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Life insurance is often associated with standard personal life policies, such as whole life and term options. However, companies also have access to life insurance benefits and one option used is referred to as “key man insurance.” Companies use key man insurance to receive a death benefit payout in case an employee critical to the company’s operations passes away. The death benefit can then be used to give the company time to recoup from the loss or hire and train the next person to fill the essential role.
What is key man insurance?
Key man insurance is a type of life insurance policy that a company purchases on the life of a founder, owner, executive or anyone else who is essential to the running of the business. The beneficiary of the policy is the company and the premiums are paid by the business. This type of policy may also be referred to as key person or a key people insurance policy. It also falls under the umbrella of a corporate-owned life insurance policy, where a company takes out a policy on a specific employee or group of employees.
A key person could be considered an owner, founder, top executive, salesperson or even someone with special knowledge and skill sets. The idea behind key person insurance is that the company would receive the death benefit to add a financial buffer in case of the sudden loss of someone critical to company operations. The payout could potentially buy the company time to strategize and determine the next steps for the business.
How is key man insurance taxed?
Key man insurance is purchased with after-tax dollars and the premiums are not tax-deductible. Like other types of life insurance policies, if the key employee passes away, the company will receive the death benefit tax-free in most cases. There are exceptions to this and a trusted tax advisor would be able to walk the company through the regulations and documentation needed. The tax forms would have to include how many employees have the key person insurance, if there was consent given by each employee and the amount of coverage in place.
Key man insurance policy types
Much like personal life insurance policies, key man insurance can be structured under different categories of life insurance. The most common categories are term and permanent life.
- Term life insurance: Term life policies provide coverage if the policyholder passes away within a certain term or time period. Typically this is a 10-, 20- or 30-year term. However, with key man insurance, the policyholder is the company and the term period could be tied to any key date, such as retirement. Term life is usually a much less expensive option than a permanent life insurance policy.
- Permanent life insurance: Permanent life insurance provides lifelong coverage as long as premiums are paid and the policy builds cash value over time, in addition to providing a death payout. Because the policy builds cash value, the business is able to access this and use it as collateral for loan purposes. It can also be sold if the company no longer wishes to maintain the policy. However, these benefits make the policy more expensive than term life options.
Key person insurance may also have options for an owner to use a buy-sell agreement. This is a buyout agreement for the life insurance policy and there are two common options. A cross-purchase plan is a buyout option used when an owner of a company dies and the remaining owners use the death payout to purchase the deceased owner’s share of the company. This option is most commonly used by small companies.
The other option is an entity purchase agreement, which requires the company to purchase the owner’s share of the business from the heirs of the estate at a pre-agreed upon price. By doing so, the deceased’s family can get the money they need right away while the company maintains control over the business.
How much key man life insurance should you purchase?
There are specific metrics used for estimating how much to purchase in key person insurance. The three main metrics include the employee’s compensation, the amount of revenue the employee directly contributes to the company and how much it will cost to replace the employee. These metrics may seem fairly straightforward, but there are instances where some employees may not directly contribute to the revenue while still providing critical expertise.
Companies that offer key man life insurance
When purchasing key man life insurance, there are a few considerations. The first major one is budget. Term life policies are typically less expensive than permanent life options and may be a better fit for the company budget. The second consideration is how much of a death benefit is needed. The higher the death benefit, the higher the premiums. The age, health and lifestyle of the insured employee will also influence the cost of premiums.
Several life insurance companies offer key person insurance and can walk a business through these considerations. Like other life insurance policies, you can compare several carriers to determine which would suit the company’s needs best, including the carrier’s reputation for claim payouts and customer service. You can find various key person policies with:
Who should have key man insurance?
Does your business need a key person insurance policy? A lender may require a company to have key person insurance in place for the top executives or other specified key employees. This is especially true if the company is solely dependent on one or two owners. These policies can also be a form of financial protection for a company. If a company’s profits would be devastated by the loss of a certain employee, a key person insurance policy could help prevent financial disaster. The loss may not always be directly related to profits either. Instead, a company may consider a policy if the business credit score or performance were dependent on an individual.
Key person insurance can also be an employee benefit. Since these policies are often portable, it could be used to retain top talent with the option for the employee to take over ownership of the policy. Where key person insurance may not be necessary is if you are a small business owner and sole proprietor. It would likely be more beneficial to a sole proprietor to have a personal life insurance policy set up for your family to receive versus key person insurance.