Imagine this: you and your college buddy started a small business, and it’s doing pretty well. You’re making good money, and you’ve got a team of about a dozen people. An appraiser says your 50% share of the business is worth over $5 million. But then, disaster strikes. Your business partner passes away unexpectedly, without a will or a plan for what happens to her share of the business. Her not-so-nice husband inherits her share and starts messing with the business. Sales drop, revenue dries up, and you’re thinking about throwing in the towel.
But what if you could have avoided all this? That’s where key person life insurance comes in. If you’d had a policy on your business partner, you would have received a payout after her death that would have allowed you to buy out her share and keep her husband from interfering.
So, what exactly is key person life insurance? It’s a policy that covers a crucial employee or partner in your business. The business owns the policy and is the beneficiary, meaning it gets the payout if the insured person dies while the policy is in effect. This is different from most life insurance policies, where the policy owner and the insured are the same person, and the beneficiary is usually a close relative.
A key person is someone who is vital to the company’s success. Their absence could threaten the company’s very existence. This insurance can be used to prevent a surviving spouse from interfering in a small business, or to compensate for the loss of a vital employee’s expertise or talent. A key person could be an employee with unique skills, an employee with important contacts, an executive responsible for daily operations, or a partner whose capital supports the company.
Key person insurance works like any other life insurance policy. Your company applies for the policy, and the key person must consent to being insured and cooperate during the application process. Your business can require key person insurance as a condition of employment. If the death benefit is large, the employee may need a medical exam to confirm they’re healthy enough for coverage. Once the policy is in effect, you pay premiums to keep it in force. If the insured person dies while it’s in force, your company collects the death benefit and can use it as it sees fit. Normally, this death benefit is tax-free.
Key person insurance is there to offset costs when a covered employee dies. These costs could include finding and training a replacement, replacing revenue the person was responsible for, covering additional costs due to the person’s death, offsetting indirect losses, buying out the person’s interest in the company, or paying debts that come due as a result of the person’s death. If the death of a key employee or partner means the company can’t continue, key person insurance can offset the costs of winding up the business.
There are several types of key person insurance. It’s usually a type of life insurance, but you can also take out disability insurance policies on key employees and partners. Term life insurance is the most affordable type, while whole life insurance is the most expensive. Variable universal life insurance offers more flexibility, and disability insurance pays ongoing benefits if the covered person becomes unable to do their job due to a disability.
If the death of an employee or business partner would seriously harm your business, you probably need a key person life insurance policy. Start with the people whose loss would threaten the company’s long-term profitability or even its existence. For less critical but still important employees, consider the cost and time it would take to replace them and get their replacement up to speed.
Key person life insurance isn’t on many business owners’ radars, so you might still have questions. The cost of key person insurance depends on several factors, including the type of policy, the insured person’s age, gender, and health, the size of the death benefit, and the insured person’s occupation and lifestyle. It’s always a good idea to shop around, especially for larger policies. You can get key person insurance from established insurance companies like State Farm, Allstate, and Nationwide.
How much key person insurance you need depends on several factors, including the cost to replace the employee, how much the employee contributes to your company’s earnings, the cost to buy out the person’s interest in the company, and the business risk if the person dies. Unlike most business expenses, key person insurance premiums are not tax-deductible. However, the death benefits are usually tax-free, as long as you report the policy’s existence to the IRS while it’s in force.
In conclusion, human capital is one of a business’s most important assets. If your business would struggle to recover from the death of a key employee or partner, you should look into key person life insurance. It could be a lifesaver if tragedy strikes.
