Key Characteristics

• Business is the policy owner
• Business is the beneficiary
• Business pays all premiums
• Coverage amount reflects the employee’s value to the company
• Protects business operations, not employees’ family
• Funds are used for business purposes only

Common Uses of Proceeds

• Recruiting and training replacement staff
• Covering lost revenue during transition
• Paying debt or loan obligations
• Meeting payroll and operating expenses
• Maintaining customer relationships
• Funding buyout agreements

Distinct from Other Coverage

• Not employee benefits: Does not provide for family
• Not group insurance: Covers specific individuals only
• Not disability insurance: Replaces lost business value
• Not liability coverage: Protects business continuity

The Financial Impact

• Immediate costs: Recruitment agencies, advertising, and interview time
• Training expenses: Onboarding and skill development for replacement
• Lost productivity: 6-12 months for replacement to reach full effectiveness
• Customer attrition: Clients may leave due to service interruption
• Employee morale: Remaining staff may leave due to uncertainty
• Cash flow disruption: Operations may not generate normal revenue

Types of Key Persons

• Founder or owner: Essential leadership and business relationships
• Top salesperson: Brings in substantial revenue or clientele
• Technical expert: Unique skills difficult to replace
• Manager: Oversees operations or critical departments
• Client relationship manager: Maintains major account relationships
• Operations manager: Manages day-to-day business functions

Business Stability Benefits

• Maintains continuity of operations during transition
• Preserves cash flow and revenue streams
• Retains the confidence of customers and vendors
• Protects employee jobs during the transition period
• Demonstrates business stability to lenders and investors
• Allows orderly succession or sale of the business

Basic Process

1. Policy Setup: Business purchases a life insurance policy on a key employee
2. Ownership: Business owns the policy and pays premiums
3. Beneficiary Designation: Business is named as the beneficiary
4. Employee Consent: Employee must consent to being insured
5. Coverage Amount: Policy face value reflects the employee’s value to the business
6. Premium Payment: The Business deducts premiums as a business expense
7. Death Event: Upon employee death, a claim is filed with the insurer
8. Benefit Payment: Tax-free proceeds paid to the business

Key Legal Requirements

• Employee must have an insurable interest (legitimate business relationship)
• Employee must consent in writing to the policy
• Business must have a financial interest in the employee’s continued life
• An employee cannot have control of the policy
• Business must own the policy outright
• Coverage amount must be reasonable for business value

Flow of Funds Example

• Business pays $1,000 monthly premium (tax-deductible)
• Employee earns $200,000/year but does not pay for policy
• Employee has no ownership interest in policy
• Upon death, the insurance company pays $1,000,000 to business
• Business receives funds tax-free
• Business uses funds for operational transition

Strong Candidates for Coverage

• Business owners or founders
• Top revenue-generating employees
• Employees with unique technical skills
• Long-term employees with deep client relationships
• Department or division heads managing significant operations
• Employees are difficult to replace in the labor market
• Individuals with specialized certifications or licenses

Evaluation Criteria

• Employee compensation level relative to company size
• Percentage of revenue generated by this employee
• Number of direct reports or teams managed
• Client base or customer relationships controlled
• Time required to replace employee skills
• Difficulty recruiting comparable talent
• Financial impact if the position remains vacant

Not Typical Candidates

• Entry-level positions with multiple candidates
• Roles are easily filled within the labor market
• Administrative positions without unique skills
• Employees are regularly scheduled for turnover
• Positions requiring minimal company-specific knowledge
• Roles that could be outsourced

Methods for Determining Amount

• Multiple of salary: 5-10x annual compensation (common baseline)
• Revenue multiple: Employee generates (if applicable)
• Replacement cost analysis: Recruitment, training, productivity gap
• Discounted earnings approach: Years to full replacement productivity
• Debt obligation method: Loan amount, key person guarantees
• Business valuation method: Percentage of business value

Typical Coverage Examples

• Sales manager ($100K salary, $2M revenue): $1-2M coverage
• CFO ($150K salary, financial controls): $750K-1.5M coverage
• Top salesperson ($120K salary): $500K-1M coverage
• Operations director ($100K salary, 50-person team): $1-2M coverage
• Solo professional in 5-person firm: $500K-1M coverage

Coverage Amount Formula

• Annual salary × 5-10 years to replace
• Plus: Recruitment and training costs (6-12 months costs)
• Plus: Estimated revenue loss during transition (3-12 months)
• Plus: Temporary replacement staffing costs
• Minus: Salary savings during vacancy period (if any)
• = Recommended coverage amount

Key Person Policy Types Comparison

Term Life Insurance

Best for temporary coverage needs

• Coverage for a specific time period (10-30 years)
• Lower monthly premiums than permanent coverage
• Appropriate if the key person may leave the company
• Suitable for young, growing businesses
• Can be converted to permanent if needed
• No cash value accumulation
• Coverage ends at term expiration

Whole Life Insurance

Best for long-term stability needs

• Coverage for entire lifetime (until age 100+)
• Fixed monthly premiums that never increase
• Builds cash value over time
• Policy can be loaned against or surrendered
• No expiration or renewal concerns
• Appropriate for established businesses
• Higher initial premium cost

Universal Life Insurance

Best for flexible premium needs

• Premiums can be adjusted year to year
• Cash value component with interest earnings
• Lower initial premiums than whole life
• More affordable than whole, more flexible than term
• Requires ongoing monitoring
• Premiums can increase if interest rates drop
• Lifetime coverage available

