Key Person Insurance Death Benefit: How the Business Can Use the Proceeds

What the Business Receives When a Key Person Dies

When an insured key person dies, the insurer pays the death benefit to the business that owns the policy and is named as its beneficiary, in a single sum or otherwise. The business then decides how to use the money. Uses a business might consider include covering lost revenue, recruiting a replacement, servicing debt or holding a reserve while the business adjusts.

This question usually comes from owners, partners and finance leads at closely held companies. Some already hold a policy on a founder, rainmaker or technical lead. Others are weighing one and want to see what the payout event looks like. In a key person arrangement, the business owns the policy, pays the premiums and is the beneficiary. For that reason, the key person insurance proceeds belong to the business and not to the insured's family. The basic structure is explained in how key person insurance works.

Section 101(a)(1) of the Internal Revenue Code provides that "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." That rule is subject to exceptions, and two of them matter in business planning:

• the transfer-for-value rule in section 101(a)(2), and
• the employer-owned contract rule in section 101(j).

This page covers the payout and how the business uses the money. The full rules are set out under key person insurance tax treatment.

What Happens at the Payout

A claim starts the process. The business, as policyowner and beneficiary, notifies the insurer and submits the documents the insurer asks for. The insurer then pays the death benefit under the contract's terms. Claim forms, documentation and timing vary from insurer to insurer, and they are confirmed with the insurer involved.

Once the money arrives, it is a business asset. It sits on the company's books and is subject to the company's own governance, such as board approval, partner votes or operating-agreement provisions. The business's real decision is therefore not whether it receives cash, but what the cash is meant to accomplish.

The Financial Risks a Key Person Death Creates

Revenue may be the first thing to move. A business that loses the salesperson who brings in much of its revenue, a rainmaker or the holder of its main client relationships can see near-term revenue fall while clients reconsider.

Other financial exposures follow:

• Replacement costs. Finding, hiring and onboarding a qualified successor takes time and money, and a recruiter or a premium salary may be part of it.
• Lender and creditor concerns. Business loans may carry covenants tied to particular individuals. A lender may tighten terms after such a loss, depending on the loan documents.
• A cash-flow gap. Payroll, rent and supplier bills continue while revenue and leadership are rebuilt.

These exposures are the business problem. The death benefit is a funding mechanism structured to address them. It does not make any of them disappear, and how well it covers them depends on the amount and the facts.

The Ownership and Beneficiary Risks That Affect the Payout

Ownership records decide where the check goes. For the proceeds to reach the business directly, the business must be the named beneficiary, and the ownership records should match the arrangement. If the designation has changed, or was recorded incorrectly, the proceeds may go elsewhere. The reasons are covered on the page on the key person insurance beneficiary.

Transfer for value. Under section 101(a)(2), when a policy is transferred "for a valuable consideration," 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 limit does not apply in two cases:

• where the transferee's basis is determined in whole or in part by reference to the transferor's basis, or
• where the transfer is "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."

Employer-owned contracts. Section 101(j)(1) generally limits the exclusion to "the sum of the premiums and other amounts paid by the policyholder for the contract." That cap is lifted only when a section 101(j)(2) exception applies and the section 101(j)(4) requirements were met "before the issuance of the contract." A section 101(j)(2) exception is either one based on the insured's status or one for amounts paid to the insured's heirs. Under section 101(j)(4), before the contract is issued the employee must be notified in writing that the policyholder intends to insure the employee's life and of the maximum face amount for which the employee could be insured, must give written consent to being insured under the contract and to that coverage continuing after employment ends, and must be informed in writing that the policyholder will be a beneficiary of any proceeds payable on the employee's death. Neither condition works alone.

IRS Notice 2009-48, in its questions and answers, states the following points:

• "employee" includes an officer, director and highly compensated employee (A-5);
• a contract owned by the owner of an entity, for example to finance buying another owner's interest, is not employer-owned (A-1);
• ownership by a partnership or sole proprietorship does not keep a contract from being employer-owned (A-3);
• failure to obtain written consent "cannot be corrected after the insured employee has died" (A-13).

Under section 6039I, as Notice 2009-48 describes it, an applicable policyholder that owns one or more employer-owned life insurance contracts issued after August 17, 2006 must file a return for each year the contracts are owned, and a taxpayer satisfies that requirement by filing Form 8925. Section 101(j) notice and consent, Form 8925 reporting and any transfer of a policy between owners need individual review of the contracts involved, by the insurers and a qualified tax professional.

The Operational Risks the Proceeds Are Meant to Cover

Some losses never show up on a balance sheet at first. A key person often carries specialized knowledge, technical know-how, and client and supplier relationships that no one else holds in full.

Delivery can also suffer. Projects may stall, and contract performance may slip if the person was central to getting work done. The leadership gap can unsettle the remaining staff, and some employees may leave.

The structural purpose of the arrangement is to give the business time and capital while it works through these disruptions. The proceeds can pay for interim management, retention bonuses or outside help. They cannot transfer the knowledge or the relationships themselves, and the result depends on how the business manages the transition.