Key Man Insurance: Tax Benefits And Financial Security

Key man life insurance is a type of life insurance policy that a company purchases to cover a founder, owner, or critical employee. It is also called key person or key employee insurance. The company can use the death benefit proceeds to recoup lost business or invest in hiring and training the next person to fill the essential role. The premiums for key man insurance are not tax-deductible. However, the company receives the death benefit tax-free in most cases.

Key man insurance premiums are not tax-deductible

Key man insurance is a type of life insurance policy that a company purchases to cover founders, owners, executives, or anyone else essential to a business's operations. The company is the beneficiary and pays the premiums.

> [T]here is no deduction allowed for premiums paid on any life insurance policy, or endowment or annuity contract if the taxpayer is directly or indirectly a beneficiary under the policy or contract.

The IRS also specifically addresses key man insurance in Section 1.264-1(a), stating that:

> [P]remiums 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.

In short, because the company is the beneficiary of the policy, the IRS prohibits the deducting of key man insurance as an expense.

However, there is an exception to this rule. If the premiums on a key man policy are charged to the insured individual as taxable income, then the company can declare the premiums as a tax deduction. In this case, companies often use the cash value of the policy as a retirement benefit for the employee.

Death benefits are usually paid to the company tax-free

In the case of key man life insurance, the company is both the owner and the beneficiary of the policy. The employee has no rights or participation in the policy, but the company must notify the employee of its intent to purchase coverage and obtain written permission before doing so. While key man life insurance premiums are not tax-deductible, the proceeds of the policy are usually provided to the company tax-free. This is because, in most cases, death benefits from life insurance policies are not considered taxable income.

There are a few other factors that can affect the tax status of death benefits. For example, if the death benefit is paid in installments that include interest, then the interest will be subject to taxation. Additionally, if the death benefit goes to the estate of the deceased rather than a named beneficiary, it may be subject to federal or state estate tax if the value of the estate exceeds the exemption limit.

It is important to note that tax laws regarding life insurance can be complex and may vary depending on the specific circumstances and location. As such, it is always recommended to consult with a tax professional to ensure compliance with all applicable regulations and documentation requirements.

The company must notify the employee of their intent to purchase coverage

When a company decides to purchase key man life insurance, it must notify the employee of its intent to do so. This is a legal requirement. The company must also provide the employee with details of the policy and obtain their written consent. This can be done using an Employer Owned Life Insurance Acknowledgement and Consent form, which can be obtained from the insurer.

The employee must be informed in writing of the following:

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

The company must secure the key man's written consent. This is because the employee has no rights or participation in the policy. The key man insurance policy is owned by the company, and the company is also the beneficiary. The company pays the premiums and receives the death benefit if the insured employee passes away.

The company must also include certain details about the coverage in its annual corporate tax return. This includes the number of employees insured, the amount of coverage in force, and whether each insured employee has provided written permission for the policy.

The employee must give written consent to the company

The employee's written consent is obtained through an Employer Owned Life Insurance Acknowledgement and Consent form, which can be obtained from the insurer. This form ensures that the employee is aware of and agrees to the company's plan to take out an insurance policy on their life. It is important to note that the employee has no rights or participation in the policy, but their consent is still required by law.

The company must also include documentation of the employee's written consent in their corporate tax return. This is part of the tax requirements for key man insurance, which also include details about the amount of coverage and the number of employees insured. Obtaining written consent from the employee is a crucial step in the process of purchasing key man insurance and helps protect the employee's rights.

The company must report all employer-owned life insurance arrangements to the IRS

The requirement to report employer-owned life insurance arrangements to the IRS is related to the tax implications of such policies. In general, proceeds from life insurance policies are tax-free under the general exception rules in Sec. 101(a). However, with the enactment of the Pension Protection Act of 2006, the amount of tax-free treatment on employer-owned life insurance (EOLI) contracts is limited to the total amount of premiums paid and other amounts paid by the policyholders, with any remaining proceeds being taxable. This change eliminated the previous tax-free treatment of EOLI contracts, which were previously afforded full exclusion under Sec. 101(a).

To avoid tax implications, companies must meet certain notice and consent requirements before issuing an EOLI contract. Specifically, the insured employee must be notified in writing of the intent to insure their life, the maximum amount of the policy, and that the company will be the beneficiary of any proceeds upon the employee's death. The employee must also provide written consent to being insured under the contract and agree that the coverage may continue after their employment ends.

It is important to note that failure to obtain timely notice and consent will result in the insurance proceeds becoming taxable. However, the IRS has stated that it will not challenge the exception to the exclusion limitation if the company has made a good-faith effort to satisfy these requirements, including having a formal system in place to obtain notice and consent. Nevertheless, any corrections must be made no later than the due date of the tax return for the year the policy was issued, and consent cannot be corrected after the insured's death.

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