Premium Treatment

• Generally deductible as business expense (IRC Section 162)
• Reduces taxable business income
• No limit on deduction amount if reasonable
• Creates tax savings for the business
• Improves net income on an after-tax basis
• Example: $1,000 premium reduces taxable income by $1,000 (at 25% tax rate = $250 tax savings)

Death Benefit Treatment

• Tax-free receipt at death (IRC Section 101(a)(1))
• No federal income tax on death benefit proceeds
• Not included in business income
• Not subject to self-employment tax
• Full amount available for business use
• Example: $1,000,000 death benefit = $1,000,000 received with no tax liability

Cash Value Accumulation

• Growth of cash value is tax-deferred inside the policy
• No annual tax on investment earnings
• Business reports no taxable income from cash value growth
• Can borrow against cash value without tax consequences (generally)
• Surrender of policy may create a taxable gain if the surrender exceeds premiums paid

Implementation Steps

1. Identify key employees and analyze financial impact
2. Obtain board approval for the key person insurance program
3. Determine coverage amounts for each employee
4. Obtain written consent from each insured employee
5. Provide the insurance company with employee information
6. Complete the underwriting process with the insurer
7. Review and approve policy terms and conditions
8. Establish premium payment procedures
9. Document business purpose and rationale
10. Inform appropriate stakeholders of the policy

Required Documentation

• Board resolution authorizing key person insurance
• Written employee consent forms (signed by insured employees)
• Analysis of business value and financial impact
• Coverage determination documentation
• Policy application and all related paperwork
• Policy contract and illustration documents
• Annual policy statements and correspondence
• Premium payment records and receipts

Ongoing Administration

• Monitor policy annually for performance
• Adjust coverage as business changes
• Update or terminate coverage for departing employees
• Review coverage adequacy annually
• Ensure premiums are paid on time
• Monitor whole life policy cash value growth
• Maintain documentation of business rationale
• Review and update key person designations

Does the employee know they are insured?

Direct answer: Yes, employees must provide written consent to be insured under key person policies. The employee cannot be unaware of the insurance.

Life insurance law requires the insured person’s knowledge and written consent. Insuring someone without their knowledge violates insurable interest requirements and could result in policy voidance. Many employees appreciate knowing their value is recognized through key person insurance, as it demonstrates their importance to the business. Some employees may have concerns about privacy or implications of the policy, which should be addressed transparently.

Does the employee benefit from key person insurance?

Direct answer: No, key person insurance is designed to protect the business, not to provide benefits to the employee or employee’s family.

The business owns the policy, pays premiums, and receives the death benefit. The employee’s family does not automatically receive any funds from the key person policy. If the business wants to provide death benefits to employees or their families, that requires separate employee life insurance or group life insurance programs. Key person insurance serves a different purpose—protecting the business’s operational and financial interests. Some businesses use key person proceeds to provide retention bonuses or assistance to grieving families, but this is discretionary and not required by the policy.

Can the business use key person insurance proceeds for any purpose?

Direct answer: Legally, yes—the business can use proceeds for any legitimate business purpose. However, the IRS may challenge excessive coverage amounts if the use doesn’t align with the stated business purpose.

Once the business receives death benefit proceeds, there are no restrictions on how the funds are used—the business can allocate them to debt reduction, payroll, operations, or other business needs. However, maintaining documentation of the original business rationale for coverage is important. If the insurance company or IRS later questions whether the coverage amount was excessive, being unable to demonstrate reasonable business use could create tax complications. The best practice is to establish in advance how proceeds will be used if a covered employee dies, then follow that plan consistently.

What if a key person becomes disabled instead of dying?

Direct answer: Key person life insurance does not pay for disability—only for death. Disability is a separate risk requiring separate coverage.

If a business wants to protect against disability of key employees, it should implement business disability insurance (overhead expense insurance) or disability buyout insurance as separate policies. These policies provide income replacement or funds to cover business operating expenses if a key person becomes unable to work. A comprehensive key person protection program may include both life and disability coverage, recognizing that either event creates significant business disruption. Disability is actually more likely than death for working-age individuals, making disability protection an important complement to life insurance.

Can key person insurance be used in a business succession plan?

Direct answer: Yes, key person insurance can help fund business succession plans by providing capital for buyouts or ownership transitions.

When a business owner who is also the key person dies, the life insurance proceeds provide liquidity to facilitate ownership transition. Proceeds can be used to buy out the deceased owner’s interest from their heirs, fund a redemption agreement with remaining owners, or provide working capital for new ownership to operate the business. For partnership succession or cross-purchase agreements, key person insurance complements buy-sell agreement funding by providing supplemental capital. However, key person insurance is distinct from the life insurance used specifically to fund buy-sell agreements—the coverages serve different purposes even if they may overlap in some situations.

How often should key person coverage be reviewed?

Direct answer: Key person insurance should be reviewed annually or whenever significant business changes occur.

Regular reviews ensure coverage remains appropriate as the business grows, contracts, or shifts focus. Changes requiring review include significant growth or decline in revenue, departure or addition of key employees, changes in business structure, expansion into new markets, or major organizational restructuring. Additionally, reviews should assess whether policies are performing as expected, premiums remain affordable, and coverage amounts still reflect current business value. As employees age or gain more experience, the business value they represent may change, requiring coverage adjustments. Annual reviews represent a best practice for maintaining alignment between insurance coverage and actual business needs.