Key Employee Insurance: Insuring a Non-Owner the Business Depends On

Short Answer: What Key Employee Insurance Does for a Non-Owner

Key employee insurance is a life insurance policy a business buys on a non-owner employee whose skills, relationships or knowledge it depends on. The business applies for the policy, owns it, pays the premiums and is the beneficiary. If the employee dies, the death benefit goes to the business to absorb the loss.

Because an employer owns a contract on an employee's life, section 101(j) of the Internal Revenue Code governs whether that death benefit is excluded from the employer's gross income. The situation here is the non-owner employee specifically. Business Life Insurance treats insuring owners, partners and buy-sell funding as separate subjects, and the general concept is explained under key person insurance.

Why Insuring a Non-Owner Key Employee Is a Distinct Business Problem

A "key employee," in the business-planning sense, is a person without an ownership stake whose specialized knowledge, client relationships, technical skills or leadership produce revenue or operational continuity that would be hard to replace quickly. The term here is a planning label, not a statutory definition.

The business problem comes first. A sudden death can interrupt revenue, strain loan terms, delay projects and force costly recruiting and training. Unlike an owner's death, no ownership interest changes hands and no buy-sell obligation is triggered. The exposure is purely operational and financial.

Two baseline points frame the arrangement. Insurable interest is a matter of state law and varies by state. And 26 U.S.C. § 264(a)(1) provides that "No deduction shall be allowed for" premiums on a life insurance policy "if the taxpayer is directly or indirectly a beneficiary under the policy."

How Businesses That Insure Non-Owner Employees Can Be Structured

When the business itself owns the policy on a non-owner employee's life and is its beneficiary, that ownership is what can bring the employer-owned contract rules into play.

IRS Notice 2009-48 A-1 states that a contract is employer-owned "only if it is owned by a person engaged in a trade or business and is otherwise described in § 101(j)(3)." It adds 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." A contract the entity itself owns on a non-owner employee, with the entity as beneficiary, can fit the section 101(j)(3) definition.

A-3 adds that, for a contract otherwise described in section 101(j)(3), "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." A-5 confirms that "employee" includes "an officer, director, and highly compensated employee." Business Life Insurance addresses professional practices and named industries on their own pages.

The Risk That Triggers the Need: What the Business Loses When a Key Non-Owner Dies

Several kinds of loss may prompt the question:

• Revenue disruption. A salesperson, technician or relationship manager may carry a book of business or expertise that drives a material share of revenue.
• Loan terms. A business's loan documents may address key-person coverage. For a non-owner employee, whether they do depends on the lender's own policy and the loan terms, not on a general rule.
• Replacement cost. Proceeds can fund search, onboarding and training during a transition.
• Project and contract continuity. In professional services or technology firms, losing a key person mid-project can bring penalties or client loss.

The business problem, not the insurance product, drives the analysis. The amount and type of coverage depend on facts specific to the business and the employee.

How Key Employee Insurance Works When the Insured Is a Non-Owner

Mechanically, the arrangement is simple. The employer is the applicant, owner, premium payer and beneficiary. The employee is the insured and has no interest in the policy, unless the business separately builds an executive bonus or split-dollar arrangement. At death, the employer receives the proceeds and may use them for replacement costs, lost revenue or debt. The page on how key person insurance works covers these roles generally.

The tax layer is more demanding. Section 101(a)(1) generally excludes from gross income amounts "paid by reason of the death of the insured." For an employer-owned contract, section 101(j)(1) provides that the excluded amount "shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract." That cap is lifted only if both of these hold:

1. A section 101(j)(2) exception applies. One exception is based on the insured's status. Under section 101(j)(2)(A)(i), it applies when the insured "was an employee at any time during the 12-month period before the insured's death." Under section 101(j)(2)(A)(ii), it also applies when the insured is, at the time the contract is issued, a director, a highly compensated employee within the meaning of section 414(q) (without regard to paragraph (1)(B)(ii) of that section), or a highly compensated individual within the meaning of section 105(h)(5), with "35 percent" substituted for "25 percent" in subparagraph (C) of that section. A second exception, in section 101(j)(2)(B), applies to the extent the amount is 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 policyholder), to a trust established for the benefit of either, or to the insured's estate, or is used to purchase an equity (or capital or profits) interest in the policyholder from such a person.
2. Notice and consent were met before issuance. Under section 101(j)(4), before the contract is issued the employee must be notified in writing of the intent to insure and "the maximum face amount." The employee must also be told in writing that the policyholder will be a beneficiary. Finally, the employee must provide written consent "to being insured under the contract and that such coverage may continue after the insured terminates employment."

Neither condition works alone: section 101(j)(2) applies its exceptions only to a contract for which the section 101(j)(4) notice and consent requirements are met.

Ownership Structure and the Employer-Owned Life Insurance Rules

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." That person, or a related person, must be "directly or indirectly a beneficiary under the contract." The contract must also cover an insured "who is an employee with respect to the trade or business of the applicable policyholder on the date the contract is issued." The "applicable policyholder" is the owning business and, under section 101(j)(3)(B)(ii), certain related or commonly controlled persons.

26 U.S.C. § 6039I requires every applicable policyholder owning such contracts issued after its enactment to file a return "for each year such contracts are owned." That return is Form 8925. It shows:

• the number of employees at year end;
• the number of those employees insured;
• the total insurance in force;
• the policyholder's name, address, taxpayer identification number and type of business;
• whether the policyholder has a valid consent for each insured employee, or else the number of insured employees without one.

Section 6039I(b) also requires the policyholder to keep records sufficient to determine compliance with section 6039I and section 101(j). Notice and consent, and Form 8925 reporting, need individual review of the contracts involved, by the insurers and a qualified tax professional. Premiums remain nondeductible under 26 U.S.C. § 264(a)(1) whenever the employer is directly or indirectly a beneficiary.

Coverage and Funding Considerations for Non-Owner Key Employees

The amount turns on the employee's revenue contribution, the cost of replacing the employee and the obligations outstanding. The page on key person coverage amounts discusses how businesses frame that judgment.

Term life insurance pays a death benefit for a defined period. Permanent contracts, such as whole life and universal life, carry cash value, which is a contract feature and not an investment or savings plan. Section 101(j)(3) applies to any life insurance contract that meets its terms, whether term or permanent. Premiums, underwriting, forms and contract terms vary by insurer and are confirmed with the insurers involved.

When the employee leaves, the business as owner may keep the policy, surrender it, convert a term policy to permanent coverage if the contract allows, or transfer it. A transfer for value can bring section 101(a)(2) into play. That provision limits the exclusion to the consideration paid plus later premiums, subject to its listed exceptions, including a transfer "to the insured." Conversion and policy exchanges are separate topics and fall outside this one.