Key Person Insurance
Key Person Insurance Tax Treatment: Premiums, Proceeds and the EOLI Rules
Published October 8, 2026 · Updated October 9, 2026
Technical summary / key takeaways
- Section 264(a)(1) allows no deduction for premiums on a life insurance policy if the taxpayer is directly or indirectly a beneficiary under it.
- Section 101(a)(1) generally excludes from gross income amounts paid under a life insurance contract by reason of the insured's death.
- For an employer-owned contract, section 101(j)(1) caps the exclusion at the premiums and other amounts paid unless two conditions are both met: a section 101(j)(2) exception applies, and written notice and consent were given before the contract was issued.
- Notice and consent alone do not lift the cap, and an exception alone does not lift it either.
- Notice 2009-48 states that a failure to obtain written consent "cannot be corrected after the insured employee has died."
- Section 6039I requires an annual return for employer-owned contracts issued after the date that section was enacted, and Form 8925 is the form used to make it.
Technical Summary: How Key Person Insurance Is Taxed
Key person insurance proceeds are generally excluded from a business's gross income under section 101(a)(1) of the Internal Revenue Code. When the business owns a policy on an employee and is directly or indirectly a beneficiary of it, section 101(j) caps that exclusion at the premiums and other amounts paid. The cap lifts only if both conditions are met: a section 101(j)(2) exception fits, and written notice and consent came before the policy was issued.
Owners, partners and finance leads of closely held companies usually ask this after the business has bought, or is weighing, a policy that funds its recovery from losing a critical person. The policy is only the funding mechanism for that continuity plan. The tax rules decide how much of the money arrives intact.
A key person contract is usually an employer-owned life insurance (EOLI) contract under 26 U.S.C. § 101(j)(3). Premiums are generally not deductible, because 26 U.S.C. § 264(a)(1) denies a deduction when the taxpayer "is directly or indirectly a beneficiary." That rule is treated fully on the page on key person premium deductibility. Under 26 U.S.C. § 6039I, a business that owns EOLI contracts issued after that section's enactment also files an annual return, which is made on Form 8925. This page covers how the proceeds and the contract are taxed and reported.
What Key Person Insurance Is: Definition and EOLI Classification
In business planning, key person insurance is a life insurance contract that a business owns on an employee or officer whose death would materially harm the business. The business usually owns the policy, pays the premiums and is the beneficiary. The proceeds then fund the business's own recovery. The key person insurance overview covers the planning concept in full.
The Code's own term is "employer-owned life insurance contract." Under 26 U.S.C. § 101(j)(3)(A), this is a contract that:
- "is owned by a person engaged in a trade or business," with that person, or a related person, "directly or indirectly a beneficiary"; and
- "covers the life of an insured who is an employee with respect to the trade or business of the applicable policyholder on the date the contract is issued."
Section 101(j)(5)(A) provides that "employee" includes "an officer, director, and highly compensated employee." Notice 2009-48, A-5, repeats this and adds that a director is an independent contractor when acting as a director.
The Notice also marks the edges of the definition. A-1 says 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 says that ownership by a partnership or a sole proprietorship does not prevent a contract from being one.
Applicable Rules: The Federal Statutes That Govern Taxation
Six federal authorities shape the tax treatment of a key person contract.
- 26 U.S.C. § 101(a)(1). "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." The exclusion is subject to listed exceptions, including subsection (j).
- 26 U.S.C. § 101(a)(2). After a "transfer for a valuable consideration" of a contract, the exclusion generally may not exceed the consideration paid plus the premiums and other amounts the transferee paid afterward. Transfers 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 are excepted. Transfers with a carryover basis are also excepted. Whether a particular policy transfer, or the section 101(j) notice, consent and Form 8925 reporting for a particular contract, meets these rules needs individual review of the contracts involved with a qualified tax professional.
- 26 U.S.C. § 101(j)(1). For an employer-owned contract, the exclusion "shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract."
- 26 U.S.C. § 101(j)(2). This section sets out two kinds of exception. One is based on the insured's status. The other covers amounts paid to the insured's heirs. Either one applies only where the notice and consent requirements are met.
