Key Person Insurance Required by a Lender: How It Works for Business Loans

Who This Strategy Is For

The readers in view are owners whose loan involves a life insurance condition, not businesses insuring staff. They include:

• sole proprietors applying for an SBA 7(a) loan that is not fully secured;
• single-member LLC owners in the same loan position;
• owners of closely held businesses that depend on one owner's active participation;
• owners whose loan agreement includes a condition about life insurance.

A business insuring a non-owner employee for continuity is a different arrangement, driven by the business's own planning rather than an SBA condition, and a business-owned policy on an employee, under which the business is directly or indirectly a beneficiary, can be an employer-owned life insurance contract under section 101(j).

When Key Person Insurance Under a Loan Condition May Fit

Facts that fit the SOP condition cleanly include:

• the loan is not fully secured and the borrower plainly fits one of the SOP categories;
• the business has one clear owner whose work drives revenue, so there is no question about whom to insure;
• the principal is insurable and a policy can be issued in time for the loan closing;
• the owner accepts assigning the policy to the lender for the loan term;
• the coverage amount stated in the loan documents falls within what the insurer will issue.

In these cases the policy serves a single, defined purpose, and the main work is completing the assignment the loan documents call for.

When It May Not Fit or May Complicate the Loan

Complications can come from the person, the collateral or the ownership structure.

• Underwriting. A principal with health issues may face delays, higher costs or a declined application, which can hold up closing.
• Full security. If the loan is fully secured, the quoted SOP condition does not apply, though a loan agreement may still include a condition about life insurance.
• Shared participation. When several owners are equally active, it may be unclear whether the business depends on "one owner's active participation."
• Employee status. If the business owns the policy, is directly or indirectly a beneficiary and the insured is an employee, including an officer, section 101(j) may apply.
• Mismatch. A face amount or term that cannot be matched to the loan terms may call for a different policy or added coverage.

Potential Advantages of Carrying This Coverage

Several features are described here, not promised.

• Loan access. Where the SOP condition or the loan agreement calls for coverage, an acceptable assigned policy is part of meeting the loan condition.
• Debt retirement. If the principal dies during the loan term, proceeds assigned under the agreement can be applied to the balance as the assignment provides.
• Residual proceeds. Depending on the assignment's terms, proceeds beyond the assigned interest may go to the named beneficiary, as the owner designated.
• Contract features. A permanent policy may build cash value as a feature of the contract.

Whether any of these features matter depends on the loan terms, the policy and the owner's other plans.

Important Tax and Compliance Considerations

Premiums come first. 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." IRS Publication 334 (2025), the agency's tax guide for small business, states: "If you take out a policy on your life or on the life of another person with a financial interest in your business to get or protect a business loan, you can't deduct the premiums as a business expense," nor "as interest on business loans or as an expense of financing loans."

Proceeds come next. Section 101(a)(1) provides that gross income "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. Publication 334 states that, in the loan setting, "the proceeds of the policy are not taxed as income even if they are used to liquidate the debt." Two limits matter here. The transfer-for-value rule in section 101(a)(2) can reduce the exclusion after a transfer for value. For employer-owned contracts, section 101(j) caps it unless an exception and notice and consent both apply. The section 101(j)(2) exceptions, which apply only where the notice and consent requirements are met, cover an insured who was an employee at any time during the 12-month period before death, or who is, when the contract is issued, a director, a highly compensated employee or a highly compensated individual as the statute defines those terms by cross-reference. They also cover amounts to the extent paid to a member of the insured's family, a designated beneficiary of the insured other than the applicable policyholder, a trust for the benefit of either, or the insured's estate, or used to purchase an equity (or capital or profits) interest in the applicable policyholder from one of those persons.

Reporting follows ownership. Section 6039I requires every applicable policyholder owning one or more employer-owned life insurance contracts issued after the section's enactment to file a return, at the time and in the manner the regulations prescribe, showing for each year the contracts are owned the number of employees, the number insured, the total insurance in force and whether a valid consent exists for each insured employee, and to keep records. The IRS's Form 8925, Report of Employer-Owned Life Insurance Contracts, is the form for this report.

Alternatives to a Business-Owned Collateral Assignment Policy

Other structures are possible when a loan condition calls for coverage.

• Individually owned and assigned. The owner holds the policy, pays the premiums and assigns rights to the lender. Under Notice 2009-48 A-1 and A-3, a policy owned by the owner rather than the business, or by a sole proprietor on his or her own life, is not an employer-owned contract.
• Term or permanent. Term coverage runs for a set period that can be matched to the loan; permanent coverage continues longer and carries cash value as a contract feature.
• Existing policy. The SOP says lenders "may accept the pledge of an existing life insurance policy."

A transfer of an existing policy to a new owner for valuable consideration can bring in section 101(a)(2). That provision excepts transfers "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," and carryover-basis transfers. Replacing a policy by exchange is a separate topic outside this page's scope.

Planning Example: Sole Proprietor SBA 7(a) Loan (Hypothetical)

Hypothetical Example — for illustration only; not a coverage recommendation or tax advice.

Assumptions: a sole proprietor borrows under a Standard 7(a) loan. The loan is $800,000; the collateral shortfall under the SOP is assumed to be $500,000; the owner owns a new term policy on his or her own life and pays the premiums. The assignment is assumed to give the lender the right to proceeds up to the outstanding balance, with any remainder going to the owner's spouse as the named beneficiary. No premium figure is used.

1. Collateral shortfall: assumed to be $500,000, so the policy is issued for $500,000.
2. At closing, the lender's assigned interest is capped at the lesser of the $500,000 face amount and the $800,000 balance, which is $500,000.
3. Several years later the balance is $300,000. The lender's interest is $300,000; the unassigned interest is $500,000 − $300,000 = $200,000.
4. If the owner died then, $300,000 would go to the lender and $200,000 to the named beneficiary.

Tax points: section 264(a)(1) disallows a deduction where the taxpayer is directly or indirectly a beneficiary, and Publication 334 applies this to loan-related premiums. Notice 2009-48 A-3 states that a sole proprietor's policy on his or her own life is not an employer-owned contract. Actual loan terms, coverage and tax treatment depend on the specific facts.