Life insurance helps companies to reduce the risk of business disruption by paying a death benefit if employees that are critical to business operations pass away.
A life policy can also be used as an employee benefit, since the life insurance policy can be transferred to the executive or insured employee by the company. Though life insurance premiums aren’t tax deductible, the proceeds of the policy are usually provided to the company free of income tax.
Also known as corporate-owned life insurance (COLI), life insurance is purchased by a business to insure the life of one of the company’s employees. It’s intended to help the company recover from the loss of an employee that contributes significantly to the business, if that person’s death would reduce productivity or the company’s value. People an employer might have covered by a policy include top salespeople, executives and other decision-makers, highly visible employees, and employees with unique knowledge or skillsets.
As with any life insurance policy, policies have three primary roles:
Owner: This is the person or entity that purchases the life insurance policy and typically pays the premiums. The owner has the right to transfer, sell or change the terms of the policy.
Insured: This is the person upon whose death the policy would pay the death benefit. Therefore, premiums are directly tied to the health and lifestyle of the insured.
Beneficiary: This is the person or entity that would receive the death benefit should the insured pass away during the period of coverage.
life insurance differs from other life insurance policies in that the business is both the owner and the beneficiary of the policy. The employee essentially has no rights or active participation in the policy. However, the business is legally required to notify the insured employee of its intent to purchase coverage on the employee, provide them with details of the policy, and obtain their written permission before purchasing it. All of this can be done using an Employer Owned Life Insurance Acknowledgement and Consent Form, which can be obtained from the insurer.
Any type of life insurance policy can be structured as life insurance, including either of the two primary categories of life insurance:
Term life insurance: Term life insurance only provides coverage for a predetermined amount of time, such as 10 or 20 years, and is significantly less expensive than permanent life insurance. Typically, for a policy, the length of the term is tied to a specific date—such as the employee’s expected retirement—or a projected timeline—such as time it might take to double the sales team.
Permanent life insurance: In addition to providing lifelong coverage, a portion of permanent life insurance premiums are added to a cash value account which grows in value over time. The policy’s cash value is an asset that can be used the business as collateral for a loan and, if the policy was written by a mutual insurer, would make the business eligible to receive dividends. Since permanent life insurance policies accumulate value over time, they can also be sold in a life insurance settlement should the company decide that it no longer wants coverage.
Given the high cost of permanent life insurance, and that company needs often evolve over time, term coverage is often used as life insurance. However, permanent life insurance can be structured as an employee benefit, as the policy, and its cash value, can be transferred to the insured after a certain number of years or at a particular milestone.
No matter the type of policy you choose, you should make sure your life insurance offers flexible terms. For example, adding a business exchange rider to a permanent policy, allows you to change the person insured should that employee leave the company. Similarly, many key executive life insurance policies allow you to periodically increase or decrease the policy’s limits, as the needs of the company change.
life insurance is typically only required if your company wants to obtain a loan or investment. The SBA, as well as many banks, often require life insurance as part of their lending criteria, since small businesses tend to be particularly dependent upon one or two employees, usually, the co-founders. Similarly, if your business is trying to raise money, investors may want assurance that the loss of certain employees wouldn’t cause the company to go bankrupt.
Aside from lenders’ requirements, companies typically purchase life insurance as a form of financial protection. A policy is important if the loss of a particular employee would adversely impact your profits. This is often the case if:
The company’s brand and strength are tied to a particular employee’s name or reputation.
The company’s continued performance, or certain ongoing projects, are tied to the employee’s role or unique skills.
The loss of the employee could trigger a reduction in existing or new business.
The loss of the employee would affect the company’s credit or cause a business loan to become due.
In the worst-case scenario, of your company so dependent on an employee that it could potentially go out of business if they were to die, life insurance can also provide an alternative to declaring bankruptcy. The policy’s death benefit could be used to pay any debts, provide employee severance, shut down the business, and distribute any remaining funds to investors.
Key executive life insurance also can serve as part of a benefit plan that’s used to attract and reward key employees, since the policy can be transferred to the insured. There are multiple ways to structure this perk. One way would be to purchase a permanent life insurance policy which would be given to the employee upon retirement, after a certain number of years with the company, or based upon a certain level of performance.
