The value of a business is measured by the quality of the people in it. You put so much time and money into recruiting, training and developing your team of key people. Have you thought to yourself what would happen if your best salesman, partner or engineer were to die suddenly? Have you considered what would happen to the business without that key person? How would you replace that income? Worse, how long would it take you to find a new employee?
Key person life insurance may be the most valuable insurance for your business. This post will explore what “key man” life insurance is the best for your employees.
What Is Key Person Life Insurance?
Key person life insurance, also known as key man life insurance, is a life insurance policy taken by a business on its key employee or employees in case they should die prematurely. The business is the beneficiary of the policy, and the proceeds are intended to protect the business from a financial fall due to a loss of that special talent or a key person in the company.
Key person life insurance is considered a type of policy rather than an actual policy, which means it could be any type of policy such as term, whole or universal life.
Who Is a Key Employee?
A key employee is an individual who poses a special talent, skill, leadership or experience that contributes significantly to your business income. Losing that “special” person can have many negative effects on a business’s bottom line. Examples of a key person are the business owner, CFO or vice president.
Why Should a Business Get a Key Person Life Insurance Policy?
Having a business is full of unpredictable risks, and the higher the risks, the greater the rewards. However, there are some risks that you shouldn’t attempt to take.
Just ask yourself this question: How will your business survive the death of a key person? What if that key person is your business partner who is also a top salesperson and responsible for 70% of sales in your company?
The purpose of insurance is to replace a financial loss. If a loss of a particular person in your company will cripple the company, you should get key person life insurance. This ensures the survival of the business for clients, employees and creditors.
Who Owns the Life Insurance Policy?
The company is responsible for the paid premiums and is the beneficiary in case of death of the key person. The company may agree in advance to split the death benefit or to pay some for the deceased’s family.
How Much Life Insurance Is Advisable?
There is no a clear answer or formula for this question. However, keep in mind that the life insurance underwriter will only allow 5–10 times the key employee’s income. In other words, if he/she makes $100,000 per year, the max death benefit the company could buy is $1 million. There are a few questions you can ask yourself in trying to assess how much the key employee is worth to your business:
- How much does the key employee contribute to the overall company’s income?
- How long will it take to replace and train a new employee?
- What is the cost of temporary replacement?
- What is your budget?
- What is the age and health of the key person? This will determine the premium.
If a company is earning $1 million per year, the key employee is responsible for 20%—or $200,000 per year—of the company’s income, and it may take you 4 years to get a new replacement and training in place, then you should consider buying a $800,000 life policy.
Underwriting Process for Key Person
The life insurance carrier will look into a few details regarding the business and also the key person who needs to be insured. The underwriter will ask about the…
- Type of business
- Role in organization
- Specialized skills
- Cover letter indicating how the financial loss is calculated
As for the individual, the underwriter will look at age, current health, and medication, to name a few. The healthier and younger the key person is, the lower it will cost to insure him/her.
You can learn more about individual life insurance underwriting here.
What Kind of Life Insurance Should I Buy?
There are two types of coverage you can buy:
- Term life – This is probably the most common policy a business owner would buy, because it’s the most economical, and the term—or length—is usually sufficient. For instance, if my key person is 45 years old, and I know he will be retiring by age 65, why would I buy whole life coverage? He will not stay with me until 95 years or longer. A 20-year term policy will be sufficient. Further, I may recruit or train a different key person in 5–10 years and can drop that policy, since I don’t need it anymore.
- Whole life – As the name implies, this type of policy will last forever. You will build cash value into the policy, which you can cash out by surrendering the policy, or you can take a loan in future years. However, this type will be a lot more expensive than a term coverage.
Sample Key Person Term Life Rates
10 Year Level Term Male
10 Year Level Term Female
20 Year Level Term Male
20 Year Level Term Female
Are the Premiums Tax Deductible?
According to the IRS, Section 1.264-1(a) of the tax code provides that the premiums paid for life insurance on the life of any officer, employee or person financially interested in a business carried on by the taxpayer are not deductible where the taxpayer is directly or indirectly a beneficiary of the policy.
In other words, if you are directly or indirectly a beneficiary of such contract, you CANNOT deduct this as a business expense.
Are the Proceeds Taxable?
Generally speaking, life insurance proceeds are tax free. When it comes to a key person life insurance, the business must obtain the individual’s written consent in order to have a tax-free death benefit. There are no exceptions to this rule, even if the insured is the business owner or partner.
Under Pension Protection Act of 2006, these are the steps you must follow:
- The employee must be notified in writing about the intention of the business owner to buy life insurance and the death benefit amount. This must be done prior to the policy being issued.
- The employee must agree to being insured and that the employer may keep the policy in force even after the employee is no longer working there.
- The employee must be notified that the employer is the beneficiary of the policy.
The insurance company will provide the required forms to get employee consent; however, checking with your tax attorney is always be advisable.
You can learn more about the Pension Protection Act here.
Key man life insurance is a great way to protect your most important asset: your key people. It can also be used as an incentive to the key employee if, for example, you commit to sharing the death benefit with their family members.
Monetary compensation may be the only way a business could continue to operate after losing its owner or other key person. Investing in the future of your business may be as simple as insuring your key people.
You can go ahead and run free quotes on the bottom of this page, or give us a call at 866-326-3053 for a personalized quote.
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