- 26 U.S.C. § 264(a)(1). This section bars a premium deduction where the taxpayer is directly or indirectly a beneficiary.
- 26 U.S.C. § 6039I. This section imposes annual reporting and recordkeeping duties.
Notice 2009-48 is IRS guidance in question-and-answer form on these definitions and on notice and consent. The Notice is described here as of its 2009 date.
Requirements: Notice, Consent and the Conditions for Full Exclusion
The full exclusion depends on two conditions, and both must be present. A section 101(j)(2) exception must fit the facts. The notice and consent requirements of section 101(j)(4) must also have been met.
Under section 101(j)(4), these requirements are met only if the following happened "before the issuance of the contract":
- The employee was "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."
- The employee provided "written consent to being insured under the contract and that such coverage may continue after the insured terminates employment."
- The employee was "informed in writing that an applicable policyholder will be a beneficiary of any proceeds."
Notice 2009-48, A-7, states that the requirements apply even to a wholly owned corporation and its employee-owner. It adds that "actual knowledge alone" does not substitute for written notice and consent. The Form 8925 instructions add a timing condition: consent is not valid unless the contract is issued within a year after the consent was signed, or before the employee leaves employment, whichever is earlier.
Notice 2009-48, A-13, says the statute has no correction provision. The IRS will not challenge an exception if three conditions are all met:
- the policyholder made a good-faith effort to comply;
- the failure was inadvertent; and
- the failure was discovered and corrected by the due date of the tax return for the year the contract was issued.
A-13 is firm on one point. Because consent must be written, failure to obtain it "cannot be corrected after the insured employee has died." If a section 101(j)(2) exception does not fit, or the notice and consent requirements were not met, section 101(j)(1) limits the exclusion to the premiums and other amounts paid, and the remainder is not excluded.
How the Rules Work: Proceeds, the EOLI Cap and the Exceptions
The analysis runs in three steps.
- Section 101(a)(1) sets the baseline: death proceeds are generally excluded from gross income.
- For an employer-owned contract, section 101(j)(1) limits that exclusion to the premiums and other amounts paid.
- The limit falls away only when a section 101(j)(2) exception and pre-issuance notice and consent are both present. Neither one is enough on its own.
The insured-status exceptions, section 101(j)(2)(A). These cover an insured who either:
- "was an employee at any time during the 12-month period before the insured's death"; or
- was, when the contract was issued, a director, a highly compensated employee, or a highly compensated individual as defined for this purpose, with "35 percent" substituted for "25 percent" in the latter definition.
The heirs exception, section 101(j)(2)(B). This covers amounts paid to any of the following:
- a member of the insured's family, which section 267(c)(4) limits to brothers and sisters, a spouse, ancestors and lineal descendants;
- a designated beneficiary under the contract, other than the policyholder;
- a trust for any of those people; or
- the insured's estate.
It also covers amounts "used to purchase an equity (or capital or profits) interest in the applicable policyholder" from any of those persons.
A brief hypothetical illustration. Assume a $1,000,000 employer-owned policy and $200,000 in cumulative premiums.
- With no qualifying exception, or no pre-issuance notice and consent, the exclusion is capped at $200,000, and $1,000,000 − $200,000 = $800,000 is not excluded.
- With both conditions met, the full $1,000,000 falls within section 101(a)(1).
Section 101(j) limits only the exclusion for amounts paid by reason of death. How cash value, a feature of a permanent contract, and policy loans are treated during the insured's life is a separate question. What the business does with a payout is covered on the site's key person death benefit page.
Who This Is For: Businesses That Own Key Person Contracts
This page is written for businesses that own a contract on someone who works for them. That includes a C corporation insuring its chief engineer, an S corporation insuring a rainmaking officer, a partnership or LLC insuring a managing employee, and a sole proprietor insuring a lead technician. The text of section 101(j)(3) turns on ownership by "a person engaged in a trade or business" that is directly or indirectly a beneficiary, and on the insured's status as an employee. It sets no threshold for the size of the business or the face amount of the policy.
