Succession Strategy – Key Person Insurance

June 5th, 2015

While a business does indeed depend on every employee or person involved in it, there is often one person or a set of key persons who are crucial to its success. The loss of this key person or persons could lead to a whole range of negative outcomes – from inefficient coordination of day to day affairs to loss of contacts, goodwill, sales and even credit.

While you cannot anticipate the death of a significant person, you can set up safeguards for your business in the form of key person insurance.

What is Key Person Insurance?

As the name suggests, key person insurance is a kind of insurance that protects a corporation against the sudden death of a key employee, whose contributions, expertise, contacts and knowledge are essential to the business. This policy is normally taken out by the business on the life of an owner, partner or any other employee who is significant to its success.

How does Key Person Insurance Work?

Key person insurance policies are very simple – the business buys a life insurance policy against the life of a key person, pays the premium and receives tax-free death benefits from the policy in case the insured employee dies. The insured individual and his/her family will generally have no interest in the plan and will not receive any benefits.

As the owner and beneficiary of the policy, the business may use the death benefits to hire or retain a replacement, protect its credit or replace any loss in sales and profit caused by the key person’s death.

Benefits of Key Person Insurance

The benefits of taking out a key person insurance policy as a business include:

  • Financial protection in case of a key employee’s death
  • Can be set up for one or more persons that are crucial to the business
  • Simple sign-up process that does not involve IRS approval
  • Tax-free death benefits that can be used to replace lost profits, hiring a replacement, etc.
  • Access to a policy’s potential cash value that can be used for cash flow, retirement plans and unforeseen expenses

Key Person Insurance – Tax Implications

When a corporation takes out a key person insurance policy on an employee, the benefits are not shared with the employee or his/her family, but go to the business alone. Premiums on these plans are not tax-deductible, but the death benefits received by the business in case of the employee’s death are tax-free (except in circumstances where an alternative minimum tax may be applicable).

Example of Key Person Insurance

The owner of a construction company analyses its reputation in the market and realizes that a 45-year old female employee has played a huge role in building goodwill and contacts for the company. She currently earns $500,000 annually, so the business owner decides to invest in an accumulation universal life (UL) insurance plan for her, with annual premiums of $52,123 for 20 years, and death benefits of $5 million.

  • Since the business owner picked an accumulation UL policy, it allows them to access the potential cash value that accumulates on it over the years and use it for business expenses. They can also choose to transfer the policy to the key employee after the term of 20 years, as a supplemental retirement fund for her.
  • After the 20-year term ends, the cash value of the policy will be almost $1.3 million, and with a bonus of a little under $700,000 paid to her as a replacement for the income tax incurred by the transfer, the key employee will receive almost $2 million as a retirement income, and the company gets the same amount as a tax deduction.
  • In case she dies during the policy term, the company will receive death benefits of $5 million, which they can use to cover the cost of hiring, training and retaining a replacement, protecting their credit, or to replace the losses in income caused by her death.

 

Posted in: All,