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What Is Key Person Insurance? Key person insurance is the provision of protection to a business against the death and / or disability of a key employee. What makes a key employee is a subjective matter. Clearly, a salesperson who is responsible for the bulk of a company's income would be defined as a key employee, likewise a design or research individual who is working on key new product areas would again qualify. There are, however, many other fields in which an employee may be defined as being of special worth to the business. Back to top The Need For Key Person Insurance Clearly, the need for key person insurance is the protection of the business against unforeseen circumstances. No business would carry on without ensuring that their property ( computers, software, etc.) were protected by insurance. Statistically, it is just as likely that the staff who generate the income for the business will suffer an illness or injury that could be far more damaging to the health of the firm than the destruction of inanimate objects. Back to top Key Person Disability Insurance Especially in smaller businesses or businesses that offer a unique product or service, people who are considered key to the business are often owners. However, in any business, a key person might be an employee whose talents are critical to the business. In either event, key person disability insurance is designed to protect the business, not the individual, if the key person is disabled. The key person should, of course, have an individual DI policy to protect his or her own income. A key person disability policy provides a business with funds that can be used for various purposes, including: • To replace a disabled key person either temporarily or permanently. • To pay ongoing expenses that are no longer being offset by the key person's contribution to the business. • To cover other costs and to help alleviate financial problems arising from or increased by the disability. The business purchases and owns the policy covering the disability of certain person. If that person does become disabled, the policy benefits are triggered. The insurer pays benefits to the business, not to the insured person, and the business may then spend the funds on various expenses. If you are familiar with key person life insurance, you can see that the disability coverage fills a similar need. We remind you again that, since the odds of disability are greater than the odds of death occurring in the near future, there may be a greater need for key person disability insurance. Business owners are likely to overlook this type of insurance, so you can provide a significant service by discussing this need. Back to top Key Employee Insurance The final type of business-related insurance we'll discuss is life insurance written on the life of a key employee, who is someone vital to the successful operation of a business. A key employee might be one of the owners, but it could also be a non-owner employee without whose unique credentials the company could quickly experience financial problems. For example, suppose a small but highly successful advertising agency has built its reputation on the talents of one gifted designer. If that designer should die, the agency could lose significant accounts. Key employee insurance on the designer's life provides immediate funds to quickly recruit and hire a similarly talented replacement to help retain existing clients. The potential need for key employee insurance is not limited to small companies since companies of any size are likely to employ people whose contributions are important to ongoing business success. Key employees are found at various positions, including members of management, highly paid people whose salaries reflect their importance to the company, high quality sales or service people, or essentially anyone whose skills are highly valued and respected by the company or the company's clients. Because a life insurance buyer must have an insurable interest in the life of the insured person, the most important criterion of the insured person, the most important criterion for key employee insurance is that the employee's death would result in economic loss to the employer. Unlike other insurance-funded business arrangements we've discussed, key employee insurance requires nothing but a life insurance policy that names the employee as the insured and the business or employer as the policy owner / beneficiary. The employer pays the premium and receives the death benefit if the employee dies. Employers who want to provide a death benefit for the key employee's survivors may add a term insurance rider for this purpose. If the key employee dies, the base policy's proceeds are paid to the employer as described above and an additional amount of insurance stipulated in the rider is paid the employee's heirs. Back to top Tax Treatment Of Key Person Insurance General Rules It is made clear within the guidelines that the tax treatment of a key person insurance will be subject to the agreement of the local inspector of taxes. Having said this, as a general rule, if the local inspector agrees to grant tax relief on the premiums, then the proceeds are usually taxed as a trading receipt. Conversely, if the inspector has disallowed the premiums as a trading expense, then the proceeds of any claim should be received tax free. Please note it does not matter whether a business has been claiming tax relief on premiums and getting away with it. Until the local inspector agrees to the tax treatment of the premiums and benefits, then no certainty of tax treatment is achieved. The following are further requirements which have