Especially in businesses that are small to medium sized, a few key people may be vital to the continued success of the business. If any one of these key people is removed from the workplace by death, the business stands to suffer severe financial loss or even insolvency. Often times, such a fate can be thwarted by the infusion of money into the business. Key person insurance can guarantee that money is available to help the business through the transition when a key person dies. Key person insurance is not a certain type of insurance policy but insurance dedicated to a particular purpose—to pay a cash benefit to the business if a key person dies.
The primary purpose of key person insurance is to protect the business against losses that occur when someone whose presence is vital is no longer available to fill a key role. Sometimes, benefits payable for the key person's benefit are offered as well, but that is a secondary concern. A business generally needs the insurance benefits for one or more of several needs that arise when a key person dies.
Deciding exactly who is a key person in a business is sometimes easy, sometimes more difficult. Generally, in a smaller business owned by one person or just a few people, the owners can easily be identified as key people. However, even in very small businesses, certain employees who are not owners may also play key roles. The example of a chief photographer mentioned previously serves well here. Even if the photographer is a non-owner employee, he obviously is important to the success of the ad agency and is a candidate for key person insurance.
Whether the person is an employee or an owner-employee, the individual must serve a role that is critical to the financial health of the business. The role might be in management, finance, sales, professional or technological expertise, production or any other area or combination of areas in which, without that person's contribution, the business would be in danger of suffering financial loss. As you attempt to identify employees or owner, employees who qualify as key people, look for unique skills, business contacts, technical knowledge or other contributions that could not easily or quickly be replaced by someone else. Having an employee who serves in such a capacity gives a business an insurable interest in the key person-an interest that may legitimately be fulfilled by insurance.
It is interesting to contrast the characteristics that identify a key person with someone who does not fit that profile. For example, sometimes high compensation is used as a guideline, but salary alone is not adequate for identifying a key person, especially when the person works for a larger business. High compensation may equate with a highly competent executive of a large business, but if others in the business could step in immediately to assume that person's responsibilities, very little, if any, negative financial consequences would occur. Without an adverse financial result, there is no need for key person insurance.
On the other hand, a similar individual employed by a small or medium-sized company that employs no one else with the same talents is likely to be a key person whose absence could cause financial problems. You'll find that some insurers will not even write key person insurance for large businesses that employ many people in similar capacities.
Key person Insurance is available to all forms of business, regardless of the type of ownership. Sole proprietors may purchase key person insurance on their own lives and/or the lives of one or more key employees.
Each partner in a partnership may be covered, typically by a policy the partnership entity owns. Partners, too, might have key non-owner employees for whom key person insurance is appropriate.
And both C and S corporations are eligible to purchase key person insurance on owners and key employees. In all cases, however, the best prospects are smaller or closely held companies where business success hinges on relatively few people-possibly just one person. As you might suspect, the tax consequences may differ depending on the type of business ownership: we'll see how soon.
Let's first consider key person life insurance, which pays benefits if the insured key person dies while the policy is in force. Remember, this insurance is written for the benefit of the business, not the key person.
The business applies for and purchases a policy covering the life of the key person. The business is both the owner and beneficiary of the policy. For example, suppose the business is Temple Brothers, a partnership owned by Warren and Franklin Temple. They are both considered key people. The Temples employ Andrew Nash, whose contributions qualify him as a key employee. The Temple Brothers entity could apply for, own and be the beneficiary of three separate policies on Warren's, Franklin's and Andrew's lives.
If the business were incorporated, Temple Brothers, Inc., the corporation could purchase the policies in the same way. On the other hand, the owner of a new small corporation might prefer to own the policy personally rather than have the corporation buy it. Unfortunately, many small businesses fail in the early years. When this occurs, the corporation's assets—including life insurance policy cash values—are subject to creditors' claims. If the small corporate stockholder owns the policy personally, cash values should be safe from creditors of the business.
