Key Person and Founder Insurance for Technology Companies

Short Answer: How Key Person Insurance Works for Technology Companies

An established technology company can own a life insurance policy on a key engineer, executive or co-founder, pay its premiums and name itself as beneficiary. If that person dies, the company receives the death benefit and can use it to absorb the cost of replacing that person, lost revenue, debt or an ownership buyout.

This page is written for software, SaaS, hardware and IT services companies that already have revenue, an equity structure and senior technical leaders. Early-stage, founder-stage coverage is a separate subject, covered on the startup key person page. Two federal rules shape every company-owned policy here. The first is 26 U.S.C. § 264(a)(1), which bars a premium deduction when the business is a beneficiary. The second is 26 U.S.C. § 101(j), the framework for notice, consent and exceptions on employer-owned contracts. The page covers federal rules only. Insurance regulation varies by state.

Why Life Insurance Planning Matters for Technology Companies

In a technology company, much of the enterprise value is held by people, not by physical assets. The architecture of a platform, the roadmap of a product line and the relationships behind enterprise contracts often sit with a small group of engineers, architects and executives. Much of what they know may never be fully written down.

An established company adds formal structures on top of that concentration. These include shareholder agreements, institutional investors, credit facilities with covenants, and employment agreements. Each of these turns the loss of a principal engineer, a CTO or a revenue-driving executive into a measurable financial exposure. That exposure can show up as delayed releases, customer contracts at risk, nervous investors or lender questions.

The business problem comes first: continuity, liquidity and ownership transition. Life insurance is one way to fund a response to that problem. It is not the plan itself. Policy forms and related insurance requirements vary by state.

Key Financial Risks Specific to Technology Companies

Several kinds of exposure recur across software and hardware businesses.

• Technical leadership loss. The death of a principal engineer or architect can stall a product release. It can also put service-level commitments under customer contracts at risk.
• Revenue concentration. A sales or business-development executive may hold the relationships behind a large share of recurring revenue.
• Retention metrics. In a SaaS company, the loss of a key technical leader can unsettle customers. That can affect renewals and churn, the rate at which customers cancel.
• Financing terms. A lender or investor may ask for evidence of key-person coverage as a condition of a credit facility or equity round. These requirements vary and are confirmed with the lender or investor involved.
• Ownership concentration. In a closely held company, the death of a co-founder or controlling shareholder can trigger buy-sell obligations or start a dispute over valuation.

Valuing a technology company for buy-sell funding depends on facts specific to that company, such as recurring revenue, intellectual property and growth assumptions.

Who This Page Is For

The intended reader works at an established, revenue-generating technology company. Typical readers include:

• owners, co-founders, CFOs, general counsel and finance leads;
• companies weighing coverage on a CTO, VP of Engineering, VP of Sales, principal engineer or another executive whose loss would create a measurable financial exposure; and
• shareholders in a closely held technology company who are funding a buy-sell agreement.

Founder-stage coverage at an early-stage company is outside this page's scope. So are personal life insurance buying, product comparison and consumer coverage. The general uses of business life insurance across industries are covered on the business life insurance overview.

Key Person Insurance Considerations for Technology Companies

Key person insurance is a life insurance policy owned by a business on the life of an employee or officer whose death would cause the business a material financial loss. "Key man insurance" and "key employee insurance" are industry terms for the same arrangement. None of these terms is defined in the Internal Revenue Code.

Mechanics. In a key person arrangement:

• the company owns the policy;
• the company pays the premiums;
• the company is the beneficiary; and
• the proceeds typically fund recruiting and onboarding a replacement, cover lost revenue, retire debt or stabilize operations.

The mechanics of key person insurance are the same in any industry. What differs in technology is who tends to be insured.

Premiums. Section 264(a)(1) of the Internal Revenue Code provides that "No deduction shall be allowed for— (1) Premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy or contract."

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 in business planning:

• Transfer for value. Section 101(a)(2) can limit the exclusion when a policy is transferred for value.
• Employer-owned contracts. For an employer-owned life insurance contract, section 101(j)(1) caps the exclusion at "the sum of the premiums and other amounts paid by the policyholder for the contract."

The cap under section 101(j) lifts only when both of two conditions are met:

1. A section 101(j)(2) exception applies. The status-based exceptions cover an insured who was an employee at any time during the 12-month period before death, or who, when the contract was issued, was a director, a highly compensated employee or a highly compensated individual, as section 101(j)(2) defines those terms by cross-reference. A separate exception covers amounts paid to the insured's heirs, including family members, a designated beneficiary, a trust for them or the insured's estate.
2. Written notice and consent came first. Before the contract was issued, the employee was notified in writing, consented in writing and was told in writing that the policyholder will be a beneficiary.

Notice and consent alone do not lift the cap, and neither does an exception alone. No exception applies automatically.

IRS guidance. IRS Notice 2009-48 adds the following points, as of its date:

• A-5: "employee" includes "an officer, director, and highly compensated employee."
• A-1: a contract owned by an entity's owner, such as one used to finance buying another owner's interest, is not an employer-owned contract.

Reporting. Under 26 U.S.C. § 6039I, every applicable policyholder owning employer-owned contracts files an annual return. The return shows employee counts, insurance in force and whether a valid consent exists for each insured. The IRS collects this return on Form 8925.

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.

Buy-Sell Agreement Considerations for Technology Companies

A buy-sell agreement is a contract among co-owners that governs how an ownership interest is transferred when a triggering event, such as death, occurs. Two funding structures are common:

• Entity purchase (redemption). The company owns a policy on each owner and buys back the deceased owner's interest.
• Cross-purchase. Each co-owner owns a policy on the other owner or owners.

The difference between key person and buy-sell coverage lies in who owns the policy and who receives the proceeds.

Notice 2009-48 on ownership. Under A-1 of the notice, a policy that a co-owner holds personally to buy another owner's interest is not an employer-owned contract. Under A-3, ownership by a partnership or sole proprietorship does not by itself keep a contract from being one.

Transfer for value and business form. Transfer for value becomes an issue when an existing policy changes hands, for example when a policy is restructured or after the first death. The business form matters:

• Partnerships. Section 101(a)(2)(B) excepts a transfer "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."
• LLCs and LLPs. Whether an LLC or an LLP counts as a partnership for these rules depends on facts that need individual review.
• Corporations. Many technology companies are C or S corporations. In a corporation, a co-shareholder is not on the section 101(a)(2)(B) list, although the corporation itself is.

Transfers of policies between owners, valuation for buy-sell funding, executive bonus deductibility, split-dollar regime and taxation, and estate inclusion of life insurance each need individual review of the contracts and facts involved by the insurers and a qualified tax professional.