Guides
Key person life insurance
How key person life insurance works: who qualifies, how to size it, who owns it, and the tax rules (IRC 101(j), Form 8925) that apply to company-owned policies.
Key person life insurance is a policy a business buys on the life of someone it depends on, such as a founder, a top salesperson or a lead engineer. The business pays the premiums, owns the policy and receives the death benefit, which it can use to cover lost revenue, recruit a replacement or reassure lenders. Because the company, not a family, collects the money, federal law requires written notice and consent from the insured before the policy is issued if the company wants the proceeds to stay income tax-free.
What problem it solves
Some businesses lose far more than a salary when one person dies. Customer relationships walk out the door, a lender may call a loan, a project stalls, and investors lose confidence. The insurance does not replace the person. It gives the company cash while it recovers, in the same way a business owner's personal coverage gives a family time to adjust.
Typical uses of the proceeds:
- Covering lost profit during the months it takes to stabilize.
- Paying recruiting, relocation and training costs for a replacement.
- Retiring a loan the person guaranteed or whose repayment depended on them.
- Giving the company working capital if suppliers or customers tighten terms.
Key person insurance is different from a buy-sell policy. A buy-sell policy pays for an ownership transfer; a key person policy pays the company for the loss of a person's work. A founder-owner often needs both, plus personal coverage for the family.
Who counts as a key person
There is no legal definition for ordinary underwriting purposes, but the insurer must see a real financial interest. This is the insurable interest: who can buy life insurance on whom rule applied to a business: the company has to stand to lose money if the person dies. Insurers typically ask what the person contributes, how hard they would be to replace and how much revenue depends on them. Candidates include owners who run daily operations, the only rainmaker, a person holding a license or a technical skill the company cannot do without, or an executive named in a loan covenant.
How much coverage
Underwriters and advisers use a few rules of thumb. None is official, and the number should be defensible because the insurer may ask how you arrived at it.
| Method | How it works |
|---|---|
| Multiple of compensation | A set number of years of the person's pay and bonus, often with a ceiling set by the insurer |
| Lost profit | Profit the person generates, times the months or years needed to recover |
| Replacement cost | Recruiting, training and the productivity gap while a replacement ramps up |
| Debt coverage | The balance of loans that depend on the person |
A hypothetical example
Say a 12-person engineering firm earns about $900,000 a year in profit, and its founder, age 48, brings in most of the clients. The owners estimate that losing the founder would cut profit roughly in half for two years while the firm recruits a successor and rebuilds relationships. That suggests $900,000 of lost profit, plus $150,000 in recruiting and transition costs, so they look at roughly $1 million in coverage. The figures are illustrative, not a pricing quote or a recommendation.
Term or permanent
Most key person policies are term life insurance, because the need is tied to a period, such as the years until a successor is ready or a loan is repaid. Term costs the least per dollar of coverage. Permanent coverage can make sense when the person will always be central and the company wants a lifelong asset, but the cash value is an asset of the company and its creditors can reach it, and the premiums are not deductible either way. Read term vs whole life insurance: which fits you for the general trade-offs.
Ownership, beneficiary and the paperwork
The company is the policy owner and the beneficiary. The insured does not own the policy and has no say in who receives the proceeds, so the employee consent rule exists to protect them from being insured without knowing.
- Confirm the business reason and amount. Write down how you sized the coverage.
- Give written notice and get written consent before the policy is issued. Federal law at IRC section 101(j) requires that the employee be told in writing that the employer intends to insure their life and the maximum face amount, that the employer will be a beneficiary, and that the employee consents in writing (consent may continue after employment ends). See section 101(j) notice and consent.
- Apply and complete underwriting. The insured takes the exam and answers health questions; see how life insurance underwriting works.
- Keep the record. Retain the signed notice and consent with the policy file.
- File Form 8925 with the tax return each year you hold employer-owned life insurance contracts issued after August 17, 2006. The IRS describes it as reporting the number of covered employees and the total amount of employer-owned life insurance in force at year end, with the employer's return (IRS, About Form 8925).
Tax treatment
Two rules matter most.
Death benefit. Life insurance proceeds are generally income tax-free, but under IRC section 101(j) the tax-free amount on an employer-owned contract is limited to the premiums the company paid unless the notice and consent requirements are met and an exception applies. The exceptions include that the insured was employed within 12 months before death, or was a director, a highly compensated employee or a highly compensated individual when the policy was issued, or that the proceeds go to the insured's family, beneficiaries or estate, or are used to buy an ownership interest from them. A small company that skips the paperwork can turn a tax-free benefit into a partly taxable one.
Premiums. Under IRC section 264(a)(1), no deduction is allowed for premiums on a life insurance policy when the taxpayer is directly or indirectly a beneficiary. For key person coverage owned and collected by the company, that means premiums are generally not deductible. The rules for interest on policy loans are separate and more restrictive; see life insurance policy loans: how they work and what they risk.
A corporation that receives proceeds may also face an estate tax wrinkle if the insured is an owner whose shares are valued at death, which is the subject of the Connelly decision covered in cross-purchase vs entity-redemption buy-sell plans.
When the person leaves
If the key person leaves, the company can usually stop paying premiums, keep the policy if it has value, or sell or assign it. Be careful: selling a policy to someone other than the insured, a partner or a partnership, or a corporation in which the insured is a shareholder or officer can trigger the the transfer-for-value rule and make proceeds taxable. A common exit is selling the policy to the departing person at its value, but that transaction should be reviewed first.
Your plan should also cover the lender side: some lenders ask for a collateral assignment of life insurance of a key person policy, and the SBA addresses life insurance on certain loans; see Life insurance for an SBA loan.
Because ownership, consent and valuation rules interact, have a business attorney and a CPA review a key person plan before the application is signed.
Key takeaways
- Key person insurance is owned and paid for by the business, which also receives the benefit; it covers the loss of someone the company cannot easily replace.
- Size the amount from lost profit, replacement cost or debt, and document how you did it.
- To keep the death benefit tax-free, IRC section 101(j) requires written notice and consent before issue, and Form 8925 is filed with the company's return.
- Premiums are generally not deductible under IRC section 264(a)(1), and selling or reassigning the policy can trigger the transfer-for-value rule.
- Term coverage is the usual choice because the need is temporary.