Life Insurance for Professional Practices: Key Person, Buy-Sell and Succession Funding

Short Answer: What Life Insurance Does in a Professional Practice

In a professional practice, life insurance is a funding mechanism, not the plan itself. It can supply cash when a key professional dies, fund the purchase of a deceased owner's interest under a buy-sell agreement, and support continuity during an ownership transition. The practice's business form shapes which federal tax rules apply to the policy.

This page is for owners of medical, dental, legal, accounting and similar licensed-service practices. It covers three business problems: losing a key professional, transferring ownership at death, and keeping the practice running. Medical, dental, law and accounting practices each have their own page on Business Life Insurance with profession-level detail. Federal income-tax treatment of death proceeds turns principally on 26 U.S.C. § 101(a) and § 101(j).

Why Life Insurance Matters for Professional Practices

A professional practice is usually closely held. One licensed professional, or a few, own it, and their personal production drives most of its value. Client relationships, referral sources and reputation often attach to the individual rather than to the firm, so the practice is exposed when a principal dies.

Ownership transfer is also constrained. Who may own a practice interest, or keep one after a death, is set by state professional-licensing law, and those rules vary by state.

Practices operate as sole proprietorships, partnerships, limited liability partnerships, professional corporations and professional limited liability companies. The form matters for federal rules. IRS Notice 2009-48 states that a contract "owned by the owner of an entity engaged in a trade or business (such as for purposes of financing the purchase of an equity interest of another owner)" is not an employer-owned contract (A-1). It also states that ownership "by a partnership or sole proprietorship does not prevent the contract from being treated as an employer-owned life insurance contract" (A-3).

Two framing points apply throughout. Cash value, where a policy has it, is a contract feature, not an investment. And Section 264(a)(1) of the Internal Revenue Code provides that no deduction is allowed for "premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy."

Key Risks That Life Insurance May Address in a Professional Practice

The first risk is lost production. When a revenue-generating principal dies, the practice may lose clients, referral relationships and billing capacity at once, while rent, payroll and debt continue.

The second is a forced buyout. Surviving owners or the practice entity may owe a deceased owner's estate the price of that owner's interest and lack the cash to pay it.

The third is dissolution. Without a funded plan, a practice may have to wind down or sell at a distressed value. State licensing rules on who may hold a practice interest after a death vary by state and can narrow the buyers available.

The fourth is debt. A lender may ask for life insurance assigned as collateral. The SBA's lending rules require it only in stated circumstances: for a 7(a) loan, when the loan is not fully secured and the principal is a sole proprietor or single-member LLC owner, or the business depends on one owner's active participation. Other lenders follow their own policies. Collateral assignment requirements, employer-owned contract notice and consent, Form 8925 reporting and premium deductibility each need individual review of the contracts involved, by the insurers and a qualified tax professional.

Who This Page Is For

Readers of this page are owners, partners, shareholders and administrators of licensed-service practices, in any business form. Three situations are typical:

• A practice with two or more owners weighing a funded professional practice buy-sell agreement.
• A solo practitioner evaluating key-person coverage or a lender's collateral condition.
• A practice starting succession or continuity planning.

The page stays at the level common to professional practices. Profession-specific questions belong to the pages on medical practices, dental practices, accounting firms and law firm life insurance. Personal life-insurance buying and product shopping are outside its scope.

Key Person Considerations for Professional Practices

Key person insurance for a professional practice means a policy the practice owns on a principal whose loss would materially harm it. The practice pays the premiums, is the beneficiary, and uses the proceeds to absorb lost revenue, recruit a replacement or meet obligations. The key person versus personal coverage comparison sets out the ownership differences.

Because the practice is the beneficiary, section 264(a)(1) denies a deduction for the premiums. Section 101(a)(1) provides that gross income generally "does not include amounts received … under a life insurance contract, if such amounts are paid by reason of the death of the insured," subject to listed exceptions.

One exception is section 101(j). For an employer-owned contract, the exclusion "shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder." The cap is lifted only when a section 101(j)(2) exception applies and the section 101(j)(4) notice and consent requirements were met "before the issuance of the contract." The exceptions cover an insured who was an employee during the 12 months before death, or who at issue was a director, highly compensated employee or highly compensated individual, and amounts paid to the insured's family, designated beneficiary, a trust for them or the estate, or used to buy an equity interest from them. Notice and consent alone do not lift the cap; neither does an exception alone.

Notice 2009-48 A-5 confirms that "employee" includes "an officer, director, and highly compensated employee." Under A-7, even a wholly owned corporation and its owner-employee need written notice and consent. Section 6039I requires an applicable policyholder to file an annual return for these contracts, the IRS form for which is Form 8925.

Buy-Sell Considerations for Professional Practices

A buy-sell agreement is a contract among owners that governs the sale of an owner's interest at death, disability or departure. Life insurance is a common way to fund the death purchase. In a cross-purchase, each owner holds a policy on the others and buys the deceased owner's interest directly. In an entity purchase, or redemption, the practice holds a policy on each owner and buys back the interest. The buy-sell life insurance page explains both structures.

Transfer for value is the rule to watch when policies move between owners. Section 101(a)(2) limits the exclusion after a transfer "for a valuable consideration" to the consideration plus later premiums. Section 101(a)(2)(B) excepts a transfer "to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer."

That list treats partnerships and professional corporations differently. A partner of the insured is on it. In a professional corporation buy-sell agreement, a co-shareholder is not, although the corporation itself is. No federal source cited here says whether an LLP or an LLC is a partnership for these rules.

For corporations, the Supreme Court held in Connelly v. United States that a corporation's "contractual obligation to redeem" a deceased shareholder's shares "did not diminish the value of those shares" for federal estate tax. Transfers of policies between owners, valuation for buy-sell funding, estate inclusion of an owner's policy, executive bonus deductibility and split-dollar taxation also each need individual review. State licensing rules on ownership transfer vary by state.