How Much Key Person Insurance Does a Business Need?

Ownership, Premiums, and Beneficiary in a Key Person Arrangement

In the usual structure, the business owns the policy, pays the premiums and is the beneficiary. That arrangement carries several federal tax consequences, which the site's page on how business life insurance works also traces.

Premiums. 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."

Death proceeds. 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 general rule has limits that matter in business planning:

• Transfer for value. Section 101(a)(2) limits the exclusion when a policy is transferred "for a valuable consideration." It then lists exceptions, 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.
• Employer-owned contracts. 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 is lifted only when two conditions are both met. First, a section 101(j)(2) exception must apply. Second, the notice and consent requirements of section 101(j)(4) must have been met before the contract was issued. One exception is based on the insured's status: the insured was an employee at any time during the 12-month period before death, or was a director, a highly compensated employee or a highly compensated individual when the contract was issued. The other exception covers amounts paid to the insured's heirs or used to buy an equity interest from them.

Which contracts are employer-owned. Notice 2009-48 adds several points:

• A-5 states that "employee" includes "an officer, director, and highly compensated employee."
• A-1 states that a contract "owned by the owner of an entity ... (such as for purposes of financing the purchase of an equity interest of another owner)" is not an employer-owned contract.
• A-3 states that, for a contract otherwise described in section 101(j)(3), ownership by a partnership or sole proprietorship "does not prevent the contract from being treated as an employer-owned life insurance contract."

Reporting. Section 6039I generally requires an applicable policyholder owning employer-owned contracts issued after the section's enactment to file a return for its employer-owned contracts for each year such contracts are owned.

How notice and consent, the exceptions, transfers and this reporting duty apply depends on the contracts involved and calls for individual review with a qualified tax professional.

Key Factors That Shape the Coverage Amount

Businesses typically weigh several factors when they ask how much key man insurance to carry:

• Revenue contribution. This is the share of revenue tied to the key person's direct efforts or relationships.
• Replacement cost. This covers recruiting, hiring, training and onboarding a successor, plus any interim revenue loss during the transition.
• Debt obligations. Some loans carry a lender condition for coverage on a principal. Those conditions come from the lender or the loan program and differ between them.
• Ownership-transition exposure. If the key person is also an owner, buying out that person's interest is a separate need. That is buy-sell sizing, not key person sizing.
• The section 101(j) notice figure. For an employer-owned contract, section 101(j)(4)(A) requires written notice of "the maximum face amount for which the employee could be insured at the time the contract was issued." Notice 2009-48 A-12 states that this means disclosing a face amount of life insurance, "either in dollars or as a multiple of salary, that the applicable policyholder reasonably expects to purchase with regard to the employee during the course of the employee's tenure." It adds that additional notice and consent are required if the aggregate face amount of the employer-owned contracts for an employee exceeds the amount of which the employee was given notice and to which the employee consented.
• Policy type. Term coverage addresses a defined exposure over a fixed period. Permanent coverage may be used when the exposure is ongoing, or when cash value is a contract feature the business intends to use. Both are structural choices.
• Premium capacity. This is the business's ability to pay premiums without straining operations.

No federal rule supplies a universal dollar formula. The key person insurance coverage amount remains a business-planning judgment.

Potential Advantages of Sizing Coverage to the Business Exposure

Aligning the face amount with an identified exposure has several possible effects. Each depends on the facts of the arrangement.

First, coverage sized this way can give the business a defined pool of funds for the specific loss, without insuring well beyond it.

Second, a face amount matched to a lender's stated condition may satisfy a collateral-assignment requirement. A collateral assignment pledges part of the policy's death benefit to a lender as security for a loan. Lender requirements vary and are confirmed with the lender.

Third, death proceeds may be excluded from gross income under section 101(a)(1). That outcome is subject to section 101(a)(2) and, for employer-owned contracts, to the section 101(j) conditions. When the exclusion applies, the proceeds give the business liquidity that is not reduced by income tax.

Fourth, documented estimates of revenue and replacement cost give the business a written rationale for the face amount. That record may be useful if the arrangement is examined later.

Important Considerations and Limitations

Cost comes first. Because section 264(a)(1) allows no deduction for premiums when the taxpayer is directly or indirectly a beneficiary, a business that is the beneficiary has no deduction for the premiums it pays. The site's pages on key person premium deductibility and business life insurance cost cover that point in more depth.

Timing is a second limitation. Section 101(j)(4) requires notice and consent "before the issuance of the contract." Notice 2009-48 A-7 states that "actual knowledge alone" cannot substitute for written notice and consent, even for a wholly owned corporation and its employee-owner. A-13 describes only limited relief for an inadvertent failure, and only if three conditions are all met:

1. The policyholder made a good faith effort to meet the requirements.
2. The failure was inadvertent.
3. The failure was discovered and corrected no later than the due date of the tax return for the taxable year in which the contract was issued.

A-13 also states that a failure to obtain the written consent "cannot be corrected after the insured employee has died."

If the section 101(j) cap applies, proceeds above the premiums and other amounts paid fall outside the exclusion. A transfer of the policy can also reduce the exclusion under section 101(a)(2).

Insurance rules, including replacement, suitability and free-look rules, vary by state.

A key person policy funds a defined loss. It does not replace a buy-sell agreement or a succession plan.

When to Review the Coverage Amount

Business events, more than calendar dates, usually prompt a fresh look at the face amount. Common triggers include:

• a significant change in the key person's compensation or role;
• a material change in revenue, debt load or ownership structure;
• the key person acquiring or giving up an ownership interest;
• a new or refinanced loan carrying a lender condition for coverage;
• adding or ending a buy-sell agreement that overlaps with the key person coverage;
• a proposed increase in coverage, which raises the question of whether it fits within the maximum face amount stated in the original written notice under section 101(j)(4)(A).

The timing and frequency of reviews depend on the business's circumstances. No federal rule cited on this page sets a mandatory review interval.

Hypothetical Example: Sizing a Key Person Policy for a Closely Held Business

This example is hypothetical and uses round figures. It assumes the following:

• A corporation has $2,000,000 in annual revenue.
• One employee generates 40% of that revenue.
• Replacing the employee would cost an estimated $150,000.
• The business has a $500,000 loan outstanding.
• The employee is not an owner.
• The business's only stated goals are to cover one year of the employee's revenue, the replacement cost and the loan balance.

The arithmetic runs as follows:

1. Revenue exposure: $2,000,000 × 40% = $800,000
2. Add replacement cost: $800,000 + $150,000 = $950,000
3. Add the loan balance: $950,000 + $500,000 = $1,450,000

On these assumptions, the illustrative figure is $1,450,000. Because the business would own the contract, be its beneficiary and insure an employee, the contract would be employer-owned under section 101(j)(3). The written notice under section 101(j)(4)(A) would therefore state the maximum face amount before issue, and the face amount applied for would be compared against that stated maximum.

The figure illustrates the arithmetic only. It is not any business's actual coverage need and is not a recommendation. A real sizing decision turns on facts this example does not have.