Key takeaways
- In a standard key person arrangement, the business owns the policy, pays the premiums and is named as the beneficiary, while the key person is only the insured.
- Section 264(a)(1) of the Internal Revenue Code allows no deduction for life insurance premiums when the taxpayer "is directly or indirectly a beneficiary under the policy," which is the usual position of a business holding key person coverage.
- Section 101(a)(1) generally excludes death proceeds from gross income, but for an employer-owned contract section 101(j) caps that exclusion at the premiums and other amounts paid unless a section 101(j)(2) exception applies and written notice and consent were given before the contract was issued.
- Written notice and consent alone do not lift the section 101(j) cap, and a qualifying exception alone does not lift it either; the statute conditions relief on both.
- The only statutory definition of "key person," in section 264(e)(3), applies to the policy-loan interest rules and is not a general test of who may be insured.
- Life insurance in this setting is a funding mechanism inside a continuity plan, not the plan itself; the plan describes what the business would do, and the policy may supply cash to do it.
- Structure, ownership and tax treatment turn on the facts of the specific contracts and the business, which is why they are reviewed with the insurers involved and qualified tax, legal and insurance professionals.
Published October 6, 2026 · Updated October 8, 2026
Short Answer: What Key Person Insurance Is
Key person insurance is life insurance that a business buys on someone whose death would harm it, such as a founder, a principal salesperson or the person who holds key client relationships. The business owns the policy, pays the premiums and is the beneficiary, so the death benefit is paid to the business to help it absorb the loss.
The question usually comes from an owner, a partner, a shareholder or a finance lead at a closely held company who has noticed how much of the business rests on one or two people. The same idea, often called key man insurance, keyman insurance or a key man policy in older usage, can also take the form of disability coverage, though Business Life Insurance treats the life insurance version here. In everyday business language, "key person" simply means an individual whose loss would materially damage the company. That everyday meaning is not a legal definition. The Internal Revenue Code gives "key person" a defined meaning in only one narrow place, section 264(e)(3), which concerns the deduction of interest on policy loans and describes "an officer or 20-percent owner." The general key person insurance definition used throughout the market is broader and is set by the business's own facts, not by statute.
What follows walks through the full chain that runs from the business to the policy: the business, the key person, that person's economic value, the resulting coverage need, the policy, the business as owner and the business as beneficiary. Along the way it sets out the federal tax rules that shape the arrangement.
How Key Person Insurance Works
Start with the business problem, because the policy only makes sense in relation to it. Many closely held companies depend on a small number of people for a large share of what keeps them running: the revenue a rainmaker brings in, the relationships a founder maintains with major clients, the technical knowledge an engineer carries, or the leadership that lenders and investors associate with a particular executive. When that person dies, the effects can spread quickly. Sales may slow, clients may reconsider, projects may stall, and a lender may grow concerned about whether the business can keep servicing its debt. The business may also face the direct cost of finding, hiring and training someone to step into the role.
Key person life insurance is one way a business may pre-fund part of that disruption. The mechanics follow a fairly consistent sequence.
The application and the insured's consent
The business, acting through its authorized officers or managers, applies to an insurer for a policy on the key person's life. The key person takes part in underwriting, the insurer's process of evaluating health and other factors to decide whether to issue coverage and on what terms. For an employer-owned contract, the insured's written consent before the policy is issued is also one of the conditions section 101(j) attaches to the income-tax treatment of the proceeds, a point developed under ownership and tax treatment.
Ownership, premiums and the beneficiary designation
Once the policy is issued, the business is the policyowner: it holds the contractual rights, such as changing the beneficiary or surrendering the contract. The business pays the premiums from its own funds and names itself as beneficiary.
What happens at the insured's death
When the insured dies, the insurer pays the death benefit to the business. From that point, the proceeds are business funds. Businesses commonly use such funds to recruit and train a replacement, to cover revenue lost during the transition, to pay down or reassure a lender on outstanding debt, to stabilize payroll and operations, or to contribute toward obligations under an existing ownership agreement. These are common uses, not outcomes any policy assures; what the money accomplishes depends on the size of the benefit, the business's other resources and the decisions its remaining owners and managers make.
