Key Employee Life Insurance: Taxable Or Not?

Key employee life insurance, also known as key man insurance, is a type of life insurance policy that a company purchases to cover a founder, owner, or critical employee. The policy is intended to protect the business from financial loss in the event of the death of a key employee. While the premiums for key man insurance are not tax-deductible, the company typically receives the death benefit tax-free. However, there are certain exceptions and tax considerations that businesses should be aware of when purchasing and receiving payouts from these policies.

Key employee life insurance premiums are not tax-deductible

Key employee life insurance, also known as key man insurance, is a type of life insurance policy that a company purchases to cover a founder, owner, executive, or anyone else essential to a business's operations. The company owns the policy, pays the premiums, and is the beneficiary. This type of insurance is designed to protect the business from financial losses in the event of the key employee's death or long-term inability to work.

While the benefits received by the company in the event of the key employee's death are typically tax-free, the premiums paid for key employee life insurance policies are generally not tax-deductible. This means that the company cannot claim a tax deduction for the amount they spend on these insurance premiums.

According to the IRS, "there is no deduction allowed for premiums paid on any life insurance policy [...] if the taxpayer is directly or indirectly a beneficiary under the policy." This rule applies specifically to key employee life insurance under Section 1.264-1(a) of the IRS code, which states that "premiums paid for life insurance on the life of any officer, employee, or person financially interested in a business carried on by the taxpayer are not deductible where the taxpayer is directly or indirectly a beneficiary of the policy."

The reason for this tax treatment is to prevent businesses from claiming deductions for expenses that also provide a benefit to the company. In the case of key employee life insurance, the company is the beneficiary of the policy and would receive a payout in the event of the insured person's death. Therefore, the IRS does not allow the premiums to be deducted as a business expense.

However, there may be certain situations where key employee life insurance premiums could be tax-deductible. For example, if the premiums are charged to the insured individual as taxable income, the company may be able to declare the premiums as a tax deduction. Additionally, if the key employee is the owner and beneficiary of the policy, the premiums may be tax-deductible for the company.

Proceeds are usually provided to the company free of income tax

Key man insurance is a type of life insurance policy that a company purchases to cover a founder, owner, or critical employee. The company is the owner and beneficiary of the policy and pays the premiums. The proceeds from the policy are typically provided to the company free of income tax. However, there are a few exceptions to this.

For contracts entered into before August 17, 2006, the death benefit is generally received income-tax-free by the beneficiary. However, there are situations where the death benefit may be taxable as income. It is important to consult with a tax advisor or financial professional to understand the regulations and documentation needed.

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 employer/beneficiary if certain specific requirements are met. These requirements include proper notice and consent from the employee to be insured, and the application of an exception for the death benefit to be received income-tax-free. One such exception is that the insured is an employee of the policy owner-employer at any time in the 12 months before their death. Alternatively, the employee must be a more-than-10-percent owner of the business, highly compensated, or in the top 35 percent of all employees ranked by pay.

Another exception is that the death benefit must be paid to qualifying members of the insured's family or a named beneficiary (other than the employer). Finally, the proceeds must be used by the employer to buy the insured's interest in the business from qualifying family members of the employee.

In the case of a C corporation, insurance proceeds may expose the 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.

While the proceeds from key man insurance are typically provided to the company free of income tax, it is important to be aware of the specific requirements and exceptions that may apply. Consulting with a tax advisor or financial professional is always recommended to ensure compliance with tax regulations.

Death benefits may be taxable as income in some cases

Death benefits are generally not taxable as income. However, there are certain circumstances in which death benefits may be taxable. For contracts entered into before August 17, 2006, there are some exceptions and situations where the death benefit may, in fact, be taxable as income. In such cases, it is recommended to consult a tax advisor or financial professional for guidance.

For life insurance contracts entered into after August 17, 2006, the death benefit on an employer-owned life insurance policy is typically not taxable to the employer/beneficiary if certain specific requirements are met. These requirements include obtaining proper notice and consent from the employee to be insured. Additionally, one of the following exceptions must apply:

• The insured is an employee of the policy owner-employer at any time in the 12 months before their death.
• The insured employee is a more than 10% owner of the business.
• The insured employee is highly compensated.
• The insured employee is in the top 35% of all employees ranked by pay.
• The death benefit is paid to qualifying members of the insured's family or a named beneficiary (other than the employer).
• The proceeds are used by the employer to buy the insured's interest in the business from qualifying family members of the employee.

It is important to note that, in the case of a C corporation, insurance proceeds may expose the company to or increase an existing liability for the alternative minimum tax (AMT). When benefits are paid to the estate of the insured, they may also be subject to estate tax. Therefore, it is crucial to seek professional advice to navigate the tax implications of key employee life insurance.

The business must notify the employee of its intent to purchase coverage

• The company intends to insure the employee's life.
• The maximum face amount of the policy.
• The company/employer is the named beneficiary of any death benefits.

The employee must then give their written consent for the business to proceed with the key person insurance policy. This type of insurance policy is often a requirement for small businesses or startups to obtain loans or investments, as the death or long-term incapacity of a key employee could significantly impact their operations and financial stability.

The employee must give written consent for the policy

When a company takes out a life insurance policy on a key employee, the employee must be notified in writing of the company's intention to insure their life. The employee must also be informed of the maximum face amount of the policy and that the company is the named beneficiary of any death benefits.

The requirement for written consent is in place to protect employees, as there are tax implications for the insured person. If the company is the sole owner and beneficiary of the policy, the premiums are not taxed as part of the employee's income. However, if ownership of the policy is transferred to the employee, they may have to pay taxes, as the transfer may be considered compensation.

In addition, if the employee has ownership of the policy or is a beneficiary, the premiums paid by the business may be taxed as income for the employee.

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