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Question: Why would a business owner consider key employee life insurance?

Answer: Key employee life insurance can meet a number of business needs.

A key employee is anyone who affects the overall success and profitability of the business.  A key employee could be a manager whose judgment and leadership are crucial to the business; a sales representative with knowledge of the product and customers; or any other worker who has unique technical experience or good rapport with customers, creditors, or fellow workers.

The death of a key employee may cause the loss of management skill and experience.  This could be particularly traumatic for small companies with only a few managers.  The death of a key sales representative could cause the loss of customers loyal to that particular individual, and will affect sales in general.  The death of a key employee could hurt the company’s credit rating and the ability to obtain credit in the future.

The death of a key employee will cost the business the expense of hiring and training a replacement.  The business owner may feel morally obligated to provide a substantial death benefit to the key employee’s family.

The premiums on a key employee life insurance policy are usually small compared to the death benefit. If a permanent policy is used, the cash values are shown as a business asset on the company books.  This may increase the company’s credit rating and can be a source of money in a financial crisis.

If the key employee is also an owner, a key employee policy death benefit can be used to fund a buy-out of the deceased owner-employee’s interest in the business.

Determining the amount of key employee insurance is not a precise process; it will depend upon the facts and circumstances of each situation.  Here are some broad guidelines.

In the case of sales representatives, product designers and research persons whose loss might directly cause a measurable loss of sales or earnings, advisors recommend using a multiple of lost sales or earnings.  For example, suppose a business owner estimates that the loss of a key sales rep would cause a drop in sales of $100,000 per year for five years, while a new sales rep learned the product and territory.  A key person policy of $500,000 would be in order.

Where key managers or financial officers are involved, the direct impact on sales and earnings may be harder to measure.  Many advisors recommend using a multiple of salary in those cases.  For instance, if a key manager is making $100,000 a year and the owner estimates it will take three years to recruit, train, and bring a new manager up-to-speed, a $300,000 policy would be advisable.

With key person coverage, the business applies for and is the owner and beneficiary of a policy insuring the key employee’s life.  The business pays the premiums.  The premiums are non-deductible when paid, but the death proceeds are generally tax-free to the business.

In some cases, businesses with over $5 million per year of revenue may be subject to alternative minimum tax on death proceeds.  Also, Section 101(j) of the IRC requires special notice and waiver rules to be followed to preserve the tax free death benefit.

A key employee life insurance policy has no tax effect on the insured employee.

If a cash value policy is surrendered by the employer, the proceeds are tax-free to the extent of premiums paid; any gain will be taxed as ordinary income.  Policy loans are available to the employer and are usually tax-free as long as the policy stays in force.  Loan interest may be deductible by the loan business on a limited basis.

While key employee insurance seems like a simple idea, it can help a business owner client protect his investment.

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