In the following article we will discuss key man life insurance and key man disability insurance: what is it, who needs it, and how to find the best price available. We will also briefly touch on the potential tax ramifications to a business that receives proceeds from key man insurance.
What is Key Man Life Insurance?
Key man insurance (key person insurance, key employee insurance) is life insurance taken out by a business that covers a key person or persons within that business. These people are vital to the ongoing success and survival of the business and losing them would create a substantial financial hardship to the business.
Key man insurance begins when the business identifies the key person and buys life insurance on the key man. The business then pays the premiums to the insurer and if the key man employee dies, the proceeds are paid out to the main “beneficiary,” the business.
Sample Key Man Life Insurance rates
Monthly quotes are based on a preferred plus 50 year old male; rates are for informational purposes and must be qualified for.
|Face Amount||10 Year||20 Year||30 Year||GUL to 110|
Monthly quotes are based on a preferred plus 50 year old female; rates are for informational purposes and must be qualified for.
|Face Amount||10 Year||20 Year||30 Year||GUL to 110|
You can also view our sample life insurance rates by age chart for more.
Key Man Life Insurance: Is your business protected?
The first step in the process of insuring your key employees is to first identify who they are.
Identifying Key Employees
Key man insurance should focus on three main categories: (1) Business continuity or survival, (2) impossible or difficult to replace, (3) financing for an SBA or bank loan.
- Business continuity or survival: Key man insurance should be used for any person in the business organization whose sudden death would threaten the continuity or survival of the business. Key man insurance gives creditors peace of mind knowing if the key employee dies the business will not.
- Impossible or difficult to replace: Key man life insurance should be used for any employee whose unexpected death would make it impossible or difficult for the business to find a replacement.
- Financing for an SBA or bank loan: Key man life insurance will typically be required on any owner of a business who desires to take out a SBA or bank loan.
Examples of Key Employees
- An owner, especially if the loss affects the short or long term viability of the business such as adversely affecting the company’s standing with creditors or the company’s ability to secure financing.
- A top salesperson, especially if the salesperson has become the “go-to guy” for many of the company’s top customers and brings in a sizable percent of the income of the business.
- A scientist or software engineer, who developed the company’s intellectual property would most definitely be considered a candidate for key-man insurance.
Determining the amount of key man life insurance
There are various ways to determine the amount of key-person insurance the business needs. Ultimately, the amount that should be decided on is an amount that the business can afford without taking a toll on other areas of the business. Three areas to consider are the cost of replacement, multiple of income, and percentage of business income.
Cost of replacement
What it would cost the business to replace the key employee? Factors to consider would be the time it takes to find a replacement, training, and bringing the new employee up to speed. All the while that it takes to find a replacement the business would be losing revenue due to the loss of the key employee, so the revenue loss should also be factored in. The typical number used is around ten times the key person’s earnings.
Multiple of salary/income
This is an easy valuation method but fails to take much, if anything specific to the key-employee or business, into account. Simply take the current key employees income and multiply it by a factor of five to ten times.
Percentage of business income
What percentage does the key person contribute to the overall income of the business? Once the percentage of the business income is determined, that number should be multiplied by how long it would take to find someone to fill that key person’s shoes, typically 1-3 years.
A quick way to calculate a key person’s value would be to determine the employees percentage contribution to the net or gross profits of the business. Next, multiply that number by 2 years for gross profit percentage and 5 years for net profit percentage.
For example, if a key employee contributes 10% to the company’s net profit and the company’s net profits are $1,000,000 a year, that key employee contributes $100,000 a year. Therefore, a $500,000 key man life insurance policy would be needed [(10% X $1,000,000) X 5 years] using the net profit percentage.
General underwriting requirements for Key Man Insurance
- Typically an underwriter will allow face amounts between 5-10X earned income.
- Bonuses may also be included.
- Some companies require that the bonus is paid regularly as part of a company bonus plan.
- Also, if the key person has an ownership interest in the company, the appropriate percentage of company net income can be added to his or her income.
- An Employer Owned Life Insurance Acknowledgement and Consent form needs to be signed by the employee before coverage goes into effect.
- Note: Some states have specific requirements for an employee to qualify as a key person.
A life insurance company will inquire into how the business determined the insurance amount sought. Underwriters of key man insurance typically want to know the key employee’s:
- Business Type: S Corp, LLC, C Corp, Sole Proprietorship, etc…
- Income: insurance companies will use the key man’s income level to help determine how much coverage to offer.
- Role in the business: The key man’s role in the business is important because not just anyone is considered valuable enough to be termed “key-man.”
- Specialized skill: similar to the role in the business above, the specialized skill held by a key person helps shed light on whether or not the employee is truly a key man.
- Experience: the more experienced an employee the more vital to the organization he or she becomes. Therefore, the experience level helps life insurance carriers determine how valuable a key employee truly is.
