Key Man Life Insurance: Cost & Tax Treatment
Key man life insurance helps companies reduce the risk of business disruption by paying a death benefit if a critical employee passes away. It is also called key person life insurance.
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A key man policy can be an employee benefit, if the company agrees to transfer the life insurance policy to the insured employee when the employee meets the criteria the company sets.
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 death of an employee who contributes significantly to the business, if that person's death would reduce productivity or the company's value.
People an employer might cover with 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, a key man policy has three primary roles:
- Owner: The person or entity that purchases the life insurance policy and pays the premiums. The owner has the right to transfer, sell or change the terms of the policy.
- Insured: The person upon whose death the policy would pay the death benefit. Therefore, premiums are directly tied to the health and lifestyle of the insured employee.
- Beneficiary: The person or entity that would receive the death benefit, should the insured employee pass away during the period of coverage.
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, provide details of the policy and obtain written permission from the employee 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.
Which policy types 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:
- Term life insurance: Term life insurance provides coverage for a predetermined amount of time, such as 10 or 20 years, and is significantly less expensive than permanent life insurance. Typically, for a key man policy, the term is tied to a specific date, such as the employee’s expected retirement, or a projected timeline, like how long it might take to rebuild a sales team.
- Permanent life insurance: In addition to providing lifelong coverage, a portion of permanent life insurance premiums are added to a cash value account, which grows over time. The policy’s cash value is an asset that can be used by the business as collateral for a loan and, if the policy was written by a mutual insurer, would make the business eligible to receive dividends. Since permanent life insurance policies accumulate value over time, they can be sold in a life insurance settlement if the company decides that it no longer wants coverage.
Given the high cost of permanent life insurance, and the fact that a company’s needs evolve over time, term coverage is often used for key man life insurance. However, permanent life insurance can be structured as an employee benefit, because the policy, and its cash value, can be transferred to the insured after a certain number of years or upon their reaching 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 who is insured if the covered employee leaves 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 certain type of loan or investment. The Small Business Administration (SBA) and many banks require key man life insurance as part of their lending criteria, since small businesses tend to be particularly dependent on one or two employees — usually the cofounders. Similarly, if your business is trying to raise money, investors may want assurance that the loss of specific 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 affect your profits. This is often the case if:
- The company’s brand and strength are tied to a particular employee’s name or reputation
- The company’s performance and ongoing projects are tied to the employee’s unique skills
- The loss of the employee could trigger a reduction in existing or new business
- The loss of the employee would affect the company’s credit or cause a business loan to become due
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 person life insurance can also serve as part of a benefit plan to attract and reward crucial employees, because 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 and give it to the employee upon retirement, after a certain number of years with the company or based on their 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 the sole proprietor, with no one else — such as lenders or employees — directly involved in your business’s ongoing operations, 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, how much you need will vary according to your business and the employee you're insuring. In principle, try to purchase enough key man insurance to minimize the impact of losing the insured employee to near zero. To accomplish this, you'll want to account for the revenue and profits 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 a top salesperson brings in, but the value is less tangible if many employees joined the company specifically to work with the insured person, such as a well-known CEO.
While none are comprehensive, a few commonly used methods for estimating the necessary amount of key person life insurance are:
- Multiple of compensation: The employee’s compensation is multiplied by the number of years the company expects it will take to replace the employee or recover from their death. The primary issue with this approximation is that it assumes the employee’s value to the company is reflected in their compensation.
- Percentage of revenue or profits: The amount of revenue or profits attributable to the insured employee is multiplied by the number of years it might take to replace the employee. Whether revenue or profit is better to use depends on the company and its structure.
- Cost to replace: This is a sum of the costs to find, hire and train a new employee as a replacement for the insured. This approximation should include an estimate of business lost during the recruiting period — and possibly even after the replacement is in place.
While key man 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 10✕. 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 profits, 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 part of the employee’s taxable income, which is typically in cases where the employee is 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, the cash value of the policy and the amount that's been paid in premiums.
Each year, your company’s corporate tax return will need to include details about the coverage. 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 your tax professional to ensure your company is fully compliant with all of the 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, 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:
- Type of policy purchased: Term life insurance policies are less expensive than permanent insurance, as they offer coverage for a fixed period and don’t accumulate a cash value. Each type of permanent life insurance policy has different costs, risks and benefits.
- Policy death benefit: The greater the amount of coverage, the higher the premiums will be.
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Employee’s health and lifestyle: An employee’s age, medical history, hobbies, occupation, family history, driving history and general health determine their level of risk, which will affect the premium.
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, or you may not be able to find coverage at all. If this is the case, you may have to look into other options, such as a loan, to provide compensation if your key employee passes away. And you may want to prepare for this ahead of time by creating a succession plan or beginning a search for viable replacement candidates.
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