key person life insurance
THE VALUE OF A KEY EXECUTIVE
A key executive’s ideas and leadership can be critical to the success of a business. If that executive were to suddenly pass away, the business could suffer a severe economic impact due to the loss of their unique skills and abilities. If a key executive dies, the business may have to spend a lot of money to find and train a replacement. Key person life insurance can be a wise strategy for businesses to help cover these costs during the transition period following the death of a key executive.
THE DAMAGE CAUSED BY FAILING TO PLAN
The sudden death of a key executive can have a severe economic impact on a business due to the loss of their unique skills and abilities. This can result in a disruption or slowdown in:
• A disturbance or slowdown in sales or business production.
• Significant expenses associated with recruiting and training a replacement.
• Weakening of the company’s credit rating.
PROTECTING THE BUSINESS AGAINST A LOSS OF A KEY EXECUTIVE
The business purchases a life insurance policy on the life of a key executive.(1,2) Before the issuance of the life insurance policy, the business must provide written notice to the executive that it intends to be the owner and beneficiary of a life insurance policy on the executive’s life and may choose to continue the coverage beyond the executive’s employment. The business must also notify the executive as to the maximum amount of life insurance that could be placed on the executive’s life. The executive must give written consent to such life insurance coverage.(3) The business pays all of the premiums and retains all ownership rights to the policy. If cash value life insurance is used, the cash value of the policy will accumulate in a tax-advantaged manner. If the key executive dies while the life insurance policy is in-force, the business will receive the policy death benefit income tax-free.(4) The business may use the death benefit to sustain operations following the death of the key executive.
KEEPING THE BUSINESS AFLOAT
A key person life insurance policy may provide the business with the following benefits:
• Financial protection against the sudden death of a key executive.
• The liquidity needed at the death of a key executive to recruit and train a suitable replacement.
• Potentially makes it easier to obtain business financing from a 3rd party lender, as the lender will often require life insurance coverage as collateral for such financing.
• If cash value life insurance is utilized,
• The cash value of that policy will grow on a tax-deferred basis.
• The business may book the cash value of the policy as an asset on its balance sheet.
• The business may access any available cash value for emergencies or other financial needs.
• A cash value key person life insurance policy is often utilized as the informal funding vehicle for a nonqualified deferred compensation plan.
1 In order to preserve the tax treatment of the life insurance death bene t, the key executive should be a shareholder who owns more than 5% of the shares, a director, or a highly compensated employee as defined in IRC Sec.101(j)(2)(A)(ii).
2 Please note that life insurance purchased by a business on one of its executives will reduce the executive’s total life insurance capacity. ‑ is reduction in total insurance capacity may reduce or eliminate the executive’s ability to purchase additional life insurance for the executive’s personal needs.
3 IRC Sec. 101(j)(4).
4 For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Sec. 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (i.e., the “transfer-for-value rule”); arrangements that lack an insurable interest based on state law; and an employer owned policy unless the policy qualifies for an exception under IRC Sec. 101(j).