Key person insurance is a life insurance policy a business takes out on the life of a vital employee. A key person is someone who makes significant contributions to a company and whose death would have a negative impact on the business. That person could be the company’s CEO or Founder, for example, or the Chief Sales Officer who brings massive revenue to the company.
Key person insurance, also known as key man insurance, can be an essential tool for businesses to protect themselves from the financial impact of a key employee’s death or long-term or permanent inability to work.
Key person insurance is often a requirement if your company wishes to obtain a loan or investment, as the SBA and many banks make this part of their lending criteria. Small businesses are typically more dependent on one or two essential employees than larger companies, so this type of protection can be vital for startups.
Is key person insurance tax deductible? might not be the most important question to ask, but the answer could influence your decision. So, if you are wondering whether or not you need key man insurance, answer this question: Would your business suffer financially if a key employee died or suffered a disability preventing them from working? If the answer is “yes,” you should consider purchasing key person insurance.
This coverage can help to offset the costs associated with the death or disability of a key employee, such as lost profits, recruiting and training expenses, and other financial burdens.
Let’s learn a bit more about key person insurance before we answer the central question: is key person insurance tax deductible?
How Does Key Man Insurance Work?
Much like any other life insurance policy, a key person insurance policy has three roles you should know about:
- Insured: The insured person is the company’s key contributor and the person whose death or disability would trigger a payout. The insurance premium will depend on this person’s age, health, and lifestyle, among other things.
- Owner: The policy owner is typically the company that takes out a life and disability insurance policy on the key employee. The company pays the policy premium and therefore has the right to change the policy terms or even transfer or sell the policy.
- Beneficiary: This is the person or the company that would receive the benefits in case of the insured’s death or long-term incapacity to work. You should note that, in order for the beneficiary to receive the agreed benefits, the unfortunate event must occur during the coverage period.
Before taking out a policy on one of your essential team members, you should choose between a life or a disability policy. A life insurance policy will pay the death benefits if your key employee passes away. A disability insurance policy will reimburse a firm for the expenses incurred due to the vital individual’s partial or total absence, regardless of whether it’s temporary or permanent.
The best solution might be to include a disability rider in the life insurance policy to ensure you cover multiple scenarios.
Note, however, that you must notify the key person of your intentions of getting a key person insurance policy on them, present them with the details of the coverage you’d want to obtain, and get written consent before the purchase.
Key Person Insurance Policy Types
There are two main types of key man insurance policies: permanent and term life insurance.
Permanent life insurance policies provide coverage for the entire lifetime of the insured person. The death benefit from a whole-life policy is paid out regardless of when the insured person dies. Permanent life policies also have a cash value component, which grows over time and can be accessed by the policyholder during the insured’s lifetime.
Term life insurance policies provide coverage for a specific period, typically 10, 20, or 30 years. The death benefit from a term life policy is only paid out if the insured person dies during the policy term. Term life policies do not have a cash value component.
Key person insurance policies are commonly term policies because they are significantly cheaper, and can get extended, if necessary. It might be a good idea to get flexible coverage so you could change the insured person if they leave the company and increase or decrease the premium accordingly.
Is Key Person Insurance Tax Deductible?
If the company is the owner and beneficiary of the key person insurance policy, the premium paid for the policy is not tax-deductible as a business expense. You should pay the premiums with the so-called after-tax dollars. The IRS explains that no life insurance policies are tax-deductible if the taxpayer (the company) is the policy beneficiary.
You must report every key person policy you have in place for yourself, your executives, or other high-contributing individuals to the IRS with all required supporting documentation. That means you will need to include the number of employees you have the policy for, their consent forms, and the amount of coverage for each insured.
Businesses can deduct their key person insurance premiums only if they are a part of the employee’s taxable income. In that case, the beneficiary is the employee, which doesn’t happen very often because the insured and their family would receive all the benefits if something happened to the insured.
Key person insurance might not be tax-deductible, but the benefits beneficiaries receive in case of disability or death are typically income tax-free. The only time this would not be the case is if the company is a C corporation, where policy proceeds would be a part of the AMT (alternative minimum tax) calculation.
You should always consult with your tax advisor and legal counsel before filing company taxes to ensure you do everything by the book. You wouldn’t want to miscalculate your taxes and deductions, so getting expert help is strongly recommended.
How Much Key Man Insurance Coverage Do You Need?
Unless you need to borrow money from a lender who requires a certain limit on your key person insurance policy, there is actually no one size that fits all regarding the amount of coverage you need. Your main goal when choosing how much coverage you want to purchase is to ensure you would minimize the damage from losing an essential employee with the benefits you would receive.
It is not always easy to determine how much your company stands to lose in case something happens to one of your vital employees or yourself. If the person is a valuable sales team member, you would have some actual numbers that could help you make your calculations. Otherwise, you might want to consider enlisting help from financial experts.
Here are some methods that can help you calculate the amount of key man insurance coverage you should purchase:
- Multiple of Salary Method: This method uses a multiple of the key person’s salary to determine the amount of coverage. For example, if the key person’s salary is $100,000 and the business wants to purchase $1 million in coverage, the company would use a 10x multiple of salary.
- Replacement Cost Method: This method calculates the cost of replacing the key person. The business would estimate the costs of recruiting and training a new employee to replace the key person.
- Financial Impact Method: This method estimates the financial impact of the key person’s death on the business. To do this, the company would calculate the lost revenue and profits resulting from the key person’s death.
The amount of coverage is not the only determinant of your policy premium. The type of policy and the limits you choose also influence the premium you’d have to pay. We already mentioned the insured’s age, health, and lifestyle as factors that affect policy price, but you should know that the insurer will also look into your company size, structure, and industry when calculating your premium.
If you would like to learn more about how each of these factors influences the cost of your policy, you can read our guide on the key person insurance cost.
So, is key person insurance tax deductible? As you can see, the short answer is no. But this is probably not the most critical question you have in mind when thinking about purchasing the policy for your indispensable team members.
The purpose of having a key person insurance policy is to ensure your business doesn’t lose its financial footing if you (permanently or temporarily) lose a vital team member. This is particularly significant for small businesses that rely on company founders, CEO, or other essential individuals to keep the operations running.
If you purchase a portable or transferable policy, the employee could take over ownership of the coverage if they decide to leave the company. Like that, key man insurance can be a part of employee benefits, and you can use it to attract both top talent and experienced candidates.
If you would like to learn more about the coverage, you can always reach out to one of our experienced brokers who can help you find the best option for your business. If you are ready to get an online quote for your key person insurance policy, feel free to sign up to Embroker’s digital platform and get started.
*The information contained herein is subject to Embroker’s Terms, is based upon Embroker’s experience as an insurance broker, available information, current insurance information, and marketplace, or may be of a general nature. Nothing in the content provided should be construed as tax, accounting, legal or actuarial advice. While we provide comments and recommendations related to the types and terms of insurance coverage, the decision to act or not act is ultimately the insurance purchaser’s alone.