What type of Key Man Life Insurance to choose?
Term Life Insurance
- The lowest cost life insurance will be term life. Term life comes in various term lengths and the premium is fixed for the duration of the term. Term lengths typically range from 10-30 years, although 1 and 5 year terms are available.
- We also represent a company that will offer up to $1,000,000 no exam coverage for a key employee. Therefore, if you need coverage and the key employee does not wish to take an exam, this may be an option.
Permanent Life Insurance
Permanent life insurance comes in two main flavors: Whole and Universal Life.
Whole life insurance builds cash value and lasts the lifetime of the insured. One of the benefits of cash value life insurance is the ability to access the funds via tax free policy loans. This can add liquidity to your business when you need it most. It can also add incentives for your key person to stay with your company until his or her policy has fully vested.
- Guaranteed Universal Life typically is guaranteed to last the rest of your life. It does build some cash value but at a much slower pace than whole or indexed universal life.
- Indexed Universal Life Insurance might be a good option since it potentially accumulates more cash value based in part on the performance of an underlying indices, such as the S&P 500. There is typically a cap and a floor. The cap and participation rate of the indexed account limits your gains. The floor protects you cash value from losses. IUL is beneficial because the cash value might add a further incentive to keep your key employee around in the form of a type of golden handcuff. Further, if the key employee does leave, the policy can be sold off to a third party as a life settlement. The older the key man the better price the company can receive on the now no longer needed coverage through a viatical settlement.
- Variable Life Insurance is a direct investment into the market via sub-accounts that work like mutual funds. VUL has no floor, so there is not limit on loss. Since it is investment directly tied to the market the risk is higher than with other universal life products.
Key Person Disability Income Insurance
Consider the benefits of key person disability income insurance for a business. All to often a business will purchase key person life insurance on a valued employee, but will neglect to consider what might happen if that key employee were to suffer a disability. Key employee life insurance does not pay out for a disability, so you are leaving your business vulnerable to a potential disability, which is statistically more likely to occur than death.
Business Overhead Expense Insurance coverage provides cash to your business if your key employee is disabled. The key person disability insurance policy provides needed income to your company or business to allow you time to find a suitable replacement and train them to replace your key employee long term, or give your key employee the time he or she needs to rehabilitate, so that your company can continue to advance.
You may also want to consider individual short-term or long-term disability income insurance for you and your employees. There is much to be said about the peace of mind knowing that your business expenses and your own income will be supplemented if a disability occurs.
Need help choosing the right key person disability income insurance for your business needs? Give us a call today and we will help walk you through the various options available.
What type of coverage is best for key person business insurance?
There really is no one size fits all answer or policy. Each life insurance and disability insurance product has unique features and benefits. Additionally, some include important life insurance riders, such as a disability income insurance rider, critical illness rider, chronic illness and terminal illness rider.
And if you choose a stand alone key man disability income insurance policy then you will want to be familiar with the additional beneficial riders that can be added. It is always a good idea to insulate your business from a catastrophic loss of a key man, either due to death or disability.
How long of a term do I need for Key Man Life Insurance?
Usually the term length should be tied to a specific date in the future, such as retirement. For example, if a key person is currently 45 years old and the expected retirement for that employee is age 65, then 20 year term life insurance would be appropriate.
Once again, other types of life insurance, such as whole or universal life, might be more beneficial for providing an incentive to the key employee if the cash value will be made available to the key man.
Are Key Person Insurance premiums tax deductible?
Key man insurance premiums are not tax deductible. See IRC 26 U.S. Code § 264 (a) General rule: No deduction shall be allowed for— (1) Premiums on any life insurance policy…if the taxpayer is directly or indirectly a beneficiary under the policy or contract.
Are proceeds from Key Man Life Insurance taxable?
The proceeds to the business from the key person life insurance are considered income and the business will be taxed unless the Notice and Consent requirements of Section 101(j) are met.
See IRC 101 § (j) Treatment of certain employer-owned life insurance contracts:
(4) Notice and consent requirements
The notice and consent requirements…are met if, before the issuance of the contract:
- the employee is 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 provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and
- the employee is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee.
In addition, form 8925 must be included with the employer’s annual income tax return. The following information is required:
- The number of employees at the end of the year.
- The number of employees who are insured at the end of the year under employer-owned life insurance contracts.
- The total amount of life insurance in force at the end of the year under these contracts.
- The name, address, and taxpayer identification number of the employer and the type of business in which the employer is engaged.
- Whether the employer has a valid consent for each insured employee, and if not, the number of insured employees for whom a consent was not obtained.
This information is designed to provide a general overview with regard to the subject matter covered and is not state specific. The authors, publisher and host are not providing legal, accounting, tax, or specific advice to your situation.
Leave a Comment