Key-Person Coverage: Insuring the Irreplaceable Employee

What key-person coverage is

Key-person (or “key-man”) life insurance is a policy a business owns on the life of an employee or owner whose loss would seriously harm the company. The business pays the premiums, owns the policy, and is the beneficiary. If the key person dies, the death benefit gives the company cash to weather the disruption — to cover lost revenue, recruit and train a replacement, reassure lenders and customers, or, if it comes to it, fund an orderly wind-down. It insures the business against a person, the way property insurance insures it against a fire.

Not the same as a buy-sell

Key-person coverage is often confused with buy-sell funding, but they solve different problems. A buy-sell agreement is about ownership — moving a deceased owner’s shares to the survivors or the company. Key-person insurance is about operations — giving the business itself money to survive the loss of someone critical, whether or not that person was an owner. A company can need both, and they are structured and taxed differently.

How much coverage, and what kind

There is no single formula for the right amount, because key-person coverage is insuring an economic loss, not a life. Businesses generally size it against some measure of what the person’s death would cost — common reference points include a multiple of the key person’s compensation, the estimated cost to recruit and train a replacement, the profit or revenue attributable to that person, or the amount a lender requires as a condition of a loan. Because those are judgment calls, the figure is best set with the company’s accountant and insurer rather than a rule of thumb.

The kind of policy follows the time horizon. Term life is inexpensive and fits a defined-duration need — coverage until a founder retires, a loan is repaid, or a successor is trained. Permanent coverage costs more but lasts for life and builds cash value the business can access, which some companies prefer when the dependence on the key person is open-ended. The choice is a cost-versus-duration trade-off, not a question of which product is “better.”

The §101(j) consent rule you cannot skip

Life-insurance death benefits are normally income-tax-free, but for employer-owned life insurance Congress added a trap. Under IRC § 101(j), the death benefit on an employer-owned policy is income-tax-free only if specific notice-and-consent requirements were met before the policy was issued: the employee must be notified in writing that the employer intends to insure their life and the maximum amount, must give written consent, and must be informed that the employer will be the beneficiary. An exception must also apply — for example, the insured was an employee within the year before death, or was a director or highly compensated employee.

Premiums and deductibility

The premiums a business pays on key-person coverage are generally not tax-deductible, because the business is the beneficiary of the policy (IRC § 264(a)). The trade-off is the mirror image on the other side: because the premiums are paid with after-tax dollars, the death benefit — when the § 101(j) rules are satisfied — comes in income-tax-free. This is the normal pattern for business-owned life insurance: non-deductible going in, tax-free coming out.

Sources & methodology