How this differs from buy-sell funding
Key person coverage protects the business against the economic loss of a person. A buy-sell agreement funded with life insurance addresses a different problem: who buys a departing or deceased owner's interest, and with what money. The two are often used side by side, and Business Life Insurance explains buy-sell funding on its own pages, including the mechanics of a cross-purchase buy-sell agreement.
Who Key Person Insurance Is For
Key person coverage is most often considered by businesses where value is concentrated in a few identifiable people. That includes closely held C corporations and S corporations, partnerships, limited liability companies, and professional practices such as law, accounting, medical, dental, engineering and architecture firms, where a small number of principals may generate most of the revenue or hold most of the client relationships. Practice-specific questions, such as how a law firm combines partner buyouts with key person cover, are treated on Business Life Insurance's page on life insurance for law firms.
The key person need not be an owner. A business may depend heavily on a non-owner sales director, a chief technology officer, a lead scientist or an operations manager whose departure by death would be as damaging as the loss of a founder. Many arrangements cover exactly these employees.
Businesses with outstanding loans or credit lines form another group. A lender may ask for life insurance on a principal as part of its credit decision. Whether a lender asks, and on what terms, depends on the loan, the lender's own policy and any program rules that apply to the loan; it is not a general rule that business borrowing calls for life insurance.
Two federal points bear on which key person policies are employer-owned contracts. IRS Notice 2009-48, answering questions about section 101(j), states in A-5 that "Section 101(j)(5)(A) provides that the term 'employee' includes an officer, director, and highly compensated employee." So an officer or director counts as an employee under section 101(j), as does a highly compensated employee. The same notice draws a line based on who owns the policy. In A-1 it states that "a contract that is 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 life insurance contract." In A-3 it states that "ownership of the contract by a partnership or sole proprietorship does not prevent the contract from being treated as an employer-owned life insurance contract." For a key person policy, which is owned by the business itself, the practical effect is that a partnership-owned or proprietor-owned policy on an employee can be employer-owned just as a corporate policy can. These positions are those of Notice 2009-48 as published in 2009.
Professional-licensing and ownership rules, including who may own a practice or keep an interest after a death, vary by state and are not addressed here.
When Key Person Insurance May Fit
Key person coverage may fit a business whose revenue, client base or operational continuity depends materially on one or a few identifiable individuals. The more concentrated that dependence, and the harder the person would be to replace, the more often the question arises.
It may also fit a business carrying debt or credit obligations. A lender may have stated a coverage condition, or the business may want to show lenders and investors that it has thought through how it would continue if a principal died. In either case the answer depends on the loan terms and the lender's own policy.
A business that already has a buy-sell agreement in place, or is planning one, may consider key person coverage as a separate layer. The buy-sell funding addresses the transfer of ownership; key person coverage addresses the operating disruption that can occur at the same moment. The two layers answer different questions, and the amounts and owners of the policies often differ.
Growth-stage companies are another common setting. A business that depends on a founder to close contracts, keep a technical roadmap on track or raise capital may find that losing that person would impair its ability to execute, and lenders or investors may raise the issue directly.
Each of these is a factual situation in which the strategy is commonly evaluated, not a conclusion that it suits any particular business. Whether it fits depends on the business's finances, its other resources and the role of the person involved.
When Key Person Insurance May Not Fit
Some businesses have no single person whose loss would materially affect operations or finances. Where responsibilities, relationships and knowledge are spread across a deep team, the economic case for insuring one individual may be weak.
Cost is the second common reason. Premiums are an ongoing outflow, and because a business that is the beneficiary of the policy generally cannot deduct them, the after-tax cost is the full premium. A business whose cash flow cannot sustain that cost over the period of need may find that the coverage does not fit, or that a smaller or shorter-term policy is all it can carry.
Underwriting can also rule the strategy out. The intended insured may be declined, or offered coverage on terms the business considers too costly, because of age, health or other factors the insurer weighs. Underwriting standards and pricing vary from insurer to insurer.