Notice 2009-48 refines who falls within the rule:
- A-3 says ownership by a partnership or sole proprietorship does not keep a contract from being employer-owned.
- A-3 also says a sole proprietor's policy on his or her own life is not one.
- A-1 says a contract owned by an entity's owner to finance buying another owner's interest is not one.
The way these rules work between co-owners is covered on the page on life insurance for business partners. The broader framework appears in the site's business life insurance overview.
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When the Full Exclusion Applies
Full exclusion under section 101(a)(1) remains available for an employer-owned contract only where two facts line up. A section 101(j)(2) exception must fit, and notice and consent must have preceded issuance.
Typical insured-status fact patterns include:
- an insured who was still an employee, or had been one within the 12 months before death; and
- an insured who was a director, a highly compensated employee, or a highly compensated individual when the contract was issued.
The heirs exception fits a different pattern. It covers proceeds paid to the insured's family members, a designated beneficiary other than the policyholder, a trust for them, or the estate. It also covers proceeds used to buy an equity interest in the policyholder from those persons.
Timing is the hinge. Under Notice 2009-48, A-13, a missing written consent cannot be supplied after the insured's death.
When the Full Exclusion May Not Apply
The cap under section 101(j)(1) governs in three situations:
- No pre-issuance notice and consent. The cap applies even if the insured fits an exception, such as a highly compensated employee.
- No exception fits. The cap applies even if notice and consent were completed properly. One example is a former employee who left more than 12 months before death, was not a director or highly compensated person when the contract was issued, and whose proceeds do not fall within the heirs exception.
- Both conditions are missing.
In each situation, the amount not excluded equals the death benefit minus the premiums and other amounts paid.
A separate route to taxable proceeds also exists. If the contract was transferred for valuable consideration and no exception in section 101(a)(2) applies, the exclusion is generally limited to the consideration and later premiums. Treas. Reg. § 1.101-1(g) illustrates that limit with worked examples.
Compliance Considerations: Form 8925 and Annual Reporting
Reporting runs on its own track, separate from the exclusion. Under 26 U.S.C. § 6039I(a), every applicable policyholder that owns employer-owned contracts "issued after the date of the enactment of this section" must file a return for each year it owns them. The return shows:
- the number of employees at the end of the year;
- the number of those employees insured under the contracts;
- the total amount of insurance in force at year end;
- the policyholder's name, address, taxpayer identification number and type of business; and
- that the policyholder has a valid consent for each insured employee, or the number of insured employees for whom consent was not obtained.
Form 8925 is the IRS form used for this return. Section 6039I(b) separately requires the policyholder to keep the records needed to show whether section 6039I and section 101(j) are satisfied.
The filing duty does not depend on whether a section 101(j)(2) exception is met. A business whose contracts all meet the exceptions still reports them, and a missed or inaccurate filing is a compliance gap in its own right.
Common Errors in Key Person Insurance Tax Compliance
Several recurring mistakes affect how proceeds are taxed or reported.
- Collecting consent after issuance. Section 101(j)(4) requires written notice and consent before the contract is issued. Notice 2009-48, A-13, allows limited relief only by the return due date for the year of issue, and none after the insured's death.
- Relying on an exception alone. A highly compensated insured does not lift the cap if notice and consent were not given in advance.
- Relying on consent alone. Signed forms do not lift the cap if no section 101(j)(2) exception fits when the proceeds are paid.
- Skipping Form 8925. Section 6039I requires a return for each year the business owns covered contracts.
- Deducting the premiums. Section 264(a)(1) disallows the deduction when the taxpayer is directly or indirectly a beneficiary under the policy.
- Ignoring a change of ownership. A sale or other transfer of the policy for valuable consideration can bring section 101(a)(2) into play unless one of its listed exceptions applies.
Hypothetical Example: Applying the EOLI Rules to a Key Person Policy
This example is hypothetical, and its figures are illustrative only. It rests on four assumptions:
- A closely held corporation owns a $1,000,000 policy on a key employee and is its beneficiary.
