Key man life insurance helps companies reduce the risk of business disruption by paying a death benefit if critical employees pass away.

A key man policy can also be an employee benefit, if the company transfers the life insurance policy to the executive or insured employee. Though key person life insurance premiums aren’t tax deductible, the proceeds of the policy are usually provided to the company free of income tax.

What is Key Man Life Insurance?

Also called corporate-owned life insurance (COLI), key man life insurance is purchased by a business to insure the life of one of the company’s employees. It’s intended to help the company recover from the loss of an employee that contributes significantly to the business, if that person's death would reduce productivity or the company's value. People an employer might have covered by a key man policy include top salespeople, executives and other decision makers, highly visible employees, and employees with unique knowledge or skill sets.

As with any life insurance policy, key man policies have three primary roles:

Key man life insurance differs from other life insurance policies in that the business is both the owner and the beneficiary of the policy. The employee essentially has no rights or participation in the policy. However, the business must notify the employee of its intent to purchase coverage on the employee, provide details of the policy, and obtain their written permission before purchasing it. All of this can be done using an Employer Owned Life Insurance Acknowledgement and Consent Form, which can be obtained from the insurer.

What Types of Policy Can be Used as Key Man Life Insurance?

Any type of life insurance policy can be structured as key man life insurance, including either of the two primary categories of life insurance:

Given the high cost of permanent life insurance, and that company needs often evolve over time, term coverage is often used for key man life insurance. However, permanent life insurance can be structured as an employee benefit, as the policy, and its cash value, can be transferred to the insured after a certain number of years or at a particular milestone.

No matter the type of policy you choose, make sure your key man life insurance offers flexible terms. For example, adding a business exchange rider to a permanent policy allows you to change the person insured should that employee leave the company. Similarly, many key executive life insurance policies allow you to periodically increase or decrease the policy’s limits, as the needs of the company change.

When Would Your Business Need Key Man Life Insurance?

Key person life insurance is typically required if your company wants to obtain a loan or investment. The SBA and many banks often require key man life insurance as part of their lending criteria, since small businesses tend to be particularly dependent upon one or two employees — usually, the co-founders. Similarly, if your business is trying to raise money, investors may want assurance that the loss of certain employees wouldn’t cause the company to go bankrupt.

Aside from lenders' requirements, companies typically purchase key man life insurance as a form of financial protection. A key man policy is important if the loss of a particular employee would adversely impact your profits. This is often the case if:

In the worst-case scenario, if your company is so dependent on an employee that it could potentially go out of business if they were to die, key man life insurance can provide an alternative to declaring bankruptcy. The key man policy’s death benefit could be used to pay any debts, provide employee severance, shut down the business, and distribute any remaining funds to investors.

Key executive life insurance also can serve as part of a benefit plan that's used to attract and reward key employees, since the policy can be transferred to the insured. There are multiple ways to structure this perk. One way is to purchase a permanent life insurance policy which would be given to the employee upon retirement, after a certain number of years with the company, or based upon a certain level of performance.

While key man life insurance has much to offer a company, it wouldn’t make sense in all situations. For example, if you’re a sole proprietor with no one else directly involved in your business’s ongoing operations—such as lenders or employees—key man coverage would be unnecessary. Instead, you might consider an individual life insurance policy for yourself to protect your family if they were to suddenly lose your income.

How Much Key Man Life Insurance Coverage Do You Need?

If you’re borrowing money, the lender may require a certain amount of key man coverage. Otherwise, the amount of coverage you need will vary according to your business and the employee you're insuring. In principle, try to purchase sufficient key man insurance that the impact of losing the insured employee is near zero. To accomplish this, you'll want to account for the revenue and profit attributable to the employee, the company’s cost structure, the cost to replace the employee, and any "soft" value the employee brings to the company.

Depending on who you want to insure, the calculation for how much key person coverage you need will change significantly. For example, it’s fairly simple to determine how much revenue is attributable to a top salesperson. However, the value is less tangible for a well-known CEO whom many employees joined the company to work with.

While none are comprehensive, a few commonly used methods for estimating the necessary amount of key executive life insurance are:

While key employee life insurance is usually purchased for high-earners, the face value of the policy is often limited to a multiple of the insured’s income, such as 10X. Depending on the insurer and your corporate structure, the employee’s income can include their annual bonus or a portion of the company’s net income, if they have ownership in the business. If a particular employee or executive contributes disproportionately to your company’s profit, it may be a challenge to obtain sufficient coverage.

Tax Treatment of Key Man Life Insurance

Typically, the cost of key man life insurance is not tax deductible. Premiums must be paid with after-tax dollars. Your company can only deduct key man insurance premiums if they’re considered to be part of the employee’s taxable income, in which case the employee is typically the beneficiary. This is more often the case with group life insurance than with key man life insurance.

If the insured employee passes away, the key man policy’s death benefit would be paid to the company free of income tax in most cases. The only exception is for C corporations, for which the death benefit would be included in the calculation of the alternative minimum tax (AMT) due. On the other hand, if your company decides to sell the key person life insurance policy, you may have to pay taxes, depending on the size of the settlement, cash value of the policy, and the amount that's been paid in premiums.

Each year, your company will need to include details about the coverage with its corporate tax return. This information can include the number of employees insured, the amount of coverage in force, and whether each insured employee has provided written permission for the policy to be purchased. Consult with your tax-professional to ensure your company is fully compliant with all requirements and documentation.

Tax Treatment for Employees

If your company is the sole owner and beneficiary of a key person life insurance policy, there are no tax implications for the insured employee. Premiums aren’t considered part of the insured's taxable income unless they have ownership in the policy or would be a beneficiary. If you transfer ownership of the key man policy to the employee, however, they may have to pay taxes, since the transfer may be considered compensation.

Cost of Key Man Life Insurance

The cost of key man life insurance depends on:

It’s important to note that if you’re trying to insure an older or less healthy employee, the cost of key man life insurance can be incredibly high. Alternatively, you may not be able to find coverage at all. If this is the case, you may have to look to other options, such as a loan, to provide compensation if your key employee should pass away. And you may want to prepare early for such a calamity, by creating a succession plan or beginning a search for viable replacement candidates.