Q: What is "key man" insurance, and why would an employee want to be covered by his company if he will not directly benefit by assigning his own beneficiary? What are the tax consequences of the insurance to the corporation?
"Key executive" or "key person" insurance (the gender-neutral terms are now preferred) is generally purchased by companies whose success depends largely on one or two crucial employees. These are employees so key to the firm that if one died suddenly, or became too ill to work, the company might collapse. Key executive insurance is purchased to stave off that possibility.
In some cases, key employee insurance is purchased for top executives as part of a deferred compensation benefit package, where it supplements guaranteed retirement benefits. But, generally, key employee policies should not be confused with universal or term life insurance. Life insurance protects the employee's family in the event of his or her death, and the employee names his or her own beneficiary. Key executive policies, in contrast, are owned by the company, paid for by the company, and directly benefit the company in the event of the executive's premature death.
"JACKS-OF-ALL-TRADES." "Attorneys, CPAs, and bankers all manage relationships that could be lost if their main contact dies," says John J. Baxter, a corporate-insurance agent with Bolton & Company in Pasadena, Calif. Likewise, a founding CEO or top "rainmaker" may bring in an outfit's majority revenues and new customers year after year. Losing that person would be devastating to the firm -- hence, the insurance policy. Key executive coverage is not typically purchased on rank-and-file employees.
In the case of small businesses, key person insurance can often be quite appropriate, says Larry Stone, of Stone Tapert Corporate Financial Services in Pasadena, Calif. "A lot of times, small-company owners act as jacks-of-all-trades," Stone says. "They do multiple tasks that no one else knows how to perform. Without them, the company might be in danger of collapse." A key employee policy purchased for such a person would make a lot of sense, he says.
Sometimes, Baxter says, key person insurance is used when a small firm has a large loan or line of credit with a bank. "The bank may require the owner of the company to purchase insurance that would cover the loan or line in the event of the owner's death. In this situation, the company is the owner, premium payer, and beneficiary of the policy," Baxter explains. "Upon approval of the policy by the insurance company, a collateral assignment form is completed, naming the bank as assignee of the death benefit of the policy, as their interest appears."
HOW MUCH? For example, if a company has a $1 million loan outstanding, it would purchase key person insurance on the owner for $1 million. As the loan is paid down over time, the bank would receive the remaining balance owed it, and the balance of the life insurance proceeds would be payable to the company.
Stone recommends that companies interested in key executive policies consult a financial-services firm to determine who should be insured and for how much. Insurance companies will provide coverage from five to 10 times the insured person's annual income, and larger amounts can be sometimes be underwritten if sufficient financial justification is provided, Baxter says.
The premiums paid for key employee insurance are not tax-deductible by a business. However, in the event of death, the proceeds are generally paid income tax-free. If your company hinges largely on the work of one or two top people, this kind of policy might prove to be a lifesaver for your firm.
Have a question about your business? Ask our small-business experts. Send us an e-mail at Smart Answers, or write to Smart Answers, BW Online, 45th Floor, 1221 Avenue of the Americas, New York, N.Y. 10020. Please include your real name and phone number in case we need more information; only your initials and city will be printed. Because of the volume of mail, we won't be able to respond to all questions personally.