Are You Using Key Person Insurance to Retain your Best Employees?

Published by thegulguy on

golden handcuff life insurance

So a bit of a disclaimer: The industry industry is old and stuffy – Many companies still refer to key person insurance as key man insurance but know matter what you call it, it’s all the same. In this article we’ll go through why it’s a benefit that could save your business but can also be used to retain your best employees for no additional cost!

What it is:

Key person life insurance, despite its fancy name is a regular old life insurance policy that is taken out by a business on the life of an employee.  The business is the owner of the policy, pays the premium, and receives the death benefit if the employee covered passes away.

The employee is just the insured – the rates are based on based on their age and health, and the policy only pays out if they pass away. Otherwise, they are not involved in the policy and do not benefit unless you choose to transfer it to them (more on that later!)

What it is Not:

Businesses can buy and use life insurance in a number of different ways – and they all use the same policies but use completely different rules to achieve different objectives.

You may have heard about Section 162 bonus plans that use life insurance to fund an executive retirement package – while the business is still the payor on those plans, they are not the owner, and thus the benefit is generally taxable to the employee as earned compensation and tax deductible to the business and not intended to replace lost business income.

Split dollar life insurance is similar, but not quite the same as it is a shared way of providing an employee a tax free benefit through a life insurance plan while also providing the business some benefits.

split dollar life insurance

In a split dollar policy, there are two methods of ownership – either employee or employer, but in either case, the employee chooses the beneficiary. Key person life insurance has your business as the beneficiary, because the primary purpose of the plan is to protect you!

What about Buy Sell Plans?

Buy-Sell agreements funded with life insurance are also generally not considered key man plans – as in most partnerships the owners will own the life insurance directly on each other (known as cross purchase life insurance) and the lump sum is used to purchase ownership of the business itself from the wife/estate of the deceased partner

In the few cases where the business owns the the life insurance for the buy-sell agreement itself (known as entity purchase life insurance), it has the same taxation laws as a key person life insurance purchase, and if all the owners also work at the company would be functionally identical.

Why you should care about key person life insurance:

Running a business costs money – so why spend your hard earned revenue on life insurance when you could add to your marketing spend or pocket the revenue as profit?

Most (though not all) businesses have what are considered ‘key employees’ that are essential to the proper functioning of the business.  

These might be killer sales guys, or the R&D team who is building out your revolutionary widget, or senior management executives who know the ins and outs of the business.

If they went on a shark diving vacation and didn’t come back – your business would be hugely impacted!  It may take you months to an effective substitute for that person – and your business will hemorrhage cash in the meantime.

However, by purchasing key life insurance your business gets a tax free* cash distribution that comes as either a lump sum or a stream of income that your business can use as an immediate stopgap for the losses if Todd, your Senior Vice President gets too close to the beast.

How much key person life insurance should you purchase?

Imagine if Tesla lost Elon Musk – Without hundreds of millions of dollars in cash, the company would fold more or less instantly as much of Tesla’s future is propped up by his star power and personal guarantees.

Now you may not have someone as essential to your enterprise as Elon is to Tesla – but there are most likely people in your organization where their absence would be felt heavily – whether it be a specific loss of revenue or expertise or just a huge expense in payroll finding the appropriate hire and training them up.

Think about how much that would cost you – then double it, because your expectations are probably too rosy!

That dollar figure is a good first number to look at when purchasing life insurance that will be owned by the the business, but there are other figures you should consider as well.  

Generally there is a maximum of 10 times annual compensation of the employee you’d like to insure – but if you can prove the business would suffer losses higher than that to the underwriter you should be able to get even more.  

How does this help you retain employees?

Now that you know what key life is and how it will benefit you as an owner – how can it benefit you as an owner in other ways!

Keeping critical employees is becoming a key challenge for businesses – and locking employees down with benefits is one of the few ways that you can increase longevity.

You can use either term or permanent insurance as key life policies, though term is much more applicable for limited projects – like an expansion or a specific product roll out.

Term insurance has no cash value and expires – and a high income employee would probably be insulted at the thought of being given a term policy as compensation. If you do need only short term or defined length coverage, then by all means get the term policy.  Just don’t bother offering it as an incentive.

Whole Life or (a well designed) Universal Life policy is a much better option for covering key employees for an indeterminate length of time for two reasons.

It doesn’t run out

It can be used as golden handcuffs. Eventually transferring the policy to them as a supplement to their retirement package can be a benefit worth a substantial (read: hundreds of thousands of dollars) amount to an employee.

Key life insurance does not fall under ERISA laws, which means you can be discriminatory and have a wide leeway on how and when you want to transfer these benefits to the employee.

Want to transfer 5% of the value of the insurance policy away per year to the employee? You can do that! Want a 10 year cliff before they are eligible for any benefits?  You can do that too.

Want to strip cash value for the business to use?  Yes, that’s allowed too! You can get pretty creative with all of the different ways you want to structure key life insurance as both a benefit for you and the employee.

Note: I do not provide legal or tax advice.  Please contact your corporate counsel before engaging in any of these activities

Tax treatment of key person life insurance

You should always contact your tax professional first for specific advice pertaining to your business, but generally, key person life insurance is not deductible because it is a benefit to the business not the employee.

If the employed insured by the key person policy passes away, that income is tax free to the business (because it wasn’t tax deductible – but this is not the case with C corps who have AMT issues).

If the company sells the policy or transfers it for value, the death benefit will become taxable as per the Internal Revenue Code Sec. 101(a)(2), unless one of the following five exceptions apply:

  1. Anyone whose basis is determined by reference to the original transferor’s basis
  2. The insured (or insured’s spouse or ex-spouse, if incident to a divorce under Sec. 1041)
  3. A partner of the insured
  4. A partnership in which the insured is a partner
  5. A corporation in which the insured is a shareholder or officer.

Can you be the key employee?

This is a pretty common question, and the answer is yes!  

However, it’s generally used when someone else owns a part of your business. For something like a sole proprietorship, there’s no point in having the business own a life insurance policy on you, because you and the business will both cease to exist at the same time.

There is one other use where it make sense for someone else to take out life insurance on yourself for business purposes.

Loan Covenants

When you are taking out a loan for business purposes, lenders know that there is a real chance that you will default on the loan for one reason or another.

Often, they require personal guarantees to be made from the owner of the business, that in the case of anything going wrong, the owner will use his personal assets to make things whole for the lender.

Sometimes, a lender will also ask for guarantees in the form of life insurance because the value of the business is tied up in your expertise.

SBA Loans

This arrangement is most commonly seen in conjunction with Small Business Administration loans.  SBA loans are issued by private lenders and have government guarantees to pay a portion of the loan if it defaults.  These loans are very common in smaller and midsize businesses.

If the lender determines that the “viability of the business is tied to an individual or individuals” (that’s you) they need to secure their interests via life insurance, because without you the business is at an immediate risk of failure.

If this is the case, you need to be approved and be able to transfer the contract via collateral assignment (in most cases) to the lender first as part of the loan application!

While all life insurance companies allow a transfer to an employee, not all life insurance companies offer collateral assignment. It is important to work with someone independent who knows which companies work best with SBA loans and can give you the best options out there.

If you have a business and are interested in seeing how a key person life insurance policy can protect your interests and retain employees, schedule a no obligation 15 minute introductory call now!