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Voluntary Programs

Employee-paid programs that cost nothing to sponsor and add value over what employees could get on their own.

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:

  • Recruit a replacement, which may entail headhunter fees and a hefty signing bonus. 

  • Purchase of business equity and overhead costs (there is a specific kind of insurance for these purposes that is not technically classified as key person insurance even though people think of it as such).

  • Entice a key employee to who is underperforming due to a medical problem to voluntarily leave or go on claim  - instead of firing them - 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 rather than selling the loan off.

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.

graph showing the disparity between perceived vs actual risk of disability

This is probable enough that if it does happen, one might regard the absence of coverage as an oversight.

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 not usually part of the discussion in early stages because it is capital intensive.  For now, the focus should be on essential needs, which means minimizing business exposure to a key person's death or disability at minimal cost.  We do this with disability insurance and term life insurance, not whole life or other instruments with cash value.

 

The Difference Between Long Term Disability Insurance and Key Person Insurance

Key Person insurance is for business protection, whereas Long Term Disability (LTD) insurance is for personal income protection.  If the benefit is intended to buy out other business owners, a special kind of policy is required in order to provide lump sum funding and ensure that medical recovery won't cause benefits to terminate.  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 a business buy-out and overhead.

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

These examples may differ from yours due to the impact of occupation and health for individual policies, or aggregate demographic risk factors for group policies.

To reduce the cost of disability Key Person insurance, variations of the concept exist using group coverage and/or by spreading out the benefit in monthly installments.  When you request a proposal, group and installment options will be accounted for.

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.

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