Since a proprietor and his business are considered the same, the procedure would differ slightly, but the principle would not. Let's say Cloris Batchelor is a sole proprietor with a key employee, Marge Spotz. Cloris could apply for, own and be the beneficiary of a policy on Marge's life. Marge could do likewise, even if she needed some financial help from Cloris to pay the premiums. Alternately, if Cloris has no key employees, she or her spouse, if any, could own the policy on Cloris's life. By owning the policy herself, Cloris subjects the death proceeds to being included in her estate, but in many cases that is preferable to the absence of life insurance altogether.
The key person whose life is being insured must agree to the insurance. In other words, a business may not arbitrarily decide to purchase a life insurance policy covering an employee without the employee's prior knowledge.
Whether the business entity or an individual owns the key person policy, when the key person dies the proceeds are paid to the beneficiary-either the business or the individual business owner. This is one of the key features of this type of insurance coverage: the business receives the death proceeds, not the key person's heirs or estate.
Depending on the overall plan a business develops for the use of key person life insurance, either term insurance or permanent cash value life insurance might be acceptable. Term insurance, of course, can provide significant premium savings in the early years of the policy. However, the lower premiums may be offset by much higher premiums later if the policy is continued for a long period. Still, term coverage may be best if the business believes the need will be short-term-for example, the owners expect the business to be able to accumulate adequate funds outside of the insurance to offset a key person's loss. Alternatively, a new business could consider purchasing a convertible term policy, paying the initially lower premiums, and then converting to a cash value policy when business income has increased.
In many cases, a permanent policy that builds cash values is more appropriate because the cash values are available to the business for additional or optional uses. For example:
Sometimes, companies earmark the cash values of permanent life insurance policies to further reward a loyal employee. For example, if the key person remains with the business but does not die before retiring, the policy values can provide additional retirement Income for the employee. This would be a nonqualified deferred compensation arrangement, discussed at length later in this course. Alternatively, the business could turn the policy over to the employee at retirement, relinquishing its positions as both owner and beneficiary. The employee would then have the option to retain the policy, naming his or her own personal beneficiaries, or to surrender the policy for its cash values.
An agreeable employee or a key person/owner might want to use existing life insurance policies to provide the key person insurance. For example, the key person sells to the business a policy he or she already owns on his or her own life. In some cases, this arrangement is acceptable. In others, the transfer for value rule can cause problems.
Under this rule, remember, and under certain circumstances, the death proceeds can lose their income tax exemption beyond the amount paid to acquire the policy and any premiums paid after the transfer. One circumstance that does cause loss of the tax exemption occurs when an insured employee who is not an officer or shareholder transfers a policy to a corporation. The distinction between officers and shareholders and those who do not hold those positions, then, is obviously important to the income tax consequences.
Here again are the exceptions to the transfer for value rule included in the tax law—that is, the following transfers do not cause the death proceeds to lose their tax-exempt nature:
Some additional exceptions to the transfer for value rule apply when policies are transferred from one spouse to another, when the policy is given partly as a gift, and when a corporation is involved in a tax-free reorganization. All of these situations concern the determination of basis (for gain or loss purposes) when the original owner's basis must be taken into consideration. Your clients should consult their tax attorneys if these circumstances play a role in determining whether or not to use existing policies for key person insurance.
Deciding how to value the loss of a key person for insurance purposes is partly art, partly science and partly educated guessing. Factors that can cause the value to vary include the particular type of business, its geographical location, the economic climate, and the role the specific person plays in the business, availability of people of similar skills, and many other variables. Two guidelines commonly used are:
1. The estimated value of income lost to the business as a result of the key person's death. For example, if the key person can be attributed with generating $100,000 of income annually, the policy could be written for that amount, on the assumption that a replacement could be found quickly, but that person would not be able to generate the same income or income enough to offset the costs of acquiring the new person during the next year. Or, the $100,000 could be reduced by the amount of income it is estimated a new person would be able to produce.
2. The cost to replace the key person, including recruiting hiring, relocating, training or orienting and possibly paying a higher salary. While the deceased key person's salary would no longer be required, the business might be required to pay more to attract the right person.
