Key Person Insurance

Key person insurance is coverage a business purchases on an individual whose death or disability would materially harm the business: a founder, a lead salesperson, a technical specialist, or anyone whose departure would cost the company revenue it cannot quickly replace. The National Association of Insurance Commissioners describes group life and key person insurance together as coverage "designed to help employers protect their most valuable assets — people."

The structure is what defines it. The business is the applicant, the owner of the contract, the payer of premiums and the beneficiary; the employee is merely the insured. That arrangement requires an insurable interest, which a business generally has in an employee whose services it depends on, and it puts the policy squarely inside a set of tax rules that do not apply to personal life insurance. Both a life form and a disability form exist, and the NAIC describes the disability version in the same terms: "since the company pays the premiums and is listed as beneficiary, if a key person is disabled the company can use insurance payouts to cover related costs until the employee can return to work or a replacement can be hired."

Premiums are not deductible, and the rule is short. Internal Revenue Code section 264(a)(1) provides that no deduction shall be allowed for "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." Since being the beneficiary is the whole design of key person insurance, the premiums are a nondeductible cost of doing business. The mirror image confirms it: IRS Publication 334 lists as deductible "life insurance covering your employees if you are not directly or indirectly the beneficiary under the contract." Group life for staff is deductible; key person coverage is not.

The death benefit is not automatically tax-free, and this is the trap. Most people know life insurance proceeds are generally excluded from income under section 101(a). Section 101(j) narrows that for employer-owned contracts. Its general rule provides that for an employer-owned life insurance contract, "the amount excluded from gross income of an applicable policyholder by reason of paragraph (1) of subsection (a) shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract." In other words, the default is that everything above the premiums paid is taxable income to the business.

The exceptions in section 101(j)(2) restore the full exclusion, but they open with a condition that is easy to read past. They apply only "in the case of an employer-owned life insurance contract with respect to which the notice and consent requirements of paragraph (4) are met." Only then does the exclusion survive for an insured who "was an employee at any time during the 12-month period before the insured's death" or who, at the time the contract was issued, was "a director," "a highly compensated employee within the meaning of section 414(q)," or "a highly compensated individual within the meaning of section 105(h)(5)," with a modified percentage. A separate exception covers amounts paid to the insured's family, designated beneficiary, a trust for them, or the insured's estate, or used to buy an equity interest in the business from those persons.

The notice and consent are a pre-issuance formality with permanent consequences. Section 101(j)(4) sets three requirements, all of which must be satisfied "before the issuance of the contract." The employee must be "notified in writing that the applicable policyholder intends to insure the employee's life and the maximum face amount for which the employee could be insured at the time the contract was issued"; must provide "written consent to being insured under the contract and that such coverage may continue after the insured terminates employment"; and must be "informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee." A business that skips the paperwork cannot cure it later, because the statute fixes the timing at issuance.

There is an annual reporting obligation. The IRS directs a business to use Form 8925, "Report of Employer-Owned Life Insurance Contracts," to report the "number of employees covered by employer-owned life insurance contracts issued after August 17, 2006" and the "total amount of employer-owned life insurance in force on those employees at the end of the tax year." The date is the enactment of the provision, so contracts issued before it are outside the regime.

Sizing the coverage is a business calculation, not a personal one. For personal life insurance the question is what a household needs. Here the question is what the business loses: the revenue attributable to that person, the cost of recruiting and training a replacement and the time it takes, any loan or lease with a guarantee or covenant tied to that individual, and the operating runway needed while the business steadies. Lenders sometimes require key person coverage as a condition of a business loan, and the required amount in that case is set by the loan rather than by the analysis.

How it differs from a buy-sell arrangement. Key person insurance funds the business through a loss of earning capacity. A buy-sell agreement funds the purchase of a departing owner's interest and pays whoever is buying that interest. A business with two owners may need both, and they are separate policies with separate purposes even where the same person is insured under each.

1. Identify the person and quantify the loss. What revenue depends on them, what replacing them costs, and how long the gap lasts.
2. Obtain written notice and consent before the policy is issued. All three elements in section 101(j)(4), completed in advance. This step is the one businesses skip and cannot repair.
3. The business applies as owner and beneficiary, and underwriting proceeds on the insured's health.
4. The business pays the premiums, which are not deductible under section 264(a)(1).
5. The business reports the coverage annually on Form 8925.
6. On a claim, the business receives the proceeds and uses them for whatever the loss requires: payroll, debt service, recruiting, or simply time.

A hypothetical shows what section 101(j) costs a business that skips step 2. A C corporation buys a $1,000,000 policy on its lead salesperson and pays $4,000 a year in premiums for six years, $24,000 in total. The salesperson dies and the company collects $1,000,000.

• With notice and consent obtained before issuance, and the insured having been an employee within the 12 months before death, the exception in section 101(j)(2)(A)(i) applies and the full $1,000,000 is excluded from the company's gross income.
• Without it, section 101(j)(1) caps the exclusion at "the sum of the premiums and other amounts paid by the policyholder for the contract," which is $24,000. The remaining $976,000 is taxable income to the business. At the 21 percent corporate rate that is $976,000 × 21% = $204,960 of tax on a benefit the company assumed was tax-free.

The paperwork that would have prevented that outcome was three written statements signed before the policy was issued. These are hypothetical figures illustrating the statutory cap, not a prediction of any particular result.

Pros

• Gives the business cash at the moment its earning capacity drops, which is precisely when borrowing becomes hardest.
• Can satisfy a lender's condition on a business loan, and can reassure investors and large customers that a single-person dependency is covered.
• Term coverage on a healthy person in mid-career is usually inexpensive relative to the exposure it addresses.
• A disability form exists alongside the life form, which matters because a long disability is the more probable event for most working-age people.

Cons

• Premiums are not deductible, under section 264(a)(1), so the cost is paid with after-tax dollars.
• The death benefit is taxable above premiums paid unless a pre-issuance notice-and-consent procedure was completed, and the failure cannot be cured afterwards.
• It creates an annual reporting obligation on Form 8925.
• It requires the employee's written consent, which means a conversation about insuring their life that some employees find uncomfortable.
• Cash-value forms are marketed for this purpose and cost several times what term coverage does; the products paying the largest sales commissions tend to be the most aggressively presented, so who is bringing the illustration matters as much as which product it describes.
• It does not replace the person, and a business dependent enough on one individual to need the policy may have a structural problem the insurance does not solve.