Key Person Insurance Beneficiary: Why the Business Is the Beneficiary

Technical Summary: Business as Beneficiary in Key Person Insurance

In a standard key person arrangement, the beneficiary is the business itself, not the insured person or the insured's family. The business also owns the policy, pays the premiums and receives the death benefit. Who is named as beneficiary is set by the policy's own beneficiary designation. The purpose is to replace the business's own loss, such as lost revenue or the cost of finding a successor, when a critical person dies.

Owners, partners and finance leads usually ask this question when setting up or administering a policy on a founder, executive or rainmaker. Business Life Insurance treats the policy as a funding mechanism inside a continuity plan. Two federal rules shape the structure. Section 264(a)(1) of the Internal Revenue Code bars a premium deduction when the business is a beneficiary. Section 101(j) can cap the income-tax exclusion for death proceeds of an employer-owned contract. The broader concept is explained under how key person insurance works.

Definition: What "Beneficiary" Means in a Key Person Policy

A beneficiary is the party designated to receive the death benefit when the insured dies. A key person policy has three roles that personal coverage usually spreads across a family: owner, insured and beneficiary.

The key person is the insured. This may be an employee, officer, director or owner whose death would cause the business a financial loss. In a typical arrangement, the business is both owner and sole beneficiary. The business may be a corporation, partnership, LLC or sole proprietorship. Under personal life insurance, by contrast, the insured's family members are usually named; that comparison is covered on the site's personal versus key person page.

So the answer to "who is the beneficiary of key person insurance" is the business. The answer for a "key man insurance beneficiary" is the same. "Key person insurance" and "key man insurance" are industry terms that describe the purpose of the arrangement.

Applicable Rules: The Two Federal Provisions That Govern This Structure

Premiums come first. 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." Treasury Regulation § 1.264-1(a) extends this to policies covering "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." The disallowance applies "even though they would otherwise be deductible as trade or business expenses." A business that names itself beneficiary falls within this rule, as the site's key person premium deductibility page explains.

Proceeds come second. 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." That rule is subject to listed exceptions, including subsection (j). 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 does not apply if a section 101(j)(2) exception applies and the section 101(j)(4) notice and consent requirements are met. Treasury Regulation § 1.101-1 provides regulatory guidance on the section 101 exclusion, including worked examples of transfers for value.

Requirements: Notice, Consent, and Reporting Obligations

Section 101(j)(4) sets three written conditions. Each must be met "before the issuance of the contract." Under them, 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."

Part (C) is the beneficiary disclosure this page turns on. Meeting all three is necessary, but it is not enough by itself, because a section 101(j)(2) exception must also apply. Notice 2009-48 (A-7) adds that the requirements apply even to a wholly owned corporation and its employee-owner. It also says that "actual knowledge alone" does not substitute for written notice and consent.

Reporting follows. Under section 6039I(a), every applicable policyholder owning one or more employer-owned contracts files a return "for each year such contracts are owned." The return shows the number of employees and the number insured at year end, and the total insurance in force. It also shows the policyholder's name, address, taxpayer identification number and type of business. Finally, it shows whether the policyholder holds a valid consent for each insured employee. Section 6039I(b) also requires records sufficient to show whether section 101(j) is met.

The notice-and-consent process and this annual reporting need individual review of the contracts involved by the insurers and a qualified tax professional.

How the Rules Work: Premiums, Proceeds, and the Beneficiary Designation

The structure runs in four steps, from the first premium to the use of the proceeds.

1. Premiums. The business pays each premium. Because it is directly a beneficiary, section 264(a)(1) disallows the deduction. Treasury Regulation § 1.264-1(b) states that a taxpayer who takes out a policy "for the purpose of protecting himself from loss in the event of the death of the insured" is considered a beneficiary.
2. Ownership. Under the policy's terms, the business holds the ownership rights the contract grants, such as naming or changing the beneficiary and any cash value features. In a standard arrangement the insured holds none of those rights.
3. Death. The insurer pays the death benefit to the business as named beneficiary. The business then uses it as its plan intends, for example to cover lost revenue, recruitment or debt.
4. Tax treatment. Section 101(a)(1) states the general exclusion. For an employer-owned contract, section 101(j) caps it unless a section 101(j)(2) exception applies and notice and consent were met.

The section 101(j)(2) exceptions are as follows:

• (A) The insured was "an employee at any time during the 12-month period before the insured's death." Alternatively, at issuance the insured was a director, a highly compensated employee, or a highly compensated individual, as those terms are defined for purposes of section 101(j)(2)(A)(ii).
• (B) The amounts are paid to the insured's family members, a designated individual beneficiary other than the policyholder, a trust for such persons, or the insured's estate. The exception also covers amounts used to buy an equity interest in the policyholder from those persons.

Neither exception works without notice and consent. Separately, the transfer-for-value rule in section 101(a)(2) can limit the exclusion when a policy is transferred for valuable consideration. Transfers between owners need the same individual review.

Who This Is For: Businesses That Typically Use This Structure

The business problem comes before the policy. A closely held C or S corporation, partnership, LLC or professional practice may depend on one or a few people for revenue, client relationships or operations. Losing such a person can create costs for recruiting, training or replacement, and a business-owned policy is one way to fund them.

The insured need not be rank-and-file. Section 101(j)(5)(A) and Notice 2009-48 (A-5) state that "employee" includes an officer, director and highly compensated employee. Notice 2009-48 (A-3) adds that ownership by a partnership or sole proprietorship does not by itself keep a contract from being employer-owned. A contract owned by a business owner, such as to finance buying another owner's interest, is treated differently under A-1, as described on the site's page on life insurance between partners.