- The employee was a highly compensated employee when the contract was issued.
- Cumulative premiums total $150,000, with no other amounts paid.
- The insured dies while employed, and no transfer for value occurred.
Scenario A (hypothetical): no pre-issuance notice and consent. An exception fits, but section 101(j)(4) was not met, so section 101(j)(1) applies.
- Amount excluded: $150,000.
- Amount not excluded: $1,000,000 − $150,000 = $850,000, which is includible in gross income.
Scenario B (hypothetical): notice and consent were completed before issuance, and the insured fits section 101(j)(2)(A).
- Both conditions are present, so the section 101(j)(1) cap does not apply.
- Amount excluded under section 101(a)(1): $1,000,000.
- Amount not excluded: $1,000,000 − $1,000,000 = $0.
In both scenarios, the corporation files Form 8925 for each year it owns the contract. A real contract's treatment depends on its own facts, and this example does not stand in for any reader's result.
Professional Coordination for Key Person Insurance Tax Treatment
Sections 101(a)(1), 101(a)(2), 101(j), 264(a)(1) and 6039I interact, and the result for any one contract turns on its facts. Those facts include:
- who owns the contract;
- who is named as beneficiary;
- the insured's status at issue and at death;
- whether the contract was ever transferred; and
- what notice and consent documents exist, and their dates.
A qualified tax professional typically examines the contract terms, the ownership structure, the beneficiary designation and the dated notice-and-consent records. Legal counsel may also be involved where the structure raises a transfer-for-value question or touches other provisions. Because section 101(j)(4) requires notice and consent before the issuance of the contract, and Notice 2009-48, A-13, states that failure to obtain written consent "cannot be corrected after the insured employee has died," the timing of notice and consent is a point to settle before the contract is issued. Insurance rules also vary by state.
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Frequently Asked Questions
Who is the owner of a key person life insurance policy?
The business is typically the owner, not the insured employee. The business also pays the premiums and is named as beneficiary. That combination of business ownership, business beneficiary and an employee insured at issue is what section 101(j)(3)(A) uses to define an employer-owned life insurance contract.
Is a key person insurance payout taxable to the business?
It may be, in part. Section 101(a)(1) generally excludes death proceeds from gross income. For an employer-owned contract, however, section 101(j)(1) caps the exclusion at the premiums and other amounts paid unless a section 101(j)(2) exception applies and written notice and consent preceded issuance. Any amount above the cap is not excluded.
What happens if a key person policy is taken out without notice and consent?
Section 101(j)(1) then limits the exclusion to the premiums and other amounts paid. Notice 2009-48, A-13, allows limited relief for inadvertent failures that are corrected by the return due date for the year of issue. It also states that a missing written consent cannot be corrected after the insured employee has died.
Does a section 101(j)(2) exception alone restore the full exclusion?
No. Section 101(j)(2) applies only to a contract "with respect to which the notice and consent requirements of paragraph (4) are met." An exception without pre-issuance notice and consent leaves the cap in place, and so does notice and consent without an exception.
What is Form 8925 and when must a business file it?
Form 8925 is the IRS form used for the annual return that section 6039I requires. That return covers employer-owned contracts issued after the date section 6039I was enacted. It reports employee counts, the number of insured employees, the total insurance in force and whether a valid consent exists for each insured employee.
Does the key person insurance EOLI rule apply to partnerships and sole proprietorships?
Yes, it can. Notice 2009-48, A-3, says that ownership by a partnership or sole proprietorship does not keep a contract from being an employer-owned life insurance contract. A sole proprietor's policy on his or her own life, however, is not one.
What is the transfer-for-value rule and how does it affect key person insurance?
Under section 101(a)(2), when a contract is transferred for valuable consideration, the exclusion is generally limited to the consideration paid plus the premiums paid afterward. Listed exceptions include transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, and to a corporation in which the insured is a shareholder or officer. This is a separate issue from section 101(j).
Educational information only. Not legal, tax, investment or insurance advice. Product availability and outcomes depend on individual circumstances.