Key Person Insurance is life insurance your business purchases on the lives of key employees.
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The purpose of Key Person Insurance is to help the company survive losing a person who is critical to the business. In a small business, the key people usually will be owners, founders, or a high-level employee.
When a key employee dies unexpectedly, key person insurance can provide essential funds so that the business can continue or be wound down in an orderly fashion. Some of the things that key person insurance can be used for include:
- Replacing the key employee. These costs can include hiring temporary help, recruiting expenditures to find a successor, and costs to train a new hire.
- Losses related to the absence of the key person. The key person may have been involved in sales to customers dependent upon the key person’s relationships. The key person may also have been managing ongoing projects. Their loss may lead to lost sales and profits, or delays to company projects.
- Shareholder buyouts. In companies with multiple shareholders who all work in the business, having key person insurance can provide funding to buy out the stake of the deceased shareholder or partner. Most companies would not be able to repurchase partner shares out of their ordinary cash flows or cash reserves, so having this insurance can provide liquidity to the deceased shareholder’s estate or heirs. Partnerships or closely held businesses may want to pair their key person insurance with a Buy/Sell Agreement, which spells out the terms under which the company or other partners can repurchase the ownership of the deceased partner.
- Loan guarantees. When a business borrows from a bank, company owners or partners are often required to guarantee the loans with their personal assets. By purchasing Key Person Insurance with enough coverage to pay off the business loans, the business would have the ability to pay off the business loans upon the death of the owner or partner. The deceased owner or partner’s estate would not have the burden of paying off the business loan. Having this coverage may also allow your company to borrow more easily, as banks consider key person insurance to be a company asset they include in their lending decision.
- Orderly liquidation. If a business is not able to continue due to the death of a key person, funds from key person insurance can be used to pay off company debts, pay severance to employees, return money to investors, and close the business in an orderly manner. This can give a company options other than an immediate bankruptcy upon the death of a key person.
Who needs Key Person Insurance?
Key Person Insurance is important for companies whose businesses would be devastated if a specific owner, partner, manager or employee died. Generally, a key person is someone who is very difficult or impossible to replace through hiring. The key people could have personal relationships with key clients or specialized knowledge that is difficult to hire for.
Partnerships and closely held companies with multiple shareholders who work in the business may want to have Key Person Insurance so that the remaining partners can buy out the shares of the deceased partner. This provides liquidity to the heirs of the deceased partner and is also fair to the remaining partners. Since the deceased partner is no longer able to work in the business and create value for the company, the remaining partners may not want the deceased key person’s heirs to continue to own part of the business.
If a company has debts that are personally guaranteed by an owner or partner, key person insurance in the amount of the debt can help the business repay the debt if the key person dies. Since the key person is unable to continue to generate business for the company, it may be difficult for the company to repay its debts without key person insurance.
Companies that are sole proprietorships without employees usually do not need key person insurance, because the business ends with the death of the sole proprietor. One person LLCs and one-person corporations generally would not need key person insurance, unless there is business debt personally guaranteed by the owner.
It is important not to confuse key person insurance with personal life insurance. Key person insurance is meant to benefit the company so it can continue operations. As an individual, if you have dependents such as a spouse or children who depend on your income to survive, you may also want to purchase personal life insurance.
How much Key Person Insurance should I buy?
Key Person Insurance does not compensate a business for the actual losses resulting from the death of the key person. Instead, it pays a fixed amount of money specified in the life insurance policy.
To determine how much key person insurance to buy, you need to consider the purpose of the insurance.
If the purpose of the key person insurance is to help the business continue its operations, you need to budget for the costs of hiring temporary help, recruiting costs for a replacement employee, and any lost profits that may occur due to the death of the key person.
For companies using key person insurance to fulfill a Buy/Sell Agreement, the insurance should be enough to buy out the deceased partner under the terms of the agreement.
Companies using key person insurance for loan guarantees should match the amount of key person insurance to the amount of the loan liability. If the key person dies, the company will have the resources to fully pay off the loan.
How does life insurance work?
For key person insurance policies, you generally should purchase term life insurance. Although insurance agents may try to sell you whole life or universal life policies, term life is the most appropriate for key person insurance.
With key person insurance, you are only trying to protect against the risk of the insured person dying. Other types of life insurance like whole life or variable life include investment components which bundle a risk management product with an investment product. These investment products come with much higher fees than term life and are unnecessary for protecting against key person risk.
Term life insurance policies have a fixed term, usually in years. Your company will choose a term and a dollar amount of the benefit if the insured person dies. You should choose a term that coincides with the amount of time you believe the key person will remain critical to your business. As businesses grow, they are able to hire additional employees and diversify duties, so the term you need to cover for key person insurance may be limited.
If you are using key person insurance for loan guarantees, you should match the term of the insurance to the term of the debt. If you believe your company will have sufficient cash flow to pay off the debt even without the presence of the key person, then you should choose a term that lasts until your company has that cash flow.
A term life insurance policy has an owner, an insured person, and a beneficiary. The owner is the party that pays the premiums and has the right to change the beneficiary. The insured is the person whose life is insured. If this person dies, the policy will pay out. The beneficiary is the party who will receive the payout if the insured dies.
In personal life insurance, it is common for the owner and the insured to be the same person, and the beneficiary to be their dependents. In key person insurance, the company is the owner, the key person is the insured, and the beneficiary is also the company.
Tax Treatment of Key Person Insurance
Unlike most other types of business insurance, such as commercial general liability insurance, the premiums you pay for Key Person Insurance are not tax-deductible as a business expense for companies.
Any proceeds that your company receives when a covered key person dies are not taxed, so if your policy is for $1 million, your business will receive the full $1 million without having any tax liability.
However, for large C corporations, any payouts from key person insurance are included when calculating alternative minimum tax.
If the insured key person does not have any ownership of the key person insurance, which is usually the case, any payouts from key person insurance do not affect the taxable income of that person.
Pricing of Key Person Insurance
Pricing of Key Person Insurance is determined by the amount of coverage, and the age and health status of the key person. The insured key person will be required to take a paramedical exam, which may include questions about medical history, and a blood or saliva sample.
Key Person Disability Insurance
In addition to key person life insurance, some companies also purchase key person disability insurance. This insurance can protect a company if a key employee is disabled and unable to work. A company may lose sales or have setbacks on major projects if a key employee, owner or manager is disabled, and this insurance can provide some compensation for this scenario.