Key Person Insurance

Some employees are worth more than their salary.

Every business has one or two people whose absence would do real damage: the founder whose relationships drive revenue, the rainmaker who closes half the deals, the engineer who knows how the system actually works. Key person insurance is the company’s hedge against losing them.

How it works

The structure is straightforward:

• The company is the applicant, owner, premium payer, and beneficiary of the policy.
• The insured is the key employee, who signs the application and goes through underwriting.
• If the insured dies, the company receives the death benefit. With key person disability insurance, the company receives a monthly or lump-sum benefit if the insured becomes disabled.

The proceeds aren’t earmarked. They give the company cash to do whatever the moment requires: cover lost revenue, recruit and onboard a replacement, retain remaining customers, pay down debt, reassure lenders, or buy time to find a strategic buyer if continuing without the key person isn’t realistic.

Sizing the policy

There’s no single right answer. Three methods we commonly use, often in combination:

• Multiple of salary. A rough starting point, often 5 to 10 times annual compensation. Easy to calculate, but it can understate the loss for revenue-driving roles.
• Replacement cost analysis. What does it actually cost to recruit, hire, onboard, and bring a replacement up to full productivity? Include recruiter fees, training time, lost productivity during transition, and the cost of any interim coverage.
• Contribution-to-profit analysis. Estimate the profit attributable to the key person’s role and the time it would take for the business to recover that profit stream after their loss.

Lenders and investors sometimes specify a face amount as a covenant. That’s a floor, not a ceiling.

Tax treatment

Generally, key person life insurance premiums are not deductible by the business (IRC Section 264). In exchange, the death benefit is generally received income-tax-free under Section 101(a), provided the notice-and-consent rules under Section 101(j) (added by the Pension Protection Act of 2006) were satisfied before the policy was issued. Skipping those notice-and-consent forms can turn the death benefit taxable, which is a costly paperwork mistake.

For larger C-corporations, the Corporate Alternative Minimum Tax (CAMT) enacted in 2022 applies a 15% minimum tax on adjusted financial-statement income for corporations with average AFSI above $1 billion. That threshold puts CAMT outside the world of most closely-held businesses, but if your company is in scope, the AFSI treatment of life insurance proceeds and cash value can affect the math. Specifics depend on the situation and your tax advisor’s read of the regulations.

Who needs it

• Founders whose name, reputation, or relationships are central to the business.
• Top salespeople generating an outsized share of revenue or holding the deepest customer relationships.
• Technical or operational leads whose knowledge isn’t documented anywhere else.
• Anyone whose loss would meaningfully damage operations, customer retention, or the company’s ability to borrow.

If you can name the three people whose departure would scare you the most, those are the candidates.

How to get started

• Identify the key people and the financial impact of their loss.
• Decide on coverage amount and structure (term vs. permanent, life vs. life and disability).
• Complete IRC 101(j) notice-and-consent paperwork before the policy is issued. Not after.
• Underwrite. Medical, financial, and sometimes lifestyle underwriting depending on the face amount.
• Coordinate with any buy/sell funding so the same policy isn’t double-counted for two purposes.

Done right, key person insurance is one of the cheaper risk-management line items a business carries. The premium is the cost of being wrong about how indispensable a person is, and the proceeds are what keeps the business running when “indispensable” turns out to be literal.