Key Person Insurance
A strategy to protect your business
But your level of success often means that when it comes to operating your business, you don’t do it all alone. Chances are, there are certain “key” employees that are the lifeblood of your company. These are the individuals you rely on, day in and day out.
A key employee is an employee that:
As the business owner, don’t forget that you may be one of your company’s key employees.
Have you ever thought how your business would be affected by the death or disability of one of these key employees? For example:
These are all important questions to ask. And the answers may expose an area where your business could be at risk — possibly, without your even knowing it.
On this page, we’ll explore one solution that can help you protect your business from the loss of a key employee: key person insurance. It can help you protect your business from the financial fallout that a company can experience when a key employee dies or becomes disabled.
What is key person insurance?
Key person insurance is life or disability insurance on a key employee in a business. Large or small, most businesses have several “key employees,” including the owner1 or partners, the founders and/or one or two employees who are top performers. Key person insurance provides the business with a source of funds when needed most — at the death or disability of a key employee.
Protecting your business against the death or disability of a key employee is a primary reason to purchase key person insurance. But there are other reasons as well:
A bank or lending institution may look more favorably upon a business that is applying for a loan if that business has key person insurance in place. The lender may view the business as being more capable of surviving the financial loss of a top performer. And if necessary, the cash value of the key person life insurance policy can be used as collateral for the loan.
Key person insurance can be used to help repay the loan in the event that one of your key executives should die or become disabled.
The absence of an employee who generates high sales volumes (whether through death or disability), or who is extremely successful at bringing new clients to a business, can leave a large void in that firm’s balance sheet. Key person insurance can help to smooth out your company’s cash flow until a replacement can be found.
Key person insurance can help to stabilize your company’s cash flow while you conduct a talent search to replace a key employee who has passed away or become totally disabled.
There are many advantages of key person insurance. For example:
When it comes to key person insurance, there are numerous ways to estimate how much coverage your company may need. For example, you can base the protection level you purchase on:
The primary purpose of a key person insurance plan is to protect against the death of a key employee. But because employee retention is important to business owners today, this type of plan can also be set up to provide valuable incentives to help entice your top performers to stay with your business for years to come.
With this flexible plan, you have the option to offer the key employees you select valuable benefits. For example, you may choose to:
Or, if you prefer, your business can retain the policy as a business asset, which means the policy’s cash value will continue to appear as an asset on your company’s balance sheet — and your business can access the cash value for any purpose you like. For example, you can fund the purchase of business equipment or other business-related needs. You can also access the policy’s cash value to fund your own retirement income.
John Roberts owns Monaco Manufacturing, a small medical device manufacturer. He is concerned because should anything happen to his chief engineer, Felicia Stevenson, his business could suffer greatly. It would take time to find a new engineer as talented and experienced as Felicia, and inthe meantime, he would be unable to fulfill any customized orders. John is concerned about the possibility of Felicia’s death, as well as the possibility of her becoming disabled.
First, John purchases a PayGuard Plus disability income policy on Felicia’s life with a maximum potential benefit of $1.425 M and a premium of $3,982.50.6 Should Felicia become totally disabled, this policy will pay John’s company $25,000 a month for the remaining benefit term (up to five years), or until Felicia can return to work, which ever occurs first.7 So Monaco Manufacturing will be protected in the event Felicia becomes disabled.
Then, with Felicia’s permission, John purchases a $1,500,000 Whole Life 99 key person policy on Felica’s life. The policy has an annual premium of nearly $22,377. The death benefit will protect Monaco Manufacturing should anything happen to Felicia.
Additionally, by the time Felicia reaches retirement in year 25, the policy will have a cash value of about $569,000. John could use this money to fund an additional retirement benefit for her, or he could even give her the policy outright.
When it comes to key person insurance, there are some important tax considerations to keep in mind:
1 Disability key person insurance is not available if the partner/owner has more than 5% ownership in the business.2 Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59½, any taxable withdrawal may also be subject to a 10% federal tax penalty.3 The Pension Protection Act of 2006 created certain reporting and notice-and-consent rules, and some other technical requirements, for all employer-owned life insurance. Failure to comply could subject part of the life insurance proceeds to income taxation.4 The amount of desired coverage will be subject to financial underwriting limits.5 Care should be taken not to create a promise, formal or informal, to give the policy to the executive at retirement. Doing so could inadvertently create a Non-Qualified Deferred Compensation plan which would then be subject to IRC 409A.6 Premium amount is for illustration purposes only, and is based on generic rates for a female age 40, occupation class 6 with a 90-day elimination period.7 This hypothetical disability illustration is not a contract or an offer of coverage. It describes certain standard features of our PayGuard Plus contract, which may vary by state. If a policy is issued, its provisions and pricing may differ from what is illustrated here..8 Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.9 Employer-owned life insurance is received income tax free by the business only if IRC 101(j) is complied with.All scenarios and names mentioned herein are purely fictional and have been created solely for educational purposes. Any resemblance to existing situations, persons or fictional characters is coincidental. The information presented should not be used as the basis for any specific insurance/investment advice.