Life and Health Insurance · Life Insurance · 6 min read
Business Protection and Funding Needs
- Explain how businesses identify insurable interest and utilize key person life insurance to protect against financial loss.
- Compare the structures, tax treatments, and policy requirements of cross-purchase and entity purchase buy-sell agreements.
- Describe executive life insurance arrangements, including Section 162 executive bonus plans, split-dollar setups