What Is a Keyman Policy and How It Protects Your Business

A key person policy, also known as keyman insurance, is a specialized form of coverage designed to protect a business from financial hardship. Its purpose is to mitigate financial losses that can arise from the unexpected death or incapacitation of an individual vital to the company’s operations. The business itself owns the policy, pays the premiums, and receives the benefit payout, functioning as a financial safeguard should a key employee become unable to work.

Understanding Key Person Insurance

Key person insurance is a life or disability policy a business purchases on its key employees. This coverage shields the company from financial repercussions if a key person is suddenly lost. Risks include potential loss of revenue, operational disruptions, strained client relationships, and the absence of unique skills or knowledge critical to the business’s success. The policy provides financial stability, allowing the business time to adapt, recruit, and train a suitable replacement.

Identifying a “key person” involves recognizing individuals whose absence would cause substantial harm to the business. This often includes founders, chief executive officers, top sales executives, or highly specialized engineers who possess unique expertise or client connections. A key person’s role typically involves managing important operations, making strategic decisions, or maintaining significant client relationships that directly influence the company’s bottom line. The decision rests on whether the individual’s departure would affect the company’s ability to operate and generate income.

How Key Person Insurance Functions

The business is the policy owner, paying premiums to the insurance provider. In the event of an insured event, such as the death or covered disability of the key person, the business is designated as the beneficiary and receives the insurance proceeds. This arrangement ensures funds are directly available to the company, rather than being paid to the key person’s family or estate.

Upon the death or covered disability of the insured key person, the insurance company disburses the benefit payout directly to the business. These proceeds can be allocated to various needs to ensure business continuity. Funds might be used to cover immediate operational expenses, recruit and train a replacement, or pay off existing business debts. The payout can also help compensate for lost revenue, maintain investor confidence, or provide resources for an orderly business closure if necessary.

Tax Implications of Key Person Policies

Premiums paid by a business for key person life insurance are generally not tax-deductible. This is because the business is the policy’s beneficiary and receives tax-free proceeds upon the insured event. The Internal Revenue Service (IRS), under Section 264 of the Internal Revenue Code, prohibits deductions for premiums on life insurance policies where the taxpayer is directly or indirectly a beneficiary. These premiums must be paid with after-tax dollars.

The death benefit proceeds received by the business from a key person life insurance policy are generally not subject to income tax. This tax-free status provides the business with financial relief without an additional tax burden. However, the business must meet certain notice, consent, and reporting requirements for the death benefit to remain tax-free.

The tax treatment for key person disability insurance can differ from life insurance. Premiums paid for key person disability insurance are generally not tax-deductible for the business if the business is the recipient of the benefits. Similar to life insurance, the benefits received by the business from a key person disability insurance policy are not considered taxable income. This allows the business to use the funds to cover financial losses, recruit replacements, or manage increased expenses during the key person’s disability without incurring additional tax liability.