Key Person Insurance: Protect Your Business & Avoid Tax Pitfalls
First off, I owe you an apology for missing blog last week—it’s tax season, and things have been a little hectic around here! But I’m back, and today we’re diving into a topic that’s crucial for business owners: Key Person Insurance.
What Is Key Person Insurance & Why Does It Matter?
If your business relies on a key individual—whether it’s you, a partner, or a critical employee—it’s smart to take out life insurance on them. Losing this person could mean financial instability, lost client relationships, or even the collapse of your business. Whether they’re the strategic genius, top researcher, or the one keeping the cash flowing, their absence could be devastating.
Who Owns the Key Person Policy?
The business owns the policy. Period.
The company should also have a clear agreement with the insured person about what happens to the payout. Yes, it’s weird signing both as the business owner and the covered person, but that’s what lawyers are for. Keep copies of everything, and make sure key stakeholders know where to find them.
What’s the Payout For?
Buying Out Your Shares – If you have partners or shareholders, will this money buy out your portion from your family? A proper business valuation is crucial to avoid IRS scrutiny for undervaluation.
Keeping the Business Afloat – If the payout is meant to cover expenses like payroll, rent, or outstanding debts, it needs to be structured properly. Without a clear estate plan, your business bank account could be frozen, making this insurance a critical source of emergency funds.
Keeping It Tax-Free: What You Need to Know
First, the insured person must consent to being insured, in writing. They also need to understand that the payout goes to the company—not their family—unless it’s structured as a buyout. (Again, don’t skimp—hire a lawyer.)
To keep the payout tax-free, you must meet one of these two conditions:
Exception #1:
The insured was an employee at any time during the 12 months before their death OR
The insured was a director or “highly compensated employee” when the contract was issued.
Exception #2:
The payout goes to one of the following:
A family member of the insured,
A designated beneficiary (not the employer),
A trust benefiting a family member or designated beneficiary,
A buy-sell agreement where a family member or trust receives the payout in exchange for business interest.
If these conditions are met, the death benefit remains tax-free—provided the policy meets the necessary IRS guidelines.
The Paperwork: Avoid IRS Trouble
To keep things IRS-compliant, you must file Form 8925. It’s straightforward, but filing it correctly ensures the payout stays tax-free. You’ll also need to attach those signed consent forms.
🚨 One Big No-No: Do not deduct the premiums as a business expense. The second you do, the payout becomes taxable. Report it on your P&L, but it becomes a Schedule M adjustment on your business tax return. (Not sure what that means? I do—let me handle it for you!)
For C Corporations, watch out for AMT (Alternative Minimum Tax), as the benefit received must be included in calculations.
Final Thoughts: Protect Your Business the Right Way
I know this is a tricky subject, but with the right professionals in your corner, you can avoid costly mistakes. Hopefully, this gives you clarity on the benefits and potential pitfalls of key person insurance so you can make the best decision for your business.
As always, if you have questions, let’s chat! And stay tuned for upcoming community events and our Lincoln-Way Foundation spotlight.
Until next time—stay tax-smart!