Finally, some businesses already have reserves, committed credit facilities or other resources large enough to absorb the disruption of losing a key person. For them, transferring the risk to an insurer may add cost without adding much protection. As with the situations in which the strategy may fit, these are factual patterns, and the answer for a given business turns on its own numbers.
Ownership, Premiums and Beneficiary
Three roles define the arrangement. The business is the policyowner, the premium payer and the beneficiary. The key person is the insured: the life on which the death benefit depends. The insured does not own the policy and has no right to name its beneficiary.
That allocation of roles is what brings the main federal rules into play. Because the business pays the premiums on a policy under which it is the beneficiary, the premium-deduction rule applies. Because the business is engaged in a trade or business, owns the contract and is a beneficiary, and the insured is its employee, the employer-owned life insurance rules of section 101(j) apply as well.
The premium rule in its own words
Section 264(a)(1) of the Internal Revenue Code 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." The Treasury regulation, 26 C.F.R. § 1.264-1(a), states that premiums "are not deductible from the taxpayer's gross income, even though they would otherwise be deductible as trade or business expenses, if they are paid on a life insurance policy covering the life of any officer or employee of the taxpayer, or any person (including the taxpayer) who is financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or indirectly a beneficiary of the policy."
The regulation then explains when a business counts as a beneficiary: "If a taxpayer takes out a policy for the purpose of protecting himself from loss in the event of the death of the insured, the taxpayer is considered a beneficiary directly or indirectly under the policy." That sentence describes key person insurance almost exactly. The statute draws no distinction between term and permanent policies; the test is whether the taxpayer is a beneficiary. Business Life Insurance explains the deduction question at length on its page on the tax treatment of key person premiums.
The IRS's small-business guide states the same principle for contracts issued after June 8, 1997: "you generally can't deduct the premiums on any life insurance policy, endowment contract, or annuity contract if you are directly or indirectly a beneficiary. The disallowance applies without regard to whom the policy covers."
Consent and reporting tied to ownership
Because the business owns the policy on an employee, the written notice and consent conditions of section 101(j)(4) apply before the contract is issued, and section 6039I imposes an annual return and recordkeeping duty on the business as the "applicable policyholder." Both are explained with the tax rules for proceeds. Whether premiums are deductible in a particular arrangement, and whether a business's notice, consent and reporting satisfy section 101(j) and section 6039I, needs individual review of the contracts involved by the insurers and a qualified tax professional.
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Tax Treatment of Premiums and Proceeds
The federal income tax picture has three parts: the premiums, the death proceeds, and a narrow rule on policy-loan interest that supplies the Code's only definition of "key person."
Premiums
The section 264(a)(1) disallowance governs premiums whenever the business is directly or indirectly a beneficiary, which is the ordinary key person structure. The premiums are paid with after-tax dollars.
The general exclusion for death proceeds
Section 101(a)(1) provides that, except as otherwise provided, "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured." The Treasury regulation under section 264 confirms that the exclusion can apply "whether the beneficiary is an individual or a corporation." That is the starting point. Two limits matter in business planning: transfer for value under section 101(a)(2), explained with policy structures, and the employer-owned contract rule of section 101(j).
The employer-owned life insurance cap
Section 101(j)(3)(A) defines an employer-owned life insurance contract as one that "is owned by a person engaged in a trade or business and under which such person (or a related person ...) is directly or indirectly a beneficiary under the contract," and that "covers the life of an insured who is an employee with respect to the trade or business of the applicable policyholder on the date the contract is issued." A typical key person policy meets that description.
For such a contract, section 101(j)(1) provides that the amount excluded "shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract." In plain terms, the death benefit above what the business paid in is included in gross income, unless the statute's relief applies.
The two conditions for relief
Section 101(j)(2) lifts the cap only "In the case of an employer-owned life insurance contract with respect to which the notice and consent requirements of paragraph (4) are met," and only for amounts that fall within one of its exceptions. The two conditions work together. Notice and consent alone do not lift the cap, and neither does an exception alone.
The exceptions fall into two groups.
