Key Person Life Insurance: How It Works and How It's Taxed

Key person life insurance is a policy a business buys on an owner or employee whose death would cost the business money. The business owns the policy, pays the premiums and receives the death benefit. It can use that money to cover lost profits, hire and train a replacement, or pay down debt.

The tax side has one trap owners often miss. Under federal law, the payout is fully income-tax free only if, before the policy is issued, the business gives the insured person written notice and gets their written consent, and an exception applies. Skip that step and part of the payout can become taxable. This guide explains how it works in plain terms. It is general information, not tax advice.

What is key person life insurance?

It is ordinary life insurance with the business in every seat except the insured's. Here is how the roles usually line up:

Because the business is the beneficiary, the money goes to the company, not the insured person's family. If you also want to protect your own household, you need a separate personal policy. Our guide to life insurance for self-employed people covers that side.

Who counts as a key person?

Anyone whose sudden loss would seriously hurt revenue, operations or credit. In a small business, that is often the owner. It can also be:

• A partner who brings in most of the clients
• A lead technician or head chef whose skills are hard to replace
• A sales manager who holds the major accounts
• An owner whose personal guarantee backs the business loans

There is no official list. Ask a blunt question: if this person died tomorrow, how much money would the business lose before things stabilized?

How much key person insurance does a business need?

Enough to carry the business through the loss. There is no single formula, but many businesses combine a few measures:

1. Lost profit. Estimate how much profit would drop, and for how long, while the business adjusts.
2. Replacement cost. Add recruiting fees, a signing bonus, training time and higher pay for an experienced hire.
3. Debts. Add loans that a lender might call or that the business would struggle to pay without this person.
4. Customer and lender confidence. Some businesses add a cash cushion to reassure lenders, suppliers and customers.

For example, a hypothetical landscaping company might expect to lose $150,000 of profit over 18 months, spend $50,000 hiring and training a replacement crew manager, and want $100,000 to pay down an equipment loan. That points to roughly $300,000 of coverage. These are round, illustrative numbers.

Insurers will also want the amount to be reasonable for the person's role and the company's finances. They may ask for financial statements on larger policies.

Is key person insurance taxable?

The premiums are generally not deductible, and the payout is generally tax free only if the business follows the section 101(j) rules.

Premiums

26 U.S.C. § 264(a)(1) bars a deduction for premiums on a life insurance policy "if the taxpayer is directly or indirectly a beneficiary." IRS Publication 334 repeats the rule for small businesses: for contracts issued after June 8, 1997, "you generally can't deduct the premiums" when you are a beneficiary, no matter whom the policy covers.

The death benefit and section 101(j)

A death benefit is normally income-tax free under 26 U.S.C. § 101(a). But section 101(j) sets a special rule for an "employer-owned life insurance contract." That means a policy owned by a business that is also the beneficiary, covering someone who was an employee when the policy was issued. For these policies, the tax-free amount is capped at the premiums and other amounts the business paid. Everything above that can be taxable income.

The cap does not apply if the business met the notice and consent rules and at least one of these exceptions fits:

• The insured was an employee at any time in the 12 months before death.
• When the policy was issued, the insured was a director or a highly compensated employee or individual, as the tax code defines those terms.
• The death benefit is paid to the insured's family, a designated beneficiary, a trust for them, or the insured's estate.
• The death benefit is used to buy an ownership interest in the business from those family members or heirs.

The law defines "employee" to include officers, directors and highly compensated employees. IRS Notice 2009-48 adds two answers that matter to small owners. First, the sole owner of a corporation still needs written notice and consent; knowing about the policy is not enough. Second, a policy a sole proprietor owns on their own life is not an employer-owned contract at all.

What do notice and consent require?

Three written steps, all before the policy is issued. Section 101(j)(4) and the Form 8925 instructions describe them:

1. Written notice of intent. Tell the employee in writing that the business intends to insure their life, and state the maximum face amount. The instructions say this can be in dollars or as a multiple of salary.
2. Written notice about the beneficiary. Tell the employee in writing that the business will be a beneficiary of the death proceeds.
3. Written consent. The employee consents in writing to being insured and to coverage continuing after they leave the job.

The instructions add some timing rules:

• The consent is valid only if the policy is issued within one year after it was signed, or before the employee leaves, whichever comes first.
• For these rules, the "issue date" is the latest of the application date, the effective date of coverage, or the formal issuance of the policy.
• Electronic notice and consent can work if the system meets the same three requirements.

What is IRS Form 8925?

It is the annual report a business files for its employer-owned life insurance. The IRS says the form reports the number of employees covered by these policies issued after August 17, 2006, and the total amount of coverage in force at year end. The form also asks whether the business has a valid consent for each insured employee, and how many are missing one.

You attach Form 8925 to the business's income tax return for each year it owns the policy. The instructions also say to keep records that support what you report. Your tax preparer will need a copy of the signed consent and the policy details each year.

What happens to the policy when the key person leaves?

The business has choices, and each one has consequences:

• Keep it. Because the consent covers coverage continuing after the person leaves, the business can keep paying. The 12-month employee exception will eventually stop applying, though, so check which other exception, if any, would still fit.
• Cancel it. Term coverage simply ends. A permanent policy may have a cash surrender value, and any gain above what was paid in can be taxable.
• Transfer it to the insured. Some businesses give or sell the policy to the departing person. Section 101(a)(2) generally excludes transfers to the insured from the transfer-for-value limit, but the transfer itself can still create income or gift tax issues.

Get tax advice before any of these moves.

How is key person insurance different from buy-sell insurance?

They solve different problems. Key person insurance protects the business's bottom line. Buy-sell insurance funds a buyout so surviving owners can purchase a deceased owner's share from the family.

Many businesses need both. Company-owned buyout policies raise an extra estate-tax question after a 2024 Supreme Court decision. See our guide to buy-sell agreement life insurance, and for the premium question in more depth, whether life insurance is tax deductible for business owners. More guides are in our self-employed life insurance hub.