Many small businesses depend greatly on a particular individual. This may be a key salesperson, a designer, or someone else with unique talent and ability. When this person dies, it can cause serious disruption to the business. Revenue may fall off. And the company will incur costs to recruit and train a replacement. Life insurance proceeds to cover the financial losses resulting from the death of a key person can certainly come in handy.
How key person coverage works
If the person consents, the company can take out a life insurance policy on him or her, naming the business as beneficiary. The company owns the policy, pays the premiums, and receives the proceeds when the key person dies (assuming the policy remains in effect).
Employee consent to being insured was not required for policies issued before August 18, 2006, but consent is now essential. If the company fails to obtain consent before the policy is issued, then the proceeds that would otherwise be tax free become taxable. This can result in the loss of as much as about 40% of the proceeds in taxes.
The IRS has laid out notice and consent requirements:
- The employee must be notified in writing that the applicable policyholder (i.e., the company) intends to insure the employee's life. The employee must also be informed about the maximum face amount for which the employee could be insured at the time the contract is issued;
- The employee must provide written consent to be insured under the contract and agree that such coverage may continue after the insured terminates employment; and
- The employee must be informed in writing that an applicable policyholder (the company) will be the beneficiary of any proceeds payable upon the death of the employee.
A key person policy can be any type of life insurance (e.g., whole life; term). If a whole life policy is used, the cash value of the policy is available for use by the business (e.g., via a loan or withdrawals) before the insured dies.
The cost of coverage depends, of course, on several factors. These include the face amount of the policy (e.g., $100,000; $1 million), the age of the insured, and other factors (e.g., the insured's health). The premiums usually are not deductible by the business.
In order for the business to avoid taxation on the proceeds from the policy when a key person dies, securing written consent prior to buying the policy is mandatory. However, obtaining consent is not the end of the company's responsibilities with respect to the policy; there is also an annual reporting requirement (again, this applies only to policies issued after August 17, 2006). Each year, the company must file Form 8925, Report of Employer-Owned Life Insurance Contracts, with its tax return. While failing to file this form won't trigger taxation on the proceeds if the requisite consent has been obtained, it can result in a tax penalty (the IRS hasn't specified what this is).
Key person life insurance should be considered as part of a company's risk management plan. Discuss your needs with a knowledgeable life insurance agent.