• Key person arrangements offer financial stability and seamless operations for businesses in the event of losing a crucial employee.
• These arrangements safeguard businesses from potential disruption and revenue loss caused by the departure of a key team member.
• Key person arrangements can be established with term or permanent life insurance products, which provide financial compensation to the business in case of death or disability of the key employee.

The success of a company often hinges on the expertise and unique skills of its key employees. The unexpected loss of a key team member can leave a business vulnerable to operational disruptions, financial setbacks, and even reputational damage.

Key person arrangements, in which a business takes out a life insurance policy on an executive or other strategically important employee, helps to safeguard a business against potential financial losses and maintain continuity. The funds provided through this arrangement can be used to cover expenses related to hiring and training a suitable replacement, ensuring the company's stability and ability to continue essential operations during such setbacks. 

How key person arrangements work

In a key person arrangement, the business buys a life insurance policy on the life of the key employee, pays the premium, and names itself as the beneficiary. Different types of life insurance policies can be used to implement such an arrangement, though cash value growth within a permanent life insurance policy, if utilized, is tax-deferred and shows as an asset on the corporate balance sheet. 

Premiums paid on the policy are generally not tax-deductible, but the policy proceeds are received income tax-free, as long as the arrangement complies with 101(j) regulations*. The business, as the policyowner, may have access to cash value through withdrawals or tax-free policy loans, subject to policy loan provisions and limitations.

Potential applications

Businesses of all sizes, structures and industries may benefit from implementing a key person arrangement:

• Small-to-mid-sized businesses, which rely on a limited number of employees for their success, may wish to utilize key person insurance to ensure that the business is able to weather the departure of a business owner or key revenue driver. 
• Businesses in industries that are high-growth or knowledge-intensive, such as technology or research and development, may use key person arrangements to mitigate the risk that it takes a long time to find an employee with a specialized skill set.

When used in conjunction with other business planning strategies, key person arrangements can also be used to retain valuable employees. For example, a supplemental endorsement split dollar agreement can be used in conjunction with a key person arrangement. 

In such an agreement, a company and a key employee share the cost and benefits of a life insurance policy. During the employee’s service, the life insurance policy protects the business in the event that the employee were to unexpectedly pass away. Once the employee completes his or her predetermined service requirement, the policy can be transferred to the employee to be used as a legacy planning tool or to serve as supplemental income in retirement.

Insurance product selection

A key person arrangement can be structured using a variety of life insurance products, depending on the needs of the business. 

Term life insurance is generally more affordable and straightforward, providing coverage for a specified length of time. However, it’s important to recognize that coverage expires at the end of the term, premiums may increase upon renewal, and there is no cash value accrual. A permanent life insurance policy, although it usually requires a higher premium, allows for cash value accumulation, which remains a corporate asset, and can be used as a means of offering an executive benefit to the key employee, if desired. 

Another potential solution in key person arrangements is disability income insurance, which offers income replacement if a key person becomes disabled, protecting against productivity decline or operational disruptions, and covers both short-term and long-term disabilities. Drawbacks include potentially expensive premiums and limitations or exclusions for specific conditions or disability situations. Premiums paid are not tax-deductible, although the benefits will be received tax-free by the business.

Additional considerations

A business that is considering taking out key person insurance on an employee should be aware of the underwriting process, which may require medical exams or background checks for the insured employee(s). The business must apply for an amount of coverage that can be financially justified based on the employee’s overall worth to the business. 

Additionally, premium payments may increase over time, particularly for term policies or those without premium guarantees, which could impact the company's cash flow. Businesses must also budget for these premium payments while maintaining other financial commitments. As mentioned above, these payments are not tax-deductible under IRC Section 264(a). 

It is also crucial to manage administration and compliance effectively. This involves maintaining essential documents like policy applications, corporate resolutions and consent forms. 

Businesses must ensure that state laws and regulations are adhered to. Once a key person arrangement is implemented, the business must review the policy regularly to ensure that it aligns with changing business goals and risk management strategies.

Case study

Thomas, age 45 and in good health, is a key employee at a real estate firm. Thomas is not only responsible for a significant amount of revenue to the company, but has also developed critical relationships within the industry that has helped the business flourish. Understanding the value that Thomas brings to the firm, the CFO introduces the idea of having the business own a life insurance policy on Thomas to cover an unexpected event. 

Based on Thomas’s overall value to the business, the firm decides to purchase a $1,000,000 permanent policy on him with an annual premium of $20,000 paid for 10 years. The premium is not tax-deductible to the business, but the death benefit would be received income tax-free in the event of his passing. This would provide the business with immediate liquidity to train a new hire, replace any lost revenue and reassure creditors. 

In some cases, an early cash value rider can also be added on to the policy that will get the cash value close to or equal to the cumulative premiums paid in the early years.  The cash value amount remains a corporate asset and shows up on the balance sheet.  The business could also decide to endorse a portion of the death benefit over to Thomas during employment for the benefit of his heirs should he pass prematurely.  Thomas would just be responsible for paying tax on the “reportable economic benefit” charge each year based on his age and the amount of death benefit endorsed.  

The policy can also be used as a retention tool to keep Thomas tied to the business. A secondary agreement is implemented that obligates the business to transfer the entire policy over to him at some point if he satisfies a predetermined service requirement (10 years, 20 years, age 65, etc.). If Thomas leaves before the requirement is met, the business can retain the policy for its own use. However, if Thomas completes his term of service, the business will transfer the policy to him to be used for estate planning or additional income in retirement.

Notes

* For all “employer-owned” policies, the business must obtain notice & consent from the insured employee as well as file IRS form 8925 each year with the corporate income tax return.