10.3.3 Key Person Insurance
Key person insurance is designed to help protect a business against financial loss that may be caused by the death of a key, or economically valuable, person. It gives complete control of the policy to the company as an owned asset.
Key people have several characteristics that distinguish them from other workers, such as a specialty or expertise, position and responsibility within the company, and salary (appropriately so, most key people are compensated at levels of pay in the upper income brackets).
The key person could be the company's top sales person, an engineer whose involvement in manufacturing is vital to the business, a person whose employment brings valuable business contacts to the company, an office administrator who knows the ins and outs of how the organization operates, or any one of similarly valuable people.
In this case, since the business actually owns the policy, pays the premiums and is the beneficiary, the insurance can be considered a company owned asset. The accumulating cash value of the policy creates a reserve fund and could be used as a benefit to the company as well.
Benefits
- Business indemnification (an owned asset);
- use of cash values (reserve fund);
- business credit;
- favorable tax treatment; and
- flexibility.
Premium payments are not tax deductible - Death benefits are not taxable.
Following are some potential costs that can be associated with the loss of a key person.
- The loss could have a negative effect on the company's credit rating.
- The loss could cause a burden in time and a financial burden to find, hire, and train a replacement.
- The loss can have an adverse effect on other workers.
- The loss can create an immediate need for cash to meet business obligations and to meet obligations to the deceased's spouse or other family members.
- The loss can create a residual loss of confidence from suppliers and customers.
Key person insurance can include some of the following benefits.
- The company receives needed funds that can be used to help meet financial obligations and train a replacement (business indemnification).
- While the key person is alive, the cash value of the policy is available for the business to use in a variety of ways (reserve fund).
- Creditors may be more apt to extend credit if the business has protected itself against the loss of a key person (business credit).
- Death proceeds are received income tax free (favorable tax treatment).
Key Employee Purchase
Brad owns a computer business and he has a key employee, Tim, who would like to take over the business someday. Brad knows that Tim is certainly capable of running the business but also knows Tim would be hard pressed to come up with the $150,000 assessed price. Brad's family is not interested in owning the business, so he would like to see his wife get the proceeds of any sale. They decide Tim should take out a $150,000 life insurance policy on Brad. Now they are set up to allow the business to continue and Tim will have the funds (death benefit) to purchase the business from Brad's estate, and at the same time ensure Brad's wife gets the benefits of the sale