to be met if the premiums for the key person insurance are to be agreed by the local inspector as an acceptable trading expense. The Sole Relationship Is That Of The Employer And Employee It is generally felt that where the key person has more than a 5% stake in the business, then tax relief on the premiums will be disallowed. This is because the premiums are not being paid exclusively for the purposes of the trade. On the key person's death/disablement his estate will benefit due to the proceeds of the insurance possibly increasing the value of the business. The Insurance is Intended to Meet a Loss of Profit Resulting From the Loss of the Employee's Services This requirement affects the following types of plans: Life Contracts Which Acquire a Surrender Value Whole of life and endowment plans usually generate surrender values which mean that their sole purpose is not to protect against a loss of profit. The premiums would normally not be an allowable business expense. Life Contracts With Conversion Options If the conversion options allow for the plan to be converted to a form of insurance which could acquire a surrender value, then the premiums would be unlikely to obtain tax relief. Life Insurance Solely Designed to Protect Loans Where a key person insurance is taken out to protect a loan, business relief on the premiums would not usually be granted, as a loan is a capital liability not a loss of profits. Typical examples of this would be where the lender insists on assigned life cover and the insurance, therefore, is a security for the loan and hence cannot be argued as being a protection against loss of profits. The Contract is Annual of Short-Term Insurance This element of the requirements is very subjective. As a general guideline, local inspectors will usually approve straight term assurance plans up to ten years, however, term plans with options to extend beyond this period will not have their premiums agreed as a tax deductible business expense. Tax Treatment of Benefits Once the premium treatment has been agreed by the local inspector, you can usually expect the proceeds to be treated as follows: Term Assurances Where Tax Relief Has Been Given on the Premiums The proceeds would be taxable as a trading receipt. In these circumstances, it is sometimes possible to arrange for the proceeds to be paid out over a number of trading years to reduce the tax burden. Term Assurances Where Tax Relief Has Not Been Given on the Premiums Assuming that no surrender value is payable under the plan, the proceeds are usually paid tax free. Whole Life and Endowment Assurances Where a plan generates a surrender value, the tax on the proceeds is as follows: - The surrender value prior to claim less any premiums paid. This is usually negative, hence no tax to pay. - The surrender value less any premiums paid. This is usually negative, hence no tax to pay. - The maturity value less any premiums paid. Endowment Policies Undertaken to Repay Loans Where the loans are to purchase land or buildings for the sole purpose of carrying out the firm's trade, then tax arises only on the excess of proceeds over the loan the endowment is secured upon. Back to top Business Life Insurance The Need For Business Continuation Insurance One of the most pressing problems that business insurance can solve occurs when a business owner dies. In this section we will describe what can happen to a business at an owner's death, as well as the implications for the deceased owner's survivors. You will learn how careful planning that includes business continuation insurance can counteract the negative financial consequences that result when no plan exists to address what will occur after an owner dies. Because different forms of business ownership result in different consequences at an owner's death, in the next chapter we will look separately at sole proprietorships, partnerships and closely held C or S corporations. Notice that we'll focus on closely held corporations, rather than corporations whose stock is publicly traded, since the former are those that stand to suffer greatly upon the death of a shareholder who is active in the business. This chapter discusses the general dynamics of any business owners death, regardless of how the business is legally organized. Back to top Why Business Insurance Is Important The need for business insurance arises because the death of people who are vital to the operation of a business can have far reaching effects, including the death of the business itself. An example will help illustrate the point. Olivia Kern and Elaine O'Connell were longtime friends and the co-owners of a successful 10-year-old retail business. When Elaine was tragically killed in a car accident, Olivia suffered a double loss: first, the death of her dear friend and second, the loss of her business. Why her business? While Elaine's husband and daughter both wanted Elaine's business to continue after her death, they were forced, for financial reasons, to use Elaine's share of the business income, causing the store to close. Neither of Elaine's survivors were equipped to contribute financially to the business nor were they equipped by training or personality to help run the business. Seeing the financial problems her friend's family was having, Olivia immediately began sharing profits with them and attempting to add to that amount to buy Elaine's half of the business from her heirs. These kind and thoughtful actions unfortunately resulted in cash flow problems for the business and finally, the financial burden forced Olivia to go out of business altogether. Olivia's loss was rooted in the lack of capital to purchase Elaine's half ownership from the survivors when Elaine