefits to your best employees.

These benefits typically cost more, have claw back periods, and provide significant additional compensation to your best employees.

Here are a few types of benefits that you may consider offering:

Each of these benefits can make a significant impact for the right employee. Some of them offer equity and others offer a cash payment now or in the future. Which option is best for you, depends on your company, the employees themselves, and your desired tax outcome.

The thing to remember when you are designing a key employee benefit is that the benefits must be significant enough to matter. If you offer someone earning $200,000 a $5,000 annual benefit that is clawed back if they leave within 10 years, they may be offended and wonder why such a small benefit carries a penalty.

These benefits can provide significant golden handcuffs to employees, but if they’re not golden, they just feel like handcuffs!

Our recommendation would be to set up your mainline benefits first. Once you have that done, you can review and analyze which types of key employee benefits are best. Having said that, we are believers that the right plan can keep your best employees operating at their highest level.

Summary

Protecting both your family and small business is an ongoing effort that changes from year to year. However, sometimes it can be hard to know where to start. Hopefully, this blog gives you a good roadmap and helps you see any gaps you may currently have. While we can’t cover every risk, we hope this guide helps.

Ironclad Wealth Management’s main objective is to help small business owners create a financial plan that helps them achieve their goals. If your family and small business aren’t properly protected, the rest of your plans may not matter.

If you’d like to discuss your situation with Ironclad, schedule here!

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