While life insurance has much to offer a company, it wouldn’t make sense in some situations. For example, if you’re a sole proprietor with no one else directly involved in your business’s ongoing operations—such as lenders or employees—coverage would be unnecessary. Instead, you might consider an individual life insurance policy for yourself to protect your family if they were to suddenly lose your income.
If you’re borrowing money, the lender may require a certain amount of coverage. Otherwise, the amount of coverage you need will vary according to your business and the employee you’re insuring. In principle, try to purchase sufficient insurance that the impact of losing the insured employee is near-zero. To accomplish this, you’ll want to account for the revenue and profit attributable to the employee, the company’s cost structure, the cost to replace the employee, and any “soft” value the employee brings to the company.
Depending on who you want to insure, the calculation for how much key person coverage you need will change significantly. For example, it’s fairly simple to determine how much revenue is attributable to a top salesperson. However, the value is less tangible for a well-known CEO whom many employees joined the company to work with.
While none are comprehensive, a few commonly used methods for estimating the necessary amount of key executive life insurance are:
Multiple of Compensation: The employee’s compensation is multiplied by the number of years the company expects it might take to replace them or recover from their death. The primary issue with this approximation is that it assumes the employee’s value to the company is reflected with his compensation.
Percentage of Revenue or Profits: The amount of revenue or profit attributable to the insured employee is multiplied by the number of years it might take to replace the employee. Whether revenue or profit is the better approximation to use depends on the company and its structure.
Cost to Replace: This is a sum of the costs to find, hire and train a new employee as a replacement for the insured. This approximation should also include an estimate of business lost during the recruiting period, and possibly after the replacement is in place.
While key employee life insurance is usually purchased for high-earners, you should note that the face value of the policy is often limited to a multiple of the insured’s income, such as 10X. Depending on the insurer and your corporate structure, the employee’s income can include their annual bonus or a portion of the company’s net income, if they have ownership in the business. This means that, if a particular employee or executive contributes disproportionately to your company’s profit, it may be a challenge to obtain sufficient coverage.
Typically, the cost of life insurance is not tax deductible; premiums must be paid with after-tax dollars. Your company can only deduct insurance premiums if they’re considered to be part of the employee’s taxable income, in which case the employee is typically the beneficiary. This is more often the case with group life insurance than with life insurance.
If the insured employee passes away, the policy’s death benefit would be paid to the company free of income tax in most cases. The only exception is for C corporations, for which the death benefit would be included in the calculation of the alternative minimum tax (AMT) due. On the other hand, if your company decides to sell the key person life insurance policy, you may have to pay taxes, depending on the size of the settlement, cash value of the policy, and the amount that’s been paid in premiums.
Each year, your company will need to include details about the coverage with its corporate tax return. These specifics can include such information as the number of employees insured, the amount of coverage in-force, and whether each insured employee has provided written permission for the policy to be purchased. Consult with your tax-professional to ensure your company is fully compliant with all requirements, including providing the necessary documentation.
Tax Treatment for Employees
If your company is the sole owner and beneficiary of a key person life insurance policy, there are no tax implications for the insured employee. Policy premiums aren’t considered as part of the insured’s taxable income unless they have ownership in the policy or would be a beneficiary. In the case that you transfer ownership of the policy to the employee, however, they may be liable to pay taxes, since this transfer may be considered a form of compensation.
The cost of life insurance primarily depends upon the:
Type of policy purchased: Term life insurance policies are less expensive than permanent insurance, as they offer coverage for a fixed period of time and don’t accumulate a cash value. And there are several types of permanent life insurance policy, each of which can have different costs, risks and benefits.
Policy death benefit: Naturally, the greater the amount of coverage that’s in place, the higher premiums will be.
Employee’s health and lifestyle: An employee’s age, medical history, hobbies, occupation, family history, driving history, and general health will be considered in determining their level of risk, which in turn will affect the premium that’s paid.
It’s important to note that if you’re trying to insure an older or less healthy employee the cost of life insurance can be incredibly high. Alternatively, you may not be able to find coverage at all. If this is the case, you may have to look to other options, such as a loan, to provide compensation if your key employee should pass away. And you may want to prepare early for such a calamity, by creating a succession plan or beginning a search for viable replacement candidates.