Key Man Life Insurance Policies
Key Man Life Insurance policies are the primary method used by companies to absorb the economic loss experienced due to the death of an employee whose skills, talents, experience, or personal contacts the business is dependent upon, and would be difficult to replace.
Is Your Business Reliant on One Person?
Company Owned Life Insurance
Key man life insurance policies are used for the sole purpose of absorbing the economic loss the company would experience as a result of the death of an employee. As such, premiums are paid by the company, and the company retains ownership of the policy, as well as recieves the tax free death benefit in the event of the key employees passing.
Asset to the Business
Key man life insurance policies are owned by the company, and considered an asset on the company’s books. If the company elects to purchase term insurance, the death benefit is only payable to the company tax free if the key employee passes during the stated term. If the company elects to purchase permanent insurance, the death benefit will be payable to the company tax free whenever the insured passes (whether still employed by the company or not).
Tax Free Death Benefit
Life insurance death benefits are paid to the beneficiaries tax free. In the event of an unexpected loss of an important employee, the company has access to cash…tax free, that will provide an economic cushion for lost revenue, or hiring and training a new employee.
Since the company is owner and beneficary of Key Man Life Insurance policies, the premiums must be paid with after tax dollars. However, if the Key Man policy is structured to be a split dollar life insurance policy, where the employee and their family recieves benefits, a portion of the premiums may be deducted if considered part of the employees compensation (which would make this an employee benefit). As this is a tax issue, it is important to consult a tax professional when establishing Key Man policies.
Exchange of Insured
The Exchange of Insureds Agreement is an option on select policies that provide for the exchange of one insured for another insured in a key person business situation. The exchange of insured will be processed as a surrender/new issue policy. The existing and new issue policy must be corporate-owned by the same corporation before and after the exchange.
Transfer of Ownership
Some companies may opt to own the Key Man Life Insurance policy, and be the sole benficiary during the insured employee’s tenure at the company. At a contractually stated time, such as retirement, the ownership of the policy may be transferred to the insured employee. There may be tax consequences to the company as this may be considered a form of compensation.
Frequently Asked Questions
Term or Permanent Life Insurance?
A company may purchase a key man policy as either term or permanent insurance. Term will be the most cost effective, and insure only for a stated length of time (usually insured employee’s retirement date). Permanent life insurance will be more costly as premiums above and beyond the cost of insurance go into tax deferred cash value growth which can be accessed by the company as collateral or loan provisions.
Why would a Key Man policy be important for a company to own?
In order to qualify, the company must have an insurable interest in the employee…meaning the employee must provide substantial contributions to the success of the company. This may come in the form of the brand being strongly tied to the employee, the company’s continued performance or success of a project are tied to the employee, a tragic death of the employee would create substantial revenue loss for the company, or could trigger outstanding loans to become due or loss of business credit.
How much coverage is needed?
There are a few ways to calculate the amount of insurance needed in a key man life insurance policy. Some companies use a multiple of the insured employee’s compensation. The multiple is an estimate of how long it would take to replace the employee or recover from their death. A second method is percentage of profits or revenue. This method takes an estimate of the insured employee’s contribution towards profit or revenue and multiplied by how long it would take to replace the employee or recover from their death. A third method is a simple cost to replace calculation, where the company estimates the costs recruit and train a new employee. This method should also include an estimate of lost business during the recruiting and training phase.
Can this also be used as an employee benefit?
Yes. This arrange is referred to as a split dollar life insurance policy, where the company and the insured employee may retain a percentage ownership in the policy. An example would be for the company to purchase a permanent life insurance policy on an important employee, and the premiums are considered part of a deferred compensation package. The company owns the policy until the insured retires, at which time the policy ownership is transfered to the insured. The beneficary strucutre may be a percentage remains to the company to recoup the costs, and the remaining death benefit is payable to a beneficiary of the insured’s choosing.
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Fiore, Nicholas: Company-Owned Life Insurance, Journal of Accountancy, December 31, 1999 https://www.journalofaccountancy.com/issues/2000/jan/companyownedlifeinsurance.html
ValuePenguin: Key Man Life Insurance: Cost & Tax Treatment, copyright 2019, https://www.valuepenguin.com/life-insurance/key-man-insurance