died unexpectedly. This loss could have been avoided entirely if Olivia and Elaine had executed a buy / sell agreement. Back to top The Buy / Sell Agreement Buy / sell agreements funded with life insurance provide an immediate source of money for a surviving business partner to buy the deceased person's business interest with no interruption in the business. Life insurance policies used for this purpose are also called business continuation insurance because they help the business to continue as usual even after a very important contributor dies. A buy / sell agreement for a partnership such as Olivia and Elaine's stipulates that any surviving partners will purchase the portion of a business owned by a deceased partner. Included in the agreement is the exact purchase price of the deceased person's interest in the business or a specific formula for determining its market value. The agreement must also include a guaranteed method to ensure the money is available when it is needed. Life insurance, which is the perfect method to guarantee availability of the money, can be used with either of the two types of buy / sell agreements described below. Back to top Disability Buyout or Buy-Sell Insurance You may be familiar with the concept of buy-sell agreements funded by life insurance and designed to allow an orderly buyout of a business interest when a business owner dies. Similarly, when a business owner is permanently disabled and has no hope of returning to active participation, disability buyout or buy-sell insurance can accomplish transfer of the business interest. The need for such an agreement in the case of permanent disability is, perhaps, even more urgent than for buy-sell life insurance. As you've learned, mortality rates have improved while morbidity rates have deteriorated, which means a business owner's disability is more likely than death to threaten the financial stability of a business. When an owner is disabled, both personal and business expenses continue, so the disabled person's need for income from the business does not diminish. From a humanitarian point of view, the disabled owner's business partners are likely to want to provide financial assistance, whether of not the business can actually afford to do so. The result can be both a moral and financial crisis when perceived obligations to the nonproductive disabled partner strain the financial resources of the business. Disability buyout insurance, arranged before disability occurs, provides a guaranteed way to avoid many of the problems associated with a business owner's disability. This type of coverage allows the non-disabled business owners to buy the disabled business owners to buy the disabled person's interest so the business is saved and the disabled person's interest so the business is saved and the disabled person is compensated. When the business is a partnership, the buyers are the other partners. When the business is a close corporation, the buyers are the stockholders. Even a sole proprietorship may use disability buyout insurance to fund such an agreement, with the buyer being some other specified party. A buy-sell agreement is a legal document that requires the services of the insured's attorney and accountant. Your role as an agent is to provide access to the insurance policy that funds the agreement. Insurance is the only funding mechanism guaranteed to be available exactly when needed - when disability occurs, in this case. Back to top Cross-Purchase Plan: One type of buy / sell agreement is a cross-purchase plan. Under this arrangement, each partner purchases a separate life insurance policy on every other partner's life for a sufficient amount to buy a share of the partner's interest at death. In the case of Olivia and Elaine, Olivia would purchase a policy on Elaine's life and Elaine would purchase a policy on Olivia's life. Now, suppose instead, that Elaine and Olivia had a third partner Terry. In this case, Elaine would buy two policies - one on Olivia's life, one on Terry's. Terry would buy two policies, on Olivia's and Elaine's lives. And Olivia would own policies on Terry's and Elaine's lives. Each partner buys separate policies. When Elaine was killed in the previous scenario, both Olivia and Terry would have had the life insurance proceeds from their individual policies to purchase Elaine's interest from her family. Back to top Entity Purchase Plan: Another type of buy / sell agreement, the entity purchase plan, arranges for the partnership (the entity) itself to own the life insurance policy on each partner. For example, let's say that the business partnership of Olivia, Terry and Elaine is called OTE Enterprises. OTE Enterprises as an entity purchases three separate policies - one on the life of each partner. When Elaine dies, the policy proceeds are paid to the OTE rather than to Olivia and Terry individually. OTE then uses the proceeds to buy Elaine's interest from her heirs. Back to top The Concept of Group Life Insurance One of the primary features of group life insurance is that it is made available to everyone in the group at much more attractive rates than would be available with an individual policy. Insurers are able to offer this advantage because of the law of large numbers described in Chapter One. The expectation is that many, many people of differing ages and health conditions will pass through the group over time. Some members will leave the group before they die, thus terminating their insurance coverage since group life is usually term insurance. New, often younger, members will join the group, generating additional life insurance premiums. And finally, only a few will die, requiring payment of a death benefit. Back to top |