Life Insurance Coverage on a Key
Employee
What is key employee life
insurance?
Insurance
coverage on certain employees or owners
Key employee life insurance is coverage on
the life of an employee who has special skills and makes a significant contribution
to the business. Executives and certain managers may be considered key
employees, as are certain shareholders who actively participate in the ongoing
success of the business. This type of policy used to be referred to as key-man
insurance, but the language has recently been modified.
Protects
business from losses arising from death of key person
The primary purpose for this type of life
insurance is to protect the business against financial loss if a key person
dies. Typically, the business owns the policy, pays the premiums, and is the
beneficiary of the key employee life insurance policy. Since the business owns
the life insurance covering the key person, it has control of the policy.
Policy cash values and death benefits may be used by the business for any
purpose. Policy loans may be taken by the business, or the policy may be
surrendered.
Without life insurance coverage on a key
employee, there may be serious losses to the business. Key employee policy
proceeds are often used by a business to cover the following cash needs that
can result after the death of a covered key employee:
•
Expenses
related to recruiting and training a new employee to take the place of a key
employee
•
Losses
that may occur as a result of mistakes or delays when a less capable or
inexperienced employee tries to fill the role of a key employee
•
Business
operating expenses
•
Loans
that may become due upon the death of the key person
•
Customer
and employee assurances that the business will still operate in spite of the
loss of the key person
Death
benefits not subject to federal income tax
For contracts entered into before August 17,
2006, the general rules applicable to life insurance indicates that the death
benefit is received income-tax free by the beneficiary. There are exceptions
and situations where the death benefit, in fact, may be taxable as income.
Consult with your tax advisor or financial professional for more information.
For life insurance contracts entered into
after August 17, 2006, the death benefit on an employer-owned life insurance
policy is not taxable to the employee if certain, specific requirements are met
before the issuance of the policy. First, there must be proper notice and
consent by the employee to be insured. Then, an exception must apply for the
death benefit to be received income-tax free. One exception is that the insured
is an employee of the policy owner-employer any time in the 12 month before
death, or that the employee is either a more than 10 percent owner of the
business, or highly compensated, or in the top 35 percent of all employees
ranked by pay. Or the death benefit must be paid to qualifying members of the
insured's family or a named beneficiary (other than the employer), or the
proceeds must be used by the employer to buy the insured's interest in the
business from qualifying family members of the employee.
Also, in the case of a C corporation,
insurance proceeds may expose a company to or increase an existing liability to
the alternative minimum tax (AMT). When benefits are paid to the estate of the
insured, they may be subject to estate tax.
Valuing a key employee's worth
Putting a dollar value on a key employee's
economic worth may be difficult. What would happen if the key employee died
today? Would it be difficult to replace the key employee quickly because of
special talents? How much specialized knowledge does the key person possess?
These are just a few of the questions that need to be answered. While there are
no particular rules or formulas that an employer may use to put a dollar value
on a human life, there are several costs to consider and several possible
methods to use in valuing the replacement of a key employee.
Key
employee's worth in contribution to profits
A concern for the business is how much a key
employee is worth in terms of company profits. Even if not directly responsible
for sales revenues, the employee may maintain a key customer account or be a
key to the production or operations process. Assuming it can be determined how
much a key employee contributes to profits each year, the employer could take
that amount and multiply it by a factor. One possible multiple is the number of
years or the measure of time it would take to recruit and train a replacement.
Multiplying the time period by the profit level would yield an appropriate
level of insurance coverage.
Key
employee's current salary
The employer could use a multiple of salary.
Here, the employer determines how much life insurance is needed by multiplying
the key employee's salary by the number of years it might take a newly hired
employee to reach the same skill level. The rule of thumb is for the employer
to use 3 to 10 times the key employee's salary. The employer may also want to
periodically review and increase the multiple as the key employee's value (and
salary) increases.
Cost of
replacing the key employee
There are replacement costs in terms of both
time and money--if you recruit the replacement yourself, you are spending
valuable time, and if you use a recruitment firm, there are hard dollar
expenses in the form of recruiting fees. Attracting and hiring an equally
qualified replacement may require a higher level of salary and fringe benefits
than the key employee was receiving. In some cases, it may take more than one
person to replace a key employee. The estimate for cost of replacement could be
the policy death benefit used for the key person life insurance policy.
Key
employee's excess salary
Some key employees receive excess salary.
Excess salary is that portion of the key employee's salary that is above what
would be paid to a non-key employee who performs routine job duties. The excess
amount is multiplied by the number of years it would take to recruit and train
a replacement. That amount is then used as the death benefit amount of the life
insurance bought by the employer to cover the key employee.
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. Life insurance coverage on the sole proprietor
can be used to cover these financial responsibilities. Life insurance owned by
a sole proprietor that covers the life of a key employee is called key employee
life insurance.
Key employee life insurance in a
partnership
Who should own the life insurance policy
insuring the key employee in a partnership? Let's assume that the key employee
to be insured is also a partner in a firm with four partners. Each partner may
want to own and pay for the key employee life insurance policy insuring the key
employee.
Example(s): If each partner owns and pays
the premium for a life insurance policy insuring a key partner or employee, at
the death of the insured, each partner would receive the proceeds of the
policy. If the policy is owned and paid for by the partnership, then the partnership
would receive the proceeds. Where the partnership is owner and beneficiary of
the policy, the surviving partners can enjoy the benefits of the life insurance
policy where a special allocation has been made, so long as there is economic
substance to the allocation.
Key employee life insurance in an
S corporation
There are immediate tax consequences when an
S corporation buys life insurance on a key employee. There is no tax deduction
because the corporation is the beneficiary of the life insurance policy.
