Key person insurance is a life insurance or disability policy that a business owns on an employee whose death or incapacity would cause significant financial harm. The business pays the premiums, owns the policy, and receives the death benefit. The proceeds replace lost revenue, fund the search for a replacement, cover debt obligations, and stabilize the company during a transition. It is not employee benefits; it is business protection.
Is this a fit for you?
Who This Is For
- Your business has one or two people who generate a disproportionate share of revenue
- A key person holds critical relationships, intellectual property, or operational knowledge
- Your business has debt or lease obligations that require continued revenue to service
- Lenders or investors require key person coverage as a loan covenant
- You want to protect the business value that funds your buy-sell agreement
Who This Is Not For
- No single person's departure would materially affect revenue or operations
- The company has deep bench strength and immediate successors for every critical role
- The business has sufficient cash reserves to absorb 12-24 months of disruption
- You are looking for employee benefit insurance (that is group life, not key person)
How do the options compare?
| Method | Formula | Best For |
|---|---|---|
| Revenue multiple | 5-10x the person's annual revenue contribution | Sales-driven businesses |
| Replacement cost | 2-3 years of compensation + recruiting costs + training | Technical or operational roles |
| Earnings multiple | Multiple of company earnings attributable to the key person | Companies with stable earnings |
| Debt coverage | Outstanding loans requiring the key person's involvement | Leveraged businesses |
What are the risks, costs, and alternatives?
Premiums are not tax-deductible
The IRS does not allow businesses to deduct key person insurance premiums. However, the death benefit is generally received income-tax-free by the business. Plan for the premium as a non-deductible operating expense.
Notice and consent requirements
Under the Pension Protection Act, employers must provide written notice to employees that they are being insured and obtain their written consent. Failing to comply can result in the death benefit being taxable to the business.
Coverage amount may be insufficient
Many businesses underestimate the financial impact of losing a key person. Consider lost revenue, lost relationships, recruitment costs, training time, and the disruption to remaining employees.
Policy ownership and beneficiary must be correct
The business must own the policy and be the beneficiary. If structured incorrectly, the proceeds may go to the wrong party or create unintended tax consequences.
What does this look like in practice?
Atlas Digital: Insuring the Rainmaker
Illustrative example: not an actual client.
Atlas Digital, a $6 million marketing agency, depends heavily on its co-founder and head of client services, who personally manages relationships generating $3.5 million in annual revenue. No one else at the firm has these relationships.
The company purchased a $5 million 20-year term key person policy at $3,800 per year. The coverage amount reflects the revenue at risk ($3.5M per year for two years of transition) plus $1 million for recruiting and onboarding a replacement.
When their bank renewed the company's line of credit, the lender required proof of key person coverage as a loan covenant. The policy satisfied the requirement with no additional cost.
Illustrative scenario for educational purposes. Premiums and coverage amounts vary.
Common Questions
How much key person insurance does a business need?
Coverage is generally sized to the financial impact of losing the person. Common approaches include a multiple of the revenue they contribute, their replacement cost including recruiting and training, a multiple of company earnings attributable to them, or the debt their involvement supports. The right method depends on the person's role and the business.
Are key person insurance premiums tax-deductible?
No. The IRS does not allow a business to deduct key person insurance premiums, so plan for the premium as a non-deductible operating expense. The offsetting benefit is that the death benefit is generally received income-tax free by the business, subject to the notice and consent rules and the claims-paying ability of the issuing insurance company.
Who owns and receives the benefit from a key person policy?
The business owns the policy, pays the premiums, and is named as the beneficiary; the insured employee is not the owner. If ownership or the beneficiary is structured incorrectly, the proceeds can go to the wrong party or create unintended tax consequences. Confirming the structure with your advisors before the policy is issued is important.
Do I need employee consent to insure them with key person coverage?
Yes. Under the Pension Protection Act, an employer must give written notice that an employee is being insured and obtain the employee's written consent before the policy is issued. Failing to meet these notice-and-consent rules can make the death benefit taxable to the business rather than income-tax free.
Related Questions
Who Are Your Key People?
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