What Is a Key Person Life Insurance Policy?

A key person life insurance policy is a specialized form of coverage purchased by a business to mitigate financial risks associated with the unexpected loss of a vital employee. This policy functions as a financial safeguard, protecting the company from potential harm that could arise from the death or long-term incapacitation of an individual whose contributions are essential to its operations. It provides a financial cushion, enabling the business to maintain stability during a challenging transition period.

Identifying a Key Person

A key person is an individual whose absence would inflict substantial financial detriment on a business. This includes individuals with unique skills, specialized knowledge, or critical relationships that directly influence the company’s revenue or strategic direction. Examples include a chief executive officer, a chief financial officer, or a top sales executive responsible for significant client relationships and revenue generation.

Beyond leadership roles, individuals with highly specialized technical expertise, such as a lead engineer or product designer, can also be considered key persons. The core criterion is whether the person’s death or prolonged inability to work would cause a measurable financial setback, disrupt operations, or jeopardize future projects. Businesses often assess the potential for lost revenue, increased costs for recruiting and training a replacement, or the impact on critical client relationships when identifying such individuals.

Policy Structure and Mechanics

In a key person life insurance policy, the business serves as the policy owner, premium payer, and beneficiary. The individual identified as the key person is the insured. This arrangement ensures that if the key person dies, the death benefit is paid directly to the business, rather than to the individual’s personal beneficiaries.

Upon the death of the insured key person, the business receives the death benefit, which can be utilized to maintain operational stability. These funds can cover immediate expenses like recruiting and training a replacement, compensating for lost revenue during the transition, or paying off outstanding business debts. The proceeds can also be used to facilitate an orderly winding down of the business, including providing severance to employees.

Key person policies can be structured using either term life or permanent life insurance. Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years, and is generally more affordable for temporary needs. Permanent life insurance offers lifelong coverage and may build cash value over time, which the business could access for other needs or as collateral for loans. The choice between these policy types depends on the business’s specific needs and the anticipated duration of the key person’s contribution.

Tax Treatment of Key Person Life Insurance

Premiums paid by a business for key person life insurance are not tax-deductible as a business expense. This non-deductibility is stipulated by Internal Revenue Code Section 264, which disallows deductions for premiums if the taxpayer is directly or indirectly a beneficiary of the policy. Businesses must therefore pay these premiums using after-tax dollars.

Conversely, the death benefit proceeds received by the business are typically income tax-free. This tax-free status is generally provided under Internal Revenue Code Section 101. However, for policies issued after 2006, specific notice and consent requirements must be met for the death benefit to remain tax-free.

These requirements mandate that the insured employee must be notified in writing about the employer’s intent to insure their life, the maximum face amount, and that the business will be the policy owner and beneficiary. The employee must also provide written consent to being insured and acknowledge that coverage may continue after employment ends. Failing to meet these requirements can result in the death benefit being partially or fully taxable.

While the death benefit is generally tax-free, C corporations must include it in their Alternative Minimum Tax (AMT) calculation. Businesses are also required to report employer-owned life insurance contracts annually to the IRS on Form 8925.