Who Needs Key-Person Insurance?

Practically every business owner will tell you that it takes more than one person to build a profitable business. It’s likely that several “key employees” will contribute to the success of an operation. However, while a business owner may be careful to make sure that he or she is adequately insured, the need to protect the business against the loss of a key employee is often ignored.

Fortunately, there’s a relatively easy way to safeguard the business. Appropriately enough, it’s called “key person” insurance.

Typical situation: A company takes out a life insurance policy on someone whose presence is considered crucial to the business operation. In some cases, the proper insurance protection can mean the difference between solvency and bankruptcy for the business.

The life insurance proceeds from the policy could be used for any or all of the following purposes:

  • Finding, hiring and training someone to take the place of a deceased worker
  • Paying bills to maintain the company’s good credit rating
  • Paying off business loans, which lenders may call after the death of an owner/officer
  • Making up for the loss of revenue caused by the subsequent disruption to the business

Who should be covered by a key-person policy? Start with the owner and president of the company. The rest of the group depends on the type and size of the business. For example, it may be worthwhile to insure a top salesperson, creative talent or frontline manager.

Premiums are generally not tax deductible. However, when the key person dies, the business receives the proceeds of the policy tax-free. In addition, the life insurance proceeds generally are not part of the key person’s estate. But if he or she is the sole or controlling shareholder, the proceeds may be taken into account for determining the value of the stock for estate tax purposes.

Finally, as long as there is a legitimate business reason for the insurance, the business should be able to avoid any accumulated earnings tax problem.

What happens if the key person leaves the firm for some reason? Generally, there are three options for the business owner to ponder. The company may(1) sell the ex-employee the policy as a fringe benefit, (2) transfer the policy to another key person or (3) surrender the policy for its cash value.

With the proper planning, you should be able to cover all the life insurance needs of your business. Consider this to be an important aspect of the business-planning process.