- Exceptions based on the insured's status (section 101(j)(2)(A)). These cover an insured who "was an employee at any time during the 12-month period before the insured's death," or who is, at the time the contract is issued, a director, a highly compensated employee as the Code defines that term, or a highly compensated individual as the Code defines that term (with a modified percentage the statute specifies).
- Exceptions for amounts paid to the insured's heirs (section 101(j)(2)(B)). These cover amounts paid to a member of the insured's family, to an individual who is the insured's designated beneficiary under the contract (other than the applicable policyholder), to a trust for any such person, or to the insured's estate, and amounts "used to purchase an equity (or capital or profits) interest in the applicable policyholder" from any of those persons.
Notice and consent
Section 101(j)(4) states that the requirements "are met if, before the issuance of the contract, the employee— (A) is notified in writing that the applicable policyholder intends to insure the employee's life and the maximum face amount for which the employee could be insured at the time the contract was issued, (B) provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and (C) is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee."
Notice 2009-48 adds several points. In A-7 it states that section 101(j)(4) "provides no exception that would excuse a wholly-owned corporation and its employee-owner from the notice and consent requirements," and that actual knowledge cannot "substitute for the statutory requirement that notice and consent be 'written.'" In A-13 it states that section 101(j) "does not contain a provision for correcting an inadvertent failure," while describing limited conditions under which the IRS will not challenge an exception: a good-faith effort, an inadvertent failure, and discovery and correction no later than the due date of the tax return for the year the contract was issued. It adds that "failure to obtain such consent cannot be corrected after the insured employee has died."
Notice 2009-48 also addresses which contracts are employer-owned and who counts as an employee. A-1 states that a contract owned by an entity's owner, for example to finance buying another owner's interest, is not an employer-owned contract. A-3 states that "A life insurance contract that is owned by a sole proprietor on his or her own life is not, however, an employer-owned life insurance contract." A-5 confirms that "employee" includes an officer, director and highly compensated employee.
Reporting
Section 6039I requires every applicable policyholder owning employer-owned contracts issued after its enactment to file a return showing, for each year, the number of its employees, the number insured, "the total amount of insurance in force," its identifying information, and "that the applicable policyholder has a valid consent for each insured employee (or, if all such consents are not obtained, the number of insured employees for whom such consent was not obtained)." It also requires the policyholder to keep records needed to determine whether section 6039I and section 101(j) are met. The IRS form associated with this return is Form 8925; its timing and filing details are set by the IRS and confirmed in the form's instructions.
The statutory "key person" and policy-loan interest
The Code's only definition of the term sits in section 264(e)(3): "the term 'key person' means an officer or 20-percent owner," with the number of individuals capped at "the greater of— (A) 5 individuals, or (B) the lesser of 5 percent of the total officers and employees of the taxpayer or 20 individuals." That definition serves section 264(e)(1), which, as the 2024 edition of the Code states it, preserves a deduction for certain policy-loan interest "to the extent that the aggregate amount of such indebtedness with respect to policies and contracts covering such individual does not exceed $50,000," subject to an interest-rate cap in section 264(e)(2). Section 264(e)(4) defines a 20-percent owner by stock ownership or voting power for a corporation, and by capital or profits interest otherwise. None of this decides who may be covered by key person insurance; it matters when the business borrows against a policy, and in the policy-sale rules covered below. How these rules apply to a particular business's contracts, ownership and borrowing depends on facts that only a review of those contracts can establish.
What Affects the Amount of Coverage and Its Cost
Coverage sizing begins with an estimate of the economic impact of losing the person. Businesses commonly look at the revenue or gross profit the person generates, how long a transition might take, the cost of recruiting and training a replacement, and any debt the business would want to reduce or reassure lenders about. No formula is universal, and no federal rule sets a multiple of salary or revenue for key person coverage. The insurer will also apply its own underwriting view of how much coverage is reasonable relative to the person's role and the business's finances; those limits vary from insurer to insurer.
The relevant inputs usually include:
- the insured's role in generating revenue or maintaining key relationships, and how replaceable that role is;
- the business's financial exposure, including loans, guarantees and contractual commitments;
- the period over which the business would feel the loss most;
- the business's existing reserves and credit capacity.