Because 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 life insurance 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
Corporate-owned life insurance on a key
employee can have multiple uses. It may be used to cover the loss (and subsequent
replacement) of a key employee who has special talents or makes significant
contributions to the business. Adequate amounts of key employee life insurance
should also be considered as part of a corporate risk-management program. Key
employee life insurance can provide funds at the death of a key employee when
the corporation is deciding whether the business is to be continued, sold or
liquidated.
Typically, the corporation is the owner and
beneficiary of the life insurance policy. The total amount of premiums paid is
small compared to the amount of cash that may be needed at the death of a key
employee, if loans must suddenly be repaid, for instance. Death proceeds in
excess of replacement costs or other expenses may be used as a salary
continuation plan for the survivors of the key employee or other corporate
purposes. If the key employee does not die and lives to retirement, the
policy's cash value may be used to fund a nonqualified deferred compensation
plan.
Key employee life insurance in a
limited liability company (LLC) or a limited liability partnership (LLP)
Limited liability companies offer owners the
limited liability of C corporations in conjunction with the tax and management
advantages of partnerships. They are less restrictive than S corporations.
Key employee life insurance is probably one
of the most important types of insurance a business should consider. If the key
employee life insurance plan is established properly, the business may receive
the financial resources needed for the success of the business. If there is no
key employee life insurance plan in place, the business may not successfully
recover from the loss of a key employee.
Key employee life insurance in a
professional corporation (PC)
Losses may be severe when the principal of a
professional corporation (PC) dies. A professional corporation is dependent on
the performance of the personal services of doctors, lawyers or other licensed
professionals. Typically, at the death of a principal, income and profits
decrease and expenses rise. The same situation can occur when the PC employs a
key employee of the same licensed profession who has special talent and has
made a significant contribution to the business.
When an insured key employee dies, the life
insurance death proceeds are paid directly to the business. The money may be
used to replace the key employee and continue the business. If the business is
sold, the funds are available for legal expenses. If the business is
liquidated, the proceeds can be used for any ensuing business and legal
expenses. The death proceeds may be made available for the family members of
the key employee to offset economic losses.
How is group carve-out used with
key employees?
Under a group carve-out plan an employer
removes or carves out one or more highly compensated employees from the life
insurance coverage provided by a group term life insurance policy. The
carved-out employees are then provided life insurance coverage through
individual policies. These policies may be bought through a split dollar
arrangement, a death benefit only arrangement or an executive bonus plan. The
appropriate owner and beneficiary for the policy will vary with the type of
plan. Because the coverage is under an individual policy, these policies are
portable--the employee may be able to assume ownership (and premium payment) of
the policy if he or she leaves the company. Under a carve-out arrangement the
business does not get a tax deduction for policy premiums paid. The premiums
for group life insurance are tax deductible for the business.
Tax considerations and key
employee life insurance
The following is a list of tax considerations
you should be aware of when considering key employee life insurance. You should
consult your tax advisor to evaluate the tax implications of key employee life
insurance in your specific situation.
•
Premiums
paid on key employee life insurance policies are not tax deductible.
•
Premiums
paid by the business on a policy it owns covering a key employee will not be
taxed to the employee as long as he or she did not hold incidents of ownership
in the policy. However, if the policy underlies a split dollar arrangement, the
employee will be taxed on the value of the economic benefits provided by the
policy (less any amount the employee has paid into the policy).
•
If the
business sells the key employee life insurance policy to the employee, the
employer will realize a taxable gain if the cash surrender value of the life
insurance policy is greater than its net premium costs.
•
Death
proceeds are generally not taxable to the beneficiary. A notable exception
occurs when a C corporation is the beneficiary. Here, the death proceeds may
increase the corporation's liability for the alternative minimum tax (AMT).
•
Policy
proceeds received by a corporation that are later distributed to the
shareholders may be considered taxable dividends to the shareholders.
•
The
cash value buildup in a policy owned by a C corporation (carried as an asset on
the books) may increase the corporation's liability for the alternative minimum
tax (AMT).
•
The
transfer-for-value rule may apply when a business takes over an existing life
insurance policy on a key employee instead of buying a new policy. Application
of the transfer-for-value rule may subject the business to income tax on part
or all of the insurance proceeds.
•
Matured
or surrendered policies are subject to taxation. Amounts in excess of the
policy's cost basis are subject to taxation as ordinary income. If the business
elects to receive the proceeds as annuity installments each payment will be
partially taxable.
•
Death
proceeds payable to the business should not affect the estate taxes of a key employee
who dies holding no ownership interest in the business.
•
Estate,
gift and generation-skipping transfer taxes may be affected for a key employee
who dies while holding an ownership interest in the business. The receipt of
the death benefit by the business tends to increase the value of the shares
held by the estate. When properly structured, the proceeds received and the
increase in the value of the stock should offset each other.
•
Any
death proceeds from a key employee life insurance policy that insures a partner
in a partnership and is paid to a beneficiary other than the partnership may
have to be included in the gross estate of the partner. The partner is
considered to have incidents of ownership possessed by the partnership.
Caution: This list is not all inclusive. For answers to specific questions
regarding your situation, please consult additional resources or contact CornerStone Financial.
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IMPORTANT DISCLOSURES
The
information presented here is not specific to any individual's personal
circumstances.
To the extent
that this material concerns tax matters, it is not intended or written to be
used, and cannot be used, by a taxpayer for the purpose of avoiding penalties
that may be imposed by law. Each taxpayer should seek independent advice from a
tax professional based on his or her individual circumstances.
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materials are provided for general information and educational purposes based
upon publicly available information from sources believed to be reliable—we
cannot assure the accuracy or completeness of these materials. The information
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