Key person insurance: protecting the business from a loss of talent

Key person insurance is life insurance the business owns on an owner, executive or other individual whose death would cause a financial hit, with the business as premium payer and beneficiary. The death benefit gives the company cash to cover lost revenue, recruit a replacement, repay lenders and keep customers and staff steady. It protects the business; it is not personal coverage for the family and it is not a buy-sell funding arrangement, though the two are often bought together.

Who counts as a key person

The test is financial: if this person died tomorrow, what would the company lose and how fast? Typical candidates:

• A founder-owner who holds the customer relationships or the license.
• A top sales producer whose accounts would follow them or stall.
• The engineer, chef, surgeon or scientist whose skills are hard to replace.
• A CEO or CFO whose name sits on the bank covenants.
• An officer whose death would trigger a loan default or a lender's demand for new collateral.

The business must have an insurable interest in the person, which exists for owners, officers and employees whose loss would cause real economic harm. State law sets the details, and the carrier will ask you to document the interest at application.

How to size the coverage

There is no formula the IRS or the carriers require. Underwriters will ask how you reached the number, and they will decline an amount that looks out of proportion to the person's value. Common methods:

1. Multiple of compensation. Often several times annual pay, scaled by seniority.
2. Contribution to profit. Estimate the profit the person generates over the period needed to find and train a replacement, say 12 to 36 months, and insure that amount.
3. Replacement cost. Recruiter fees, signing bonus, training time, and the productivity gap while a successor ramps up.
4. Debt and covenants. Outstanding loans the lender ties to the person; compare SBA loans and the life insurance requirement: when it applies and collateral assignment of life insurance for business loans.
5. Business value method. A fraction of enterprise value tied to the person.

The key person insurance calculator lets you try several methods side by side. Many advisors add the methods and then discount for how much of the person's contribution is truly irreplaceable.

Term, whole life or universal life

• Term is the usual choice when the exposure is time-bound, such as a loan term or the years until a successor is ready. It gives the most coverage per premium dollar and has no cash value.
• Permanent insurance (whole life or universal life) builds cash value the company can borrow against, and the coverage lasts until death if the policy stays in force. It costs materially more and the cash value is a business asset on the books, not an automatic perk.

The right fit depends on how long the exposure lasts. Insuring a founder who will be central for 20 years differs from insuring a manager with a five-year runway. The carrier will underwrite the insured's health, age, tobacco use and finances; see how insurers underwrite business life insurance.

Tax treatment

Check these with a CPA, because details depend on the entity and the policy.

• Premiums. Generally not deductible when the business is the beneficiary of the policy (IRC 264(a)(1)).
• Death benefit. Generally income-tax-free to the business under IRC 101(a), subject to the employer-owned life insurance rules below.
• Cash value. Growth inside a permanent policy is tax-deferred; loans and withdrawals have their own rules.
• Estate and business valuation. If the insured is also a controlling owner, the death benefit can raise the company's value for estate tax purposes. The Supreme Court's 2024 decision in Connelly v. United States turned on that point for redemption agreements; see Funding a buy-sell agreement with life insurance after Connelly.

The employer-owned life insurance rules: notice and consent

IRC 101(j) limits the tax-free death benefit on an employer-owned life insurance (EOLI) contract to the premiums the employer paid, unless an exception applies and the notice-and-consent rules were met. The exceptions include an insured who was an employee within the 12 months before death, or who was a director, a highly compensated employee or a highly compensated individual when the contract was issued. Proceeds paid to the insured's family, a designated beneficiary, a trust or an estate, or used to buy the insured's equity interest, also qualify.

Before the policy is issued, the employee must:

1. Be notified in writing that the employer intends to insure the employee's life and of the maximum face amount.
2. Consent in writing to being insured and to coverage continuing after employment ends.
3. Be informed in writing that the employer will be a beneficiary of the proceeds.

Skipping the written consent is the classic mistake, and it cannot be fixed after the policy issues or after the insured dies. The employer also files Form 8925 with its income tax return each year it owns EOLI contracts issued after August 17, 2006, reporting the number of employees, the number insured, total EOLI in force and whether valid consent exists for each insured. The IRS source is the Form 8925; Employer-owned life insurance: notice and consent rules under IRC 101 and COLI and BOLI explained: corporate and bank-owned life insurance go deeper. Keep the signed consent forms in the corporate records, not in an agent's file.

A worked example (hypothetical)

Say a 25-employee architecture firm in Texas has a founder who brings in about 40% of revenue. The firm estimates that after a founder's death, revenue would decline for roughly two years before a hired principal fills the gap. The owners work from the contribution-to-profit method: they estimate the lost profit during that window, add recruiting and transition cost, and compare against the firm's $1.5 million bank line, which names the founder as a key-man event of default. They choose a 15-year term policy sized to the sum, owned by and payable to the firm, and obtain the founder's signed notice and consent before the application. The firm adds the policy to its annual Form 8925 reporting. The numbers are an example only; yours will depend on your revenue concentration and recruiting reality.

Common problems

• Owner is the insured and the beneficiary is a spouse. That is personal life insurance, not key person insurance.
• No consent form on file. This can turn most of the death benefit into taxable income.
• Coverage lags the business. A policy bought for a $500,000 exposure does not cover a business that now carries $3 million.
• Departure. If the insured leaves, the company can keep paying premiums, surrender the policy, or sell it to the former employee; get the tax advice first.
• Lender requirement. If the bank requires the policy, it may want a collateral assignment; read the agreement.

Do you also need disability cover?

A key person is more often disabled than killed during working years, and disability can hurt the business as much as a death. key person disability insurance: protecting the business when a leader cannot work pays the business if the individual cannot work, and disability buy-out insurance: funding a buy-sell when an owner is disabled funds a buyout of a disabled co-owner. If co-owners need to buy out a deceased partner's family, that is a buy-sell agreement, covered in Funding a buy-sell agreement with life insurance after Connelly and cross-purchase vs entity redemption buy-sell plans. Your broker can confirm whether a policy on a key employee fits with business succession planning and the insurance that funds it.

Key takeaways

• Key person insurance is owned by and payable to the business to replace the profit and cost caused by losing a critical person.
• Size it with documented methods such as contribution to profit, replacement cost and debt tied to the person, not a round number.
• Under IRC 101(j), written notice and consent before the policy is issued, plus annual Form 8925 reporting, protect the tax-free death benefit.
• Premiums are generally not deductible when the business is the beneficiary; talk to a CPA about your entity.
• Consider key person disability as well as life coverage.