Key Person Life Insurance
Protecting a Business Against the Sudden Death of a Key Executive
The Value of a Key Executive
The success of a business may hinge on the ideas and leadership provided by a key executive. The sudden death of that key executive may have a severe economic impact on the business due to the loss of that key executive’s unique skills and abilities. Additionally, the business may have to spend substantial amounts of cash to recruit and train a replacement executive. A prudent strategy that may assist a business during the transition period following the death of a key executive is key person life insurance.
The Damage Caused by Failing to Plan
The sudden death of a key executive can have a crippling financial impact on any business. The loss of their skills and experience may result in:
🔴 Disruption in Operations: A slowdown or disruption in sales or business production.
🔴 Increased Costs: Significant expenses related to recruiting and training a replacement.
🔴 Credit Risk: A potential weakening of the company’s credit rating.
Protecting the Business Against a Loss of a Key Executive
The business purchases a life insurance policy on the life of a key executive.1 The business, prior to issuance of the life insurance policy, must provide written notice to the executive that it intends to be the owner and beneficiary of a life insurance policy on the executive’s life and may choose to continue the coverage beyond the executive’s employment. The business must also notify the executive as to the maximum amount of life insurance that could be placed on the executive’s life. The executive must give written consent to such life insurance coverage.2 The business pays all of the premiums and retains all ownership rights to the policy. If cash value life insurance is utilized, the cash value of the policy will accumulate in a tax-advantaged manner. If the key executive dies while the life insurance policy is in-force, the business will receive the policy death benefit income tax-free.* The business may use the death benefit to sustain operations following the death of the key executive.
Keeping the Business Afloat
A key person life insurance policy may provide the business with the following benefits:
Financial Protection & Stability
✅ Protection Against Loss: Provides financial protection against the sudden death of a key executive.
✅ Liquidity for Transition: Ensures the business has the liquidity needed to recruit and train a suitable replacement.
Benefits of Cash Value Life Insurance (if utilized)
✔ Tax-Deferred Growth: The cash value of the policy grows on a tax-deferred basis.
✔ Balance Sheet Asset: The business may book the cash value of the policy as an asset on its balance sheet.
✔ Emergency Access: The business may access available cash value for emergencies or financial needs.
📌 A cash value key person life insurance policy is often used as the informal funding vehicle for a nonqualified deferred compensation plan.
Key Person Life Insurance Process
1. Notice and Consent
📜 The business provides written notice to the key executive stating:
- Its intent to purchase and be the beneficiary of a life insurance policy on the executive’s life.
- The option to continue coverage beyond the executive’s employment.
- The maximum amount of life insurance that could be placed on the key executive’s life.
✍ The key executive must then provide written consent to allow the business to purchase the life insurance.
2. Premium
💰 The business:
- Purchases the life insurance policy on the key executive’s life.
- Retains full ownership rights of the policy.
- Pays the policy premiums and remains the beneficiary of the death benefit.
3. Death Benefit
⚰️ Upon the key executive’s death, the business will receive the life insurance death benefit income tax-free.*
Tax Considerations
For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries under IRC Sec. 101(a)(1). However, exceptions apply, including but not limited to:
- Transfer-for-Value Rule: If a life insurance policy is transferred for valuable consideration and does not qualify for an exception under IRC Sec. 101(a)(2).
- Insurable Interest Issues: Policies that lack an insurable interest under state law may have tax consequences.
- Employer-Owned Policies: If the policy is employer-owned, it must qualify for an exception under IRC Sec. 101(j) to remain tax-free.
This fact finder is provided to help you and your life insurance producer better understand your goals and objectives. Please return the information to your life insurance producer and not to Pacific Life as we cannot and do not provide financial, legal or tax advice.
Vital Information
The following information is to assist in illustrating a life insurance policy. The use of such a policy must be discussed with the qualified plan administrator chosen by you.
📌 Please Note: The suitability of any estimate is to be confirmed by the client and the client’s advisors.
Important Considerations for Key Person Life Insurance
1️⃣ Preserving Tax Treatment:
- To maintain the tax-free status of the life insurance death benefit, the key executive should meet one of the following criteria under IRC Sec. 101(j)(2)(A)(ii):
- Be a shareholder owning more than 5% of the company’s shares.
- Be a director of the company.
- Be a highly compensated employee as defined by the IRS.
2️⃣ Impact on Insurance Capacity:
- Life insurance purchased by a business on one of its executives will reduce the executive’s total life insurance capacity.
This reduction may limit or eliminate the executive’s ability to purchase additional life insurance for personal needs.