Added together, the value of income lost and the cost to hire a replacement result in a close estimate of the economic loss the business would suffer if the key person dies. Insurance companies sometimes use certain formulas applied to figures such as these to help decide the value of a key employee's loss. These formulas might take into consideration the type of business, the key person's position and other factors such as those mentioned above, as well as the estimated time to replace the key person.
A really simplistic approach is to multiply the key person's annual salary by a predetermined figure, such as three, five or ten, to arrive at the amount of insurance needed. For example, if the individual is earning $70,000 annually and the multiple is five, the amount of insurance would be $350,000.
The insurers with whom you do business can advise you about the approach they prefer. Whatever system or formula is used, it is important for both your clients and you as an agent to schedule frequent reviews of the amount of insurance to keep pace with increases in the key person's economic contributions to the business. We mentioned that key person life insurance can be used to fund a buy-sell agreement as explained in previous chapters. When that is the purpose of the insurance, of course, the valuation takes on even greater significance because of the estate tax considerations. Therefore, the valuation principles discussed in relation to buy-sell agreements take precedence.
Many of the taxation principles you've already learned apply to key person life insurance. We'll review briefly and mention other tax considerations.
The premiums paid for key person life insurance are not a tax-deductible expense no matter who pays them. This is true under all forms of business ownership and whether an individual or a business entity pays the premiums.
Even when a business pays the premiums for a key person policy on the life of an employee, there is no taxable income to the employee since the employee receives nothing. This differs from insurance under which the employee's personal beneficiaries’ benefit. For key person insurance, the business alone benefits, so no transaction taxable to the key person occurs.
The different rules that apply to S corporations can cause some different consequences for the shareholders when an S corporation pays premiums on key person life insurance. By law, the premiums will be considered either a nondeductible expense, deductible compensation or a nondeductible dividend.
The premium paid by an S corporation for a key person policy for which the corporation is the owner and the beneficiary as described above is considered a nondeductible expense. Because an S corporation's transactions pass through to the shareholders, though, each shareholder's basis is reduced by his or her proportionate part of the expense. For example, if there are four equal shareholders, each reduces the basis by 25% of the nondeductible premium expense.
The premium is considered compensation if the key person is an employee who either owns the policy or benefits from it in some way. Consider the case of an S corporation owner, Jason, who is also a key employee. If Jason owns a key person policy on his own life, the premium is considered compensation on which Jason must pay income taxes. The premium is deductible to Jason's S corporation as a business expense. The same is true if Jason does not own the policy but has a personal interest in it. For example, if Jason's wife, who is also a shareholder, owns the policy and will receive the death proceeds, the premium is considered compensation for Jason.
Finally, if the S corporation is closely held, the IRS may consider the premium payment to be a dividend. As you learned in Chapter Four, taxation of premiums in this case depends on whether the corporation has accumulated earnings. If so, part of the premium might be treated as a dividend, taxable to the key person/employee and nondeductible to the corporation. If there are no accumulated earnings, the premium is treated partly as a return of the investment (and not taxable) and partly as a capital gain, which is taxed.
You've learned that, for any type of corporation, accumulated earnings can be a concern. If the corporation pays premiums on key person insurance, it must somehow accumulate the funds to do so. But remember that the IRS requires corporations to pay taxes on excessive accumulated earnings in order to discourage withholding of taxable dividends. Earnings accumulated to pay premiums on key person life insurance should be able to escape taxation, however, if the company can show they fall within the "reasonable business needs" guidelines.
Normally, there will be no income taxation on the death proceeds of a key person life insurance policy paid to the business, assuming:
1. The insurance passes the "tests" to qualify as life insurance proceeds and
2. The death proceeds do not trigger the alternative minimum tax (AMT).
If the AMT might come into play if application regulations are enacted, refer to previous discussion.
