Key Person Insurance Cost: What Determines It and Why Premiums Are Not Deductible

Ownership, Premiums and Beneficiary

Ownership drives the tax answer. Section 264(a)(1) of the Internal Revenue Code provides that no deduction shall be allowed for "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), applies this rule to policies "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." It applies "even though they would otherwise be deductible as trade or business expenses." Under § 1.264-1(b), a business that "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. That describes the purpose of a key person policy. IRS Publication 334 (2025) states the same position for contracts issued after June 8, 1997.

The business therefore pays the premium from after-tax funds. In this structure the policy is not set up as pay to the insured employee.

An executive bonus arrangement is a different structure. "Executive bonus plan" is an industry term, not a qualified plan or a term the Code defines. In that structure, the employee owns the policy, and the business pays the premium as compensation. Section 162(a)(1) allows "a reasonable allowance for salaries or other compensation," and section 61(a)(1) includes compensation in the employee's gross income.

How section 264(a)(1) applies to a particular premium needs individual review of the contracts involved by the insurers and a qualified tax professional. The site's page on key person premium deductibility treats that question in detail.

Key Factors That Determine the Premium

The cost of key man insurance comes out of underwriting. Underwriting is the insurer's assessment of the likelihood that it will pay a claim. Insurers commonly consider these factors:

• Age of the insured. Older insureds generally present higher mortality risk, and the premium reflects that.
• Health and medical history. Underwriting typically considers current health, family history and lifestyle.
• Tobacco use and other lifestyle factors. These can move an insured into a different rating class.
• Face amount. This is the death benefit. A larger benefit generally means a higher premium.
• Policy type. Term insurance covers a defined period. Permanent insurance, such as whole life or universal life, includes cash value as a contract feature and generally carries a higher premium. Neither type changes the section 264(a)(1) result.
• Purpose and sizing. The amount the business needs to fund its identified exposure sets the face amount it applies for.

This page states no premium figures or rates. Premiums, rating classes and underwriting procedures vary from insurer to insurer and are confirmed with the insurers involved. Broader pricing questions are covered on the site's page about business life insurance cost.

Potential Advantages

The main advantage is that a death benefit is payable to the business when the insured dies. 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 exclusion has limits:

• Transfer for value. Under section 101(a)(2), when a policy is transferred "for a valuable consideration," the exclusion generally cannot exceed the consideration paid plus the premiums and other amounts the transferee pays afterward. The statute lists exceptions.
• Employer-owned contracts. Under section 101(j)(1), the exclusion is capped at "the sum of the premiums and other amounts paid by the policyholder." The cap is lifted only when two conditions are both met. First, a section 101(j)(2) exception must apply, either one based on the insured's status or one for amounts paid to the insured's heirs. Second, the written notice and consent requirements of section 101(j)(4) must have been met before the contract was issued. An exception alone does not lift the cap, and neither does notice and consent alone.

A lump sum can fund recruiting, training a replacement, servicing debt or stabilizing operations. The face amount can be sized to a documented estimate of the exposure. A permanent policy also carries cash value as a feature of the contract. None of this is a promise of any tax result.

Important Considerations: The After-Tax Cost

When a premium cannot be deducted, its after-tax cost equals the premium itself. With a deductible expense, part of the cost is offset by a reduction in tax. Section 264(a)(1) removes that offset when the business is directly or indirectly a beneficiary. Every premium dollar is therefore a full dollar of after-tax cost.

A business weighing coverage generally compares that full cost with the size of the exposure it is funding. That is why the face amount usually rests on a documented estimate of the loss rather than an arbitrary figure.

Employer-owned status adds compliance work that is easy to overlook. Section 101(j)(4) requires that, before issue, the employee be notified in writing of the intent to insure and of the maximum face amount. The employee must consent in writing, including to coverage continuing after employment ends. The employee must also be told in writing that the policyholder will be a beneficiary. Section 6039I requires an annual return and records for these contracts. Under Notice 2009-48 (A-13), a failure to obtain written consent "cannot be corrected after the insured employee has died."

When to Review the Plan

Coverage that fit at issue can drift out of line with the business. Owners commonly revisit key person coverage and its cost after events such as these:

• A significant change in the key person's role, compensation or ownership stake.
• A material change in revenue, debt or the exposure tied to that person.
• The key person's departure or retirement, or a change in their insurability.
• A change in entity structure, such as a partnership becoming a corporation, or an ownership buyout. A transfer of the policy can raise the section 101(a)(2) issue.
• A new loan whose lender asks for life insurance on a principal.
• A change in federal tax law affecting section 264(a)(1), section 101(a)(1) or section 101(j).
• A periodic review as part of the business's overall planning.

If the key person leaves, term conversion rights or a policy exchange may come up. Those are separate topics.

Example (Hypothetical): Estimating the After-Tax Cost

This example is hypothetical. It uses no actual premium figure, because premiums depend on underwriting. The annual premium is represented as P.

Assumptions:

• A closely held S corporation identifies a sales executive whose death would cost an estimated $500,000 in lost revenue and replacement costs.
• The corporation buys a 10-year term policy with a $500,000 death benefit on the executive.
• The corporation is the owner, the premium payer and the sole beneficiary.

Step 1. Section 264(a)(1) disallows a deduction because the corporation is the beneficiary. The annual deduction is $0.

Step 2. The after-tax cost each year is P − $0 = P.

Step 3. Total premiums over the term are 10 × P = 10P, none of it deductible.

Step 4. If the executive dies during the term, the corporation receives $500,000. Section 101(a)(1) generally excludes that amount from income. However, this is an employer-owned contract. If no section 101(j)(2) exception applies, or if notice and consent were not given before issue, section 101(j)(1) caps the exclusion at the premiums and other amounts paid, roughly 10P or less depending on timing. In that case, the excess of $500,000 over the cap is not excluded.

This example is not a coverage recommendation, and it does not show any reader's tax result.