Cost depends on a separate set of factors. The insured's age and health drive underwriting, and the policy type matters: term life insurance provides a death benefit for a defined period, while permanent life insurance, such as whole life and universal life, provides lifetime coverage while premiums are paid and includes cash value, a contract feature that accumulates inside the policy under its terms. Premiums, charges and underwriting classes vary from insurer to insurer and are confirmed with the insurers involved.
Business Life Insurance offers a key person insurance calculator that works through these inputs. Its result is an educational illustration only, not a coverage recommendation.
Common Structures for Key Person Coverage
The policy chosen for key person coverage is usually matched to how long the business expects the need to last.
Term life insurance
A term policy provides a death benefit for a specified period and has no cash value. Businesses commonly use term coverage when the need is tied to a defined period: the life of a loan, a growth phase, or the years until a non-owner key employee is expected to retire or leave. Whether a term policy can later be converted to permanent coverage is a contract feature that varies by insurer and is not developed here.
Permanent life insurance
Whole life and universal life policies provide a death benefit that does not expire while premiums are paid, together with cash value as a contract feature. The business, as owner, may be able to take policy loans against the cash value or make withdrawals, subject to the policy's terms and the applicable tax rules. Outstanding loans generally reduce the death benefit under the contract's terms. Policy-loan interest raises the narrow section 264(e) issue described with the tax rules. Permanent coverage is often considered where the business expects the need to continue indefinitely, or where it wants the policy to have a role in a later ownership transition.
Premiums under either structure
The section 264(a)(1) rule is indifferent to policy type: if the business is a beneficiary, the premiums are not deductible, whether the policy is term or permanent.
Transfers of a key person policy
A permanent policy outlives the employment relationship more often than a term policy, so businesses sometimes transfer one to the insured at retirement, to a co-owner, or to another entity. Section 101(a)(2) provides that, for "a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein," 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 statute then excepts certain transfers, including 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," and a transfer in which the transferee's basis is determined by reference to the transferor's; section 101(a)(3) removes those exceptions for a "reportable policy sale," an acquisition by a person with "no substantial family, business, or financial relationship with the insured" apart from the policy interest. A co-shareholder of the insured is not on that list, which matters in corporations and professional corporations. Whether a given transfer falls within an exception, and how it interacts with section 101(j), needs individual review of the contracts involved by the insurers and a qualified tax professional.
Related strategies with their own pages
Split-dollar life insurance and executive bonus arrangements are separate strategies that Business Life Insurance explains on their own pages; "executive bonus plan" and "section 162 plan" are industry shorthand for an executive bonus arrangement, not a special plan created by section 162, which is a deduction rule, and not terms defined in the Code or regulations. Buy-sell funding with life insurance is likewise a separate strategy with its own pages.
Potential Advantages of Key Person Insurance
Liquidity at the moment it may be needed most is the central feature. A death benefit is paid to the business as a single amount, which the business may use to stabilize operations, cover lost revenue, service or reduce debt, or fund the search for a replacement, at a time when other sources of cash may be strained.
The tax treatment of proceeds can be favorable when the statute's conditions are satisfied. Section 101(a)(1) excludes death proceeds from gross income as a general rule, and for an employer-owned contract that exclusion extends beyond the premiums paid only where a section 101(j)(2) exception applies and the written notice and consent requirements were met before issuance. Whether that happens for a given policy depends on its facts.
Permanent policies add a lifetime dimension. Cash value, as a contract feature, may be available to the business through loans or withdrawals while the insured is alive, subject to the policy's terms, the effect on the death benefit and the applicable tax rules.
Coverage may also answer a lender's question. Where a lender asks for life insurance on a principal, an existing key person policy, sometimes with a collateral assignment to the lender, may address it. Lender requirements vary and are confirmed with the lender.
Each of these is a possibility that depends on the contract, the business and the circumstances at the insured's death, not an outcome any policy assures.