Additionally, the transfer for value rule could come into play, but you've seen in various discussions how this can be avoided in many cases. When the rule does apply, the death proceeds are income taxable to the extent they exceed the value of consideration paid plus premiums paid following the transfer.
If an insured key person leaves the business or retires from the business and the business wants to take the policy's cash surrender value and terminate the policy, taxable income can result. When the cash surrender value is greater than the cost basis-the amount the business invested n the policy-the excess is taxed as income to the business. For example, suppose the policy is surrendered for its cash value of $8,000 and the cost basis is $7,000. The business must pay taxes on $1,000 of the cash surrender value.
In determining the basis, the amount the business has paid into the policy is reduced by any dividends the insurer paid during the life of the policy. In addition, if the business has taken a policy loan that is still outstanding when the policy is surrendered, the loan amount is also immediately taxable, but only to the extent the cash surrender value exceedsthe cost basis.
For an S corporation, each shareholder's portion of the cash surrender value has two effects: (1) any gain over basis is income taxable to the shareholder and (2) the shareholder's basis in the corporate stock is increased by the same amount.
When the insured key person dies and the life Insurance policy proceeds are paid to the business, there are generally no federal estate tax consequences for the deceased as long as he or she had no incidents of ownership in the policy. This is true because the business, not the key person, is the owner and the beneficiary-there is no taxable benefit to the key person's estate.
However, in the case of a partnership, where the partnership entity receives the proceeds and the key person is one of the partners, a portion of the proceeds will be included in determining the value of the insured's partnership interest for estate tax purposes.
A similar situation occurs with corporations when the key person is one of the owners. That is, based on the deceased owner's share of the stock, a portion of the proceeds will be included in determining the value of the estate.
1. All of the following could be considered key persons to a corporation EXCEPT:
A. chief financial officer.
B. sales manager.
C. president.
D. stock boy.
2. The beneficiary of a key person life insurance policy is the
A. business.
B. key person.
C. key person’s spouse.
D. key person’s estate.
3. A corporation wants to maintain a key person life insurance policy on an employee who is not an officer or shareholder of the corporation. She wants to sell the corporation an existing life insurance policy she owns on her own life; in which case
A. this type of transfer is forbidden by law.
B. the transfer for value rule makes no exception for this particular type of transfer.
C. the statement is false: the death proceeds remain tax except Susan’s estate was the
original beneficiary
D. this is known as a Section 303 which has no tax-exempt features.
4. All of the following factors should be considered when placing a value on the loss of a key person EXCEPT the
A. type of business.
B. economic climate.
C. business geographical location.
D. color of the key person’s car.
5. Business X pays the premiums for a key person life insurance policy on employee Kyle. The result of premiums paid is:
A. a business deduction for X.
B. a business deduction for Kyle.
C. taxable income X.
D. no income taxation for X.
6. When an insured key person of a corporation, not a shareholder, dies generally there are:
A. no federal estate tax consequences.
B. federal estate taxes to be paid by the deceased employee’s estate.
C. income taxes to be paid by the corporation.
D. estate taxes to be paid by the corporation.
7. The owner of a key person life insurance policy is the
. A. key person.
B. business.
C. directors.
D. stock boy.
8. Key employee Martin leaves the employ of Stark Company, which had insured Martin under a key person policy. Stark then decides to surrender the policy to the insurer for the cash surrender value. Which of the following tax consequences results?
A. Martin is taxed on the value of the premiums paid.
B. Stark is taxed on the full face amount of the policy.
C. Stark is taxed on the excess of the cash surrender value over Stark’s cost basis.
D. no tax consequences results.
9. The primary purpose of key person life insurance is to
A. prevent a valued employee from leaving the business.
B. protect the business against losses.
C. have cash available to cover expenses if the business owner becomes disabled.
D. provide funds to cover estate taxes.
10 The key person whose life is being insured must
A. pay the premiums.
B. own the policy.
C. agree to the insurance.
D. designate the beneficiary.
ANSWERS
1D 2A 3B 4D 5D 6A 7B 8C 9B 10C