No matter what type of business you have, it's likely that a couple key people are extremely important to that business. It might be the owner, founder, chief executive, head engineer, chef, creative ambassador, or other talented individual who keeps the ideas (and profits!) flowing. Insuring that person (or people) can keep your business profitable should anything happen to him or her.
Here's how it works:
Key Employee Life Insurance in a Sole Proprietorship
Life insurance on a sole proprietor is technically not considered key employee life insurance. By definition, a sole proprietorship terminates when the owner dies. Any losses or financial obligations at the death of the sole proprietor become the responsibility of the estate, not the business. An individual life insurance policy covering the sole proprietor can pay for these financial responsibilities.
Key Employee Life Insurance in a Partnership
Depending on how many partners there are, this scenario can play out several ways. If there are only two partners in a company and both are key employees, they can take out policies on each other. If there are only two partners and one is the founder and one is the star creative talent, the founder might want to own a policy on his talented employee.
Now, let's make it a little more complicated. Let's imagine that the key employee is one of four partners in a firm. Should the key employee pass away, the other three partners will want to buy out his share of the company. It's possible if each partner buys a policy on the key employee, with a face value of one-third of his share of the company. Should the key employee die, each of the three remaining partners would then get a payout from the insurance company. Each payout would equal one-third of the key employee's share, allowing the surviving partners to buy equal portions and increase their stake in the company.
Key Employee Life Insurance in an S Corporation
Most of my clients wonder whether there's a tax consequence for buying key employee life insurance as an S corporation. There is. If the corporation is the beneficiary of the policy, the premiums are not tax-deductible. Because those premiums are not deductible, the taxable income passing through to the shareholders is not reduced by the amount of the premium. If the corporation surrenders the policy, any gain would be taxed as ordinary income to the shareholders. The gain is the cash value paid to the corporation minus the net premiums paid.
Key Employee Life Insurance in a C Corporation
In a C corporation, key employee life insurance is part of any good corporate risk-management program. The policy's death benefit gives the corporation a little financial breathing room to re-evaluate in the wake of a key employee's death. The corporation can then decide whether to continue business, sell the company, or liquidate the assets and move on. For this reason, the corporation is typically the owner and beneficiary of the life insurance policy. Death benefit proceeds in excess of replacement costs or other expenses can also be used to help the employee's family, as a salary continuation plan. If the key employee doesn't die and lives to retirement, the policy's cash value can be used to fund a nonqualified deferred compensation plan.
Key Employee Life Insurance in a Professional Corporation (PC)
Losses may be especially severe when the principal of a professional corporation (PC) dies. A professional corporation depends on the performance of doctors, lawyers, or other licensed professionals. Typically, when a principal passes away, profits decrease and expenses increase. When an insured key employee dies, the life insurance death benefits go directly to the corporation itself. That money can be used to replace the key employee and continue the business. If the business is sold, those funds are available for legal expenses. If the business is liquidated, the proceeds can be used for any ensuing business and legal expenses. A portion of the death proceeds may also be offered to the employee's family members to help them through a difficult time, financially and emotionally.
There's so much more that life insurance can do to protect your business. Find out how in the video below: