Category: Life Insurance Blog
Key Person Insurance for Small and Mid-Size Businesses
June 10, 2017 Richard Reich
Every small or mid-size business typically has a key person or persons that are responsible for producing a majority of the revenue. Service businesses are typically dependent on a key person who regularly delivers revenue from their coveted client list. Should the business lose one or more key persons because of an unexpected death, the business is likely to endure severe financial challenges until a replacement can be recruited and trained. You can mitigate this risk with key person insurance.
Definition: Key Person Insurance is any type of life insurance that is purchased by the business organization on the life of the key person or persons, with the organization listed as the beneficiary. There is a defined insurable interest between the organization and the key person that results from the expected loss of revenue resulting from the death of the insured. A key person is defined as a person who is crucial to the operation of the business either by revenues generated or work product and whose absence would be detrimental to the continuation of the organization.
Why the Importance for a Service Business
The nature of the operation of a service business makes it the perfect candidate for key-person insurance. Most service businesses depend on a handful of key individuals for the majority of the revenue that supports the operation. These individuals might be officers or partners in the company or team members who have proven to be substantially valuable to the company to continue operations.
It’s not only about revenues. Many key individuals are considered irreplaceable because of their client list, industry experience, or knowledge of the services being offered by the business. Many team members in a small business may be considered invaluable because of their marketing results or technology skills.
The business only needs to run reports that indicate new and recurring revenue and marketing successes to quickly understand who the rainmakers are in the organization
How it Works
The business principal designates who in the organization is considered a key person and purchases a life insurance policy on that person, pays the periodic premiums and is the beneficiary of the policy. If the key person died unexpectedly, the business would receive the death benefit from the insurance company tax-free.
The business owner would then have the necessary funds to pay the expenses resulting from the death of the key person:
Which Type of Insurance Should be Used
Term Life Insurance is the most affordable life insurance product to fund a key person insurance plan. Since term insurance provides temporary coverage for up to thirty years and has a very low mortality rate, this insurance is much more affordable than permanent insurance like Whole Life or Universal Life. Other key benefits that make term insurance the perfect solution for the loss of a key person include:
>> Most life insurers offer policy terms for up to thirty years.
>> Many insurers offer a “return of premium” rider that would provide for the insurer to return all premiums paid to the business if the key person outlives the policy term. The business owner could use some or all of the returned premium as a retirement gift for the loyal key person or as a signing bonus for the retiree’s replacement. The money belongs to the business and can be used in any way needed.
>>Most insurers offer an accelerated death benefit rider that allows the insured to receive a large percentage of the death benefit if diagnosed with a terminal illness.
How Much Key Person Insurance Should the Business Purchase?
The amount of insurance a business should consider for a key person would be predicated on the risk involved. The amount of risk is determined by calculating the costs that will typically be incurred by the loss of the key person. These costs are related to the loss of revenue, loss of clients, possible loss of pending sales, and any other ways the business would be affected by an untimely death of a key person.
Most experienced insurance professionals have substantial key person insurance experience for service industries and can help the business principal establish an amount of insurance sufficient to cover the anticipated costs of losing a key person or persons.
Is the Death Benefit from Key Person Insurance Taxable?
Unless the required Notice and Consent requirements of Section 101(j) are met, the death benefit from the insurance policy will typically be considered income to the business and therefore taxable to the beneficiary (the business). The Notice and Consent requirements must be met before the insurance policy for each Key Person is issued by the insurer. According to IRC 101 § (j) Treatment of certain employer-owned life insurance contracts, the following requirements must be met:
- the employee is notified in writing that the applicable policyholder intends to insure the employee’s life and the maximum face amount for which the employee could be insured at the time the contract was issued,
- the employee provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and
- the employee is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee.
- The number of employees at the end of the year.
- The number of employees who are insured at the end of the year under employer-owned life insurance contracts.
- The total amount of life insurance in force at the end of the year under these contracts.
- The name, address, and taxpayer identification number of the employer and the type of business in which the employer is engaged.
- Whether the employer has a valid consent for each insured employee, and if not, the number of insured employees for whom a consent was not obtained.
How Can a Small or Mid-Size Business Get the Best Deal on Key Person Insurance?
The most effective way to get the best coverage and pricing for key person insurance is to contact an independent insurance professional who knows and understands your business.