A small business’ success may depend upon the leadership provided by its key executive. If a key executive should die, however, his or her loss could have a severe economic impact on the business once the key executive’s unique skills and abilities are gone. It may require that the business incur substantial expenses to recruit and train a replacement executive. The sudden death of a key executive could also have a crippling financial impact on a business because it could cause a disruption or slow-down in sales or business production, and could weaken the company’s credit rating. In order to ease the burden that this scenario may cause, key person life insurance can cover some of these costs related to replacing a key executive.
Premiums for key person insurance are paid by the business, which has ownership rights to the policy. If and when cash value life insurance is used, the cash value of the policy will accumulate in a tax-advantaged manner, can be used as an asset on the business’ balance sheet, and can increase the business’ credit-worthiness for commercial borrowing purposes. A cash value key person life insurance policy can be utilized as the informal funding vehicle for a non-qualified deferred compensation plan (i.e. the policy can be transferred to the employee at retirement as a bonus). If the key executive dies while the policy is in force, the business will receive the death benefit income tax-free.[1] The death benefit may be utilized to sustain operations. It can also be used to pay off debts, allocate money to investors, pay separation fees to employees, or close the business down in an organized way. In some cases, this policy provides companies some alternatives other than claiming bankruptcy.
Most importantly for a close corporation, the death benefit proceeds can be used to purchase the shares from the key person’s surviving spouse. This way, the shareholders and the key person can make arrangements in advance to compensate the decedent’s spouse while retaining control of the company in the hands of the shareholders.
It is essential that business owners review their personal and business insurance policies on a yearly basis to ensure they are properly covered. For a complimentary review of your company’s policies, please contact Jennifer Grady at (323) 450-9010.
Disclaimer: this material is provided for informational purposes only, and should not be construed as legal, financial, tax, or accounting advice. It should not, and cannot, be used for the purpose of avoiding U.S. federal, state, or local tax penalties. Please consult a licensed insurance representative before making any insurance purchases.
[1] For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC § 101(a)(1). However, life insurance death benefits may be partially or wholly taxable in certain situations; for example, under IRC § 101(a)(2) (“transfer for value” rule); arrangements that lack an insurable interest based on state law; and an employer-owned policy, unless it qualifies for an exception under IRC § 101(j).