Key Person Insurance Products
The Purpose of Key Person Insurance
Key person insurance is life or disability income insurance on a key employee in a business. Most businesses have key employees, including the owner or partners and one or two employees who are critical for business to function. Key person insurance provides the business with a source of funds when needed most — at the death or disability of a key employee.
Advantages of Key Person Insurance
1. Keep the Business From Going Under
Life and disability insurance policies provide an easy way to provide funds should anything happen to your key employee. You may needs funds to:
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Pay headhunter fees and a replacement's signing bonus
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Buy out a partner's business equity
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Cover business overhead
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Entice a key employee to who is underperforming due to a medical problem to voluntarily leave or go on claim so that they won't litigate for wrongful termination.
2. Better Credit Terms
Small Business Administration loans require life insurance for a reason, and the same reasoning applies to disability. More so, in fact, because long term disability is at least three times more likely than death. Key person insurance can influence smaller lenders, especially community banks, who may be taking on the risk themselves.
3. The Application Process has Screening Value
Before you commit to a new team member for an important position, you might want to know more about them. The underwriting process for disability insurance can be quite extensive, and the denial of coverage may raise questions that lead to important information.
The Probability of Disability is 30%
According to Milliman, an actuarial consultancy, the career risk of disability for longer than 90 days is 30%. However the perceived risk is only 2%, according to the Council for Disability Awareness, which is a gross underestimation.
The Role of Key Person Insurance in Retention
Key person insurance programs can, optionally, be coupled with "golden handcuffs" or contingent deferred compensation plans. This is an advanced feature and is generally discussed only after defining the exposure to a key person's death or disability due to it's capital-intensive nature.
The Difference Between Long Term Disability Insurance and Key Person Insurance
Long Term Disability (LTD) insurance is for personal income protection, whereas Key Person insurance is for business protection. Although the phrase "key-person insurance" loosely refers to any insurance benefit for the purpose of business continuity, there are actually specific policy types for the purpose of funding business overhead expenses and another type for business buy-outs. It is not really possible to re-purpose LTD for business protection due to regulatory obstacles, and for buy-out purposes there is a special requirement that funding must continue if recovery occurs after the buyout clause is triggered, which LTD can't do.
Cost of Key Person Insurance
Benefit Amount | Age | Product Line | Cost |
|---|
Assumptions for disability insurance: Principal policy form HH772, Washington, male, non-nicotine, 4A, 180 day elimination period
Assumptions for life insurance: Prudential policy form ICC17-PART-2017, Washington, male, nicotine or non-nicotine
Pricing depends on occupation, health, and group size, among other things, so expect your pricing to be different - higher if you have health history, lower if you are in a group of 10 or more.
Tax Treatment of Key Person Benefits
When it comes to key person insurance, there are some important tax considerations to keep in mind:
• Life and disability income insurance premiums are not deductible by your business.
• There are no tax consequences to the employee unless some benefit is paid to the employee or the employee’s estate.
• Insurance proceeds are generally received income tax-free by the business.
• In pass-through entities such as S corporations, Limited Liability Companies (LLCs) and partnerships, the death proceeds increase the basis of the owner’s business interest. Premium payments, policy cash values and policy dividends may also impact an owner’s basis; consult your professional tax advisor.
Key person life insurance is received income tax free by the business only if IRC 101(j) is complied with.
IRC §101(j) stipulates that the death benefit from employer-owned life insurance contracts issued after August 17, 2006 are taxable as ordinary income to the extent the amounts paid under the contract exceed premiums and other amounts paid by the employer. However, if certain notice and consent requirements are met before policy issue, and if certain exceptions apply, death benefits have the potential to be income tax-free. Among these requirements is that employers purchasing key person insurance should file IRS Form 8925 in order to report:
• the number of employees the business is covering through key person insurance;
• the total amount of employer-owned coverage in force; and
• how many covered employees the business has received consent (for coverage) from
Please keep in mind that we are not legal or tax advisors. You should consult your tax and legal advisors regarding your situation.
Key Person Insurance Without Medical Underwriting
(i.e., Guaranteed Issue Key Person Insurance)
To waive medical underwriting for key person life and disability insurance, there must be at least at least ten (10) individuals. If the group size later shrinks below this threshold, coverage for the remaining members is generally kept in force.
Special programs exist for guaranteed issue key person insurance which are not the same as policies used for employee benefits. Key person programs are for select members only, are non-ERISA, and are filed in certain way that permits the business to be named the beneficiary.
In Washington State, agents and brokers are also called "producers."