Important Considerations and Limitations
The premium rule is fixed rather than a planning variable. Under section 264(a)(1), a business that is directly or indirectly a beneficiary does not deduct the premiums, and the Treasury regulation treats a policy taken out to protect the business against loss on the insured's death as one under which the business is a beneficiary. The IRS's small-business guide applies the same idea to coverage bought to secure a loan: "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."
The section 101(j) conditions are cumulative and time-bound. A qualifying exception and written notice and consent before issuance are both required for the exclusion to reach beyond the premiums and other amounts paid; consent gathered after the contract is issued does not meet the statute's "before the issuance of the contract" condition, subject only to the limited administrative position described in Notice 2009-48 A-13, and, as that answer states, a missing written consent "cannot be corrected after the insured employee has died."
Reporting runs for every year the contract is owned. Section 6039I calls for an annual return and records sufficient to show compliance with section 6039I and section 101(j).
A later transfer can change the tax treatment of the death benefit. The transfer-for-value rule of section 101(a)(2) and its exceptions turn on who receives the policy and for what consideration.
Premiums are an ongoing, non-deductible cost. A business typically weighs the full after-tax premium against its cash flow over the entire period of coverage, not just the first year.
State insurance law adds its own layer. Insurable-interest, disclosure and consent rules for policies a business owns on another person vary by state, and they sit alongside the federal notice and consent conditions rather than replacing them.
Each of these turns on the specific contracts, ownership and history of the business, which is why structure, ownership and tax treatment are confirmed with the insurers and qualified tax, legal and insurance professionals.
Alternatives to Key Person Insurance
Key person coverage is one of several ways a business may plan for losing a critical person, and the alternatives often address related but different problems.
Buy-sell agreement funding. A buy-sell agreement sets out who buys an owner's interest at death or another triggering event, and life insurance is a common source of the purchase money. It addresses ownership transition rather than operating disruption. Business Life Insurance explains buy-sell funding and the comparison between the two strategies on separate pages.
Executive bonus arrangements. In what the industry calls an executive bonus or section 162 arrangement, the business pays a bonus that the key person uses to pay premiums on a policy the key person owns. These labels are industry terms, not qualified plans and not terms defined in the Code or regulations. Because the business is not the beneficiary, the section 264(a)(1) bar does not reach the bonus in the same way; the bonus is considered under section 162(a)(1), which allows "a reasonable allowance for salaries or other compensation for personal services actually rendered," and it is taxable compensation to the employee. The arrangement benefits the employee's family rather than the business.
Split-dollar life insurance. Split-dollar is an arrangement in which the business and the insured share a policy's costs and benefits. Which federal tax regime applies depends on who owns the policy and how the arrangement is structured; Business Life Insurance covers it separately.
Reserves and credit facilities. A business may choose to self-fund the risk through retained earnings or committed credit, accepting the exposure rather than transferring it to an insurer.
Disability income coverage on the key person. A key person's long-term disability can be as disruptive as a death. Disability policies are separate contracts with different terms and different tax rules from life insurance, and they are not developed here.
These are factual alternatives, often used in combination. Which mix suits a business depends on its ownership, finances and objectives.
Hypothetical Example: Estimating the Business Impact
This example is hypothetical. It uses round figures and invented assumptions to show the arithmetic of sizing and the order in which the tax rules apply. It does not represent any reader's business, contract or tax result.
Assumptions. A closely held S corporation distributes industrial equipment. One salesperson, who is a non-owner employee and is paid well enough to be highly compensated, is responsible for most of its largest accounts. Management estimates that:
- the accounts the salesperson manages produce $400,000 of gross profit a year;
- if the salesperson died, about two years of that gross profit would be at risk during the transition;
- recruiting, hiring and training a replacement would cost about $200,000;
- the business has a $500,000 bank loan it would want to reduce.
Step 1: revenue at risk. $400,000 of gross profit a year × 2 years = $800,000.
Step 2: add replacement cost. $800,000 + $200,000 = $1,000,000.
Step 3: add the loan balance. $1,000,000 + $500,000 = $1,500,000.
The illustrative coverage amount under these assumptions is $1,500,000. An insurer's underwriting may arrive at a different figure, and another method of estimating the loss could produce another result.
