According to a Business & Employee Insurance…Report by the National Association of Insurance Commissioners, “…small businesses are extremely dependent on just a few key people for their success and viability. Among these owners/managers, 71% say that they are ‘very dependent’ on only one or two key people. And even though this is significantly less likely to be the case as company size increases, the fact is that even among the firms with $ 1 million + annual revenue, almost half still acknowledge that they are ‘very dependent on one or two people to keep operations running smoothly.’ However, ‘among these small businesses, 22% have ‘Key Person Life Insurance,’ and 15% have ‘Key Person Disability Insurance…”[i] Whether an owner-employee, a skilled manager, executive, or technician, or a key salesperson, employers will usually suffer an economic loss due to loss of sales or production and replacement cost upon the unexpected death of such an employee. Often key employee insurance is set up to compensate the employer, but plans can be implemented to benefit both the employee’s family and the employer’s ongoing business.
KEY EMPLOYEE LIFE INSURANCE:
Key employee life insurance is not a specialty policy of insurers; it is a method of using life insurance to achieve various objectives established by an employer. Many businesses, for affordability reasons, use term plans such as a convertible 20 year level term plan to achieve their objective. Yet, businesses wanting to insure that benefits will be available upon the employee’s death typically will use a universal life plan or a whole life insurance plan with a term rider. Additionally, by using a permanent cash value life insurance plan, after a few years the policy will typically have enough cash value to cover an annual premium in event that employer goes through a period of reduced cash flow. Moreover, a permanent policy with a highly rated insurance company usually can be ‘paid-up’ or ‘premium offset’ after 15 or 20 years.
- PURPOSES; A business:
- Wants to retain an employee by offering a significant benefit.
- Wants to reward a select employee for their loyalty and work.
- Wants to be compensated for the economic loss caused by the death of a key employee.
- TWO OPTIONS:
- The employer applies for (is the applicant), owns (is the owner) and is the beneficiary of a life insurance policy on the key employee’s life. The employer pays the premiums and reaps all the benefits associated with the policy; and the employee has no incidents of ownership or benefit from the policy.
- The employer applies for, owns and is the beneficiary for a portion of a life insurance policy on the key employee’s life. The employer’s death benefit portion is that which would compensate the employer for a projected loss of sales or production, as well as the replacement cost, which is predicted to occur upon the expected death of the employee. Additionally, the employer would specify a portion of the death benefit to be given to the employee’s family due to the extra loyalty and promised service of the employee. This could also be used as or in connection with a split-dollar plan or non-qualified deferred compensation plan.
- INCIDENTS OF OWNERSHIP:
Typically, when it is found that the employee has or receives any incidents of ownership, the IRS (and the state) will want to assign a figure to that benefit of ownership and tax that premium portion or cash value benefit. If an employee wants a guarantee that the employer will give them an agreed upon amount of future ownership or insure a portion of the death benefit to their loved ones; and vice versa, if the employer wants to insure that the employee will stay loyal for the benefit, then for the sake of both the employee and the employer, provisions should be specified in a witnessed and notarized contract (of which both parties if they possess mental competency should insist on a copy of that written contract).
- FUNDING AND TAXES:
Many medium and large firms can self-fund or use other means of savings to fund the economic loss of a key employee. Yet, most small and medium companies cannot self-fund and or use traditional investment vehicles to meet the immediate needs that would arise due to the unexpected death of a key employee. Life insurance is normally the most practical way to provide such a fund for an insurable key employee.
The employer should understand that according to Section 264(a) of the Internal Revenue Code, ‘…No deduction shall be allowed for (1) Premiums on any life insurance policy… or annuity contract, it the taxpayer is directly or indirectly a beneficiary under the policy or contract.’ Nevertheless, the buildup of cash value inside of a permanent life insurance contract is still generally exempt from federal income tax, for both the employee and employer. Also, any death benefit assigned to the owner-employee or key employee’s beneficiaries would typically be received tax-free.
[i] Business & Employee Insurance Issues Among U.S. Small Businesses; A Report on Survey Research Conducted for the National Association of Insurance Commissioners; March 2007.