Key person insurance

Key person insurance is coverage a business buys on the life, and sometimes the disability, of someone whose loss would damage profits: a founder, top salesperson, lead engineer or rainmaker. The business owns the policy, pays the premiums and is the beneficiary. The money covers lost revenue, recruiting and training a replacement, and loan covenants or investor demands, and gives the company time to adjust.

Sizing is judgment, not a formula. Rules of thumb use a multiple of salary, but a better approach estimates the profit the person generates, the cost of finding a replacement and any debt tied to the person. Say a firm projects $400,000 of lost annual profit for three years and $150,000 of replacement costs (a hypothetical); the need is about $1.35 million, whatever a salary multiple suggests. The key person insurance calculator walks through the inputs.

The tax rules are specific. Premiums are generally not deductible under IRC section 264(a)(1) when the business is the beneficiary, and death benefits are generally income-tax-free, but employer-owned policies must meet IRC section 101(j) notice and consent requirements, with annual reporting on Form 8925. Without that consent, the tax-free amount can be capped at premiums paid. Lenders sometimes require a collateral assignment. The guides on key person insurance: protecting the business from a loss of talent and key person disability insurance: protecting the business when a leader cannot work cover structure, and insurable interest covers why the business may insure the person.