Applying the premium rule. The corporation owns the policy, pays the premiums and is the beneficiary. Under section 264(a)(1), the premiums, whatever the insurer charges, are not deductible. If the total premiums paid by the date of death are called P, the corporation has spent P after tax.
Applying the proceeds rules. Suppose the salesperson dies while still employed.
- Scenario A. Before the policy was issued, the salesperson received written notice of the intent to insure and the maximum face amount, gave written consent covering coverage after employment ends, and was told in writing that the corporation would be a beneficiary. The salesperson was also an employee within the 12 months before death, which is one of the status exceptions. Both conditions of section 101(j)(2) are present, so the section 101(a)(1) exclusion is not capped by section 101(j)(1).
- Scenario B. Same facts, but no written consent was obtained before issuance. The status exception exists, yet the notice and consent condition is not met, so section 101(j)(1) limits the exclusion to P. The amount included in gross income would be $1,500,000 − P.
The difference between the scenarios comes entirely from paperwork completed, or not, before the policy was issued. In practice the outcome also depends on other facts the example does not address, including any transfer of the policy and the corporation's reporting under section 6039I.
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Frequently Asked Questions
What is a key person in insurance?
In business usage, a key person is someone whose death or disability would materially harm the business, such as a founder, a principal salesperson or a person with technical knowledge that is hard to replace. The Internal Revenue Code defines "key person" only in section 264(e)(3), where it means "an officer or 20-percent owner," and only for the policy-loan interest rules. That statutory meaning does not limit who a business may insure.
Are key person insurance death benefit proceeds taxable?
It depends on whether the section 101(j) conditions are met. Section 101(a)(1) generally excludes death proceeds from gross income, but for an employer-owned contract section 101(j)(1) caps the exclusion at the premiums and other amounts paid. The cap is lifted only where a section 101(j)(2) exception applies and written notice and consent were given before the contract was issued; how that applies to a particular policy depends on its facts.
What are the disadvantages of key man insurance?
The main drawbacks are cost and conditions. Premiums are a recurring outlay that a business which is the beneficiary generally cannot deduct under section 264(a)(1), and full exclusion of the proceeds depends on meeting both section 101(j) conditions before the contract is issued, along with annual reporting under section 6039I. Underwriting may also be unavailable or costly, depending on the insured's age and health and the insurer's standards.
Who owns a key person insurance policy?
In a standard arrangement, the business owns the policy, pays the premiums and is the beneficiary. The key person is the insured and does not own the policy. That structure is what brings both the section 264(a)(1) premium rule and the section 101(j) employer-owned contract rules into play.
What is the notice and consent requirement for employer-owned life insurance?
Section 101(j)(4) requires that, before the contract is issued, the employee be notified in writing of the intent to insure the employee's life and the maximum face amount, give written consent to being insured and to coverage continuing after employment ends, and be informed in writing that the policyholder will be a beneficiary. Meeting these requirements is necessary but not sufficient, because a section 101(j)(2) exception must also apply. Notice 2009-48 A-7 states that a wholly-owned corporation and its employee-owner are not excused from them.
Does key person insurance cover disability as well as death?
A key person life insurance policy pays on death, not on disability. Disability income insurance on a key person is a separate contract that addresses the risk of the person becoming unable to work, with its own terms and tax rules. Businesses sometimes carry both.
What is Form 8925?
Form 8925 is the IRS form associated with the annual return that section 6039I requires of a business that owns employer-owned life insurance contracts. Section 6039I calls for the number of employees, the number insured, the total amount of insurance in force, the policyholder's identifying information, and a statement about valid consents for insured employees. Filing timing and details are set by the IRS and confirmed in the form's instructions.
Is a sole proprietor's policy on their own life an employer-owned contract?
Notice 2009-48 answers this in A-3, which states that "A life insurance contract that is owned by a sole proprietor on his or her own life is not, however, an employer-owned life insurance contract." The same answer adds that ownership by a sole proprietorship or partnership does not, by itself, keep a policy on an employee from being employer-owned.
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