Key Person Insurance for Startups and Founders

Short Answer: What Key Person Insurance Does for a Startup

For a startup, key person insurance is a life insurance policy the company owns on a founder whose death would seriously harm the business. The company pays the premiums and is the beneficiary, so the proceeds go to the company, not the founder's family, to help fund continuity.

Key person insurance is also called key man insurance. In an early-stage company the insured is usually a founder or co-founder rather than a hired executive. The federal income-tax treatment of the death benefit starts with the exclusion in 26 U.S.C. § 101(a)(1). For a contract the company owns on an employee, it also turns on the employer-owned contract rules of 26 U.S.C. § 101(j). Business Life Insurance treats the policy as one funding mechanism inside a continuity plan, never as the plan itself.

Why Key Person Risk Is Acute for Early-Stage Companies

A young company often runs on one or two people. The product vision, the technical architecture, the investor relationships, the first customer accounts and any pending regulatory approvals may all sit with a single founder. Much of that knowledge exists only in that founder's head.

An established company usually has management depth. Several executives share decisions, processes are documented, and a successor can be named from inside. A startup rarely has that bench.

The business problem is therefore larger than a lost salary. It is whether the company can keep operating and keep raising capital after the founder is gone. Each party sees that problem from its own side. Investors care about the value of their equity. Lenders care about repayment. Surviving co-founders care about control of the company and about what happens to the deceased founder's shares.

Key Risks a Startup Faces When a Founder Dies

A founder's death can trigger several financial problems at once. These are the business problems that insurance proceeds may help fund, though no policy promises that proceeds will be enough, or that coverage will be issued or available when needed.

• Lost contribution. Technical or creative work may stop, and no one can step in right away.
• Fundraising disruption. Investors may withdraw commitments or exercise protective provisions in their agreements if a named founder is no longer active.
• Loan conditions. For SBA 7(a) loans, SBA SOP 50 10 8.1 states: "If the loan is not fully secured, life insurance is required in the amount of the collateral shortfall for the principals of sole proprietorships, single member LLCs, or for businesses otherwise dependent on one owner's active participation." The SOP sets a similar requirement for 504 loans that are not fully collateralized. The one-owner-dependence condition applies only to SBA loans that are not fully secured. Otherwise, lenders follow their own internal policy.
• Equity buyout. Surviving co-founders or the company may be obligated to buy the deceased founder's shares or units.
• Runway. The company may need cash to recruit a replacement, restructure, or wind down in an orderly way.

Who This Page Is For

This page is for early-stage companies in any industry where one or two founders are hard to replace. It also serves:

• co-founders deciding how to own policies on each other;
• startup boards and investors checking whether key person coverage is in place;
• attorneys and accountants advising early-stage companies on continuity.

It does not cover an established technology company that insures key engineers and provides executive benefits. Business Life Insurance covers that setting on its technology companies page.

The page explains federal income-tax rules only. State insurance rules vary by state. Rules on who may own a business interest or keep one after a death also vary by state, as do licensing rules in regulated fields, and this page does not address them.

Key Person Insurance Mechanics for a Startup

How the policy is set up. In a typical arrangement, the company owns the policy, pays the premiums and is named as beneficiary. The policy covers the founder's life. Proceeds go to the company to fund the needs it has identified. The key person insurance overview covers this structure in more detail.

Premiums. 26 U.S.C. § 264(a)(1) provides that "No deduction shall be allowed for— (1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract." When the startup is the beneficiary, its premiums are therefore generally not deductible as a business expense. The page on key person insurance cost discusses what that means for the after-tax cost.

The death benefit. Section 101(a)(1) generally excludes from gross income amounts "paid by reason of the death of the insured." That exclusion has limits that matter for business planning:

• The transfer-for-value rule in § 101(a)(2) can limit the exclusion when a policy is transferred.
• For an employer-owned contract, § 101(j)(1) limits the excluded amount to "the sum of the premiums and other amounts paid by the policyholder for the contract."

The § 101(j) cap is lifted only when two conditions are both met:

1. A § 101(j)(2) exception applies. One exception is based on the insured's status, such as an employee during the 12 months before death, a director, or a highly compensated employee or individual when the contract was issued. The other covers amounts paid to the insured's heirs or used to buy their equity interest.
2. The written notice and consent requirements of § 101(j)(4) were met before the contract was issued.

Notice and consent alone do not lift the cap, and neither does an exception alone.

What IRS Notice 2009-48 states in its answers.

• A-1: 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-3: Ownership by a partnership or sole proprietorship does not prevent a contract from being employer-owned.
• A-5: "Employee" includes an officer, director and highly compensated employee.
• A-7: A wholly owned corporation and its employee-owner are not excused from written notice and consent.

A founder who is also an officer can therefore be an "employee" for these rules.

Reporting. 26 U.S.C. § 6039I requires each applicable policyholder that owns employer-owned contracts to file an annual return. The return reports insured employee counts and the amount of insurance in force, and states whether valid consents exist.

Whether a particular startup policy is an employer-owned contract, and whether notice, consent and reporting were handled correctly, depends on the facts of the arrangement. These questions need individual review of the contracts involved by the insurers and a qualified tax professional.

Buy-Sell Funding Considerations for Startup Co-Founders

A buy-sell agreement is a contract that sets out who buys a departing owner's interest and on what terms. Startups commonly fund one of two structures with life insurance:

• Cross-purchase: each co-founder owns a policy on the other.
• Entity purchase or redemption: the company owns a policy on each founder and buys back the deceased founder's interest.

The key person insurance vs buy-sell insurance comparison explains how the two purposes differ.

Transfer for value. Moving existing policies between founders or the company, for example when the structure changes, can raise the transfer-for-value rule. Under § 101(a)(2), after a transfer for valuable consideration the exclusion "shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee."

The rule does not apply in two situations:

• the transferee's basis is determined by reference to the transferor's basis; or
• the transfer is "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."

How the startup's entity type matters.

• LLC or LLP: No federal text addresses whether an LLC or LLP counts as a partnership for this exception.
• Corporation: A co-shareholder is not on the exception list, although the corporation itself is.

Policy transfers between owners, buy-sell structure and the business valuation behind the agreement fall within individual review by the insurers and a qualified tax professional. Legal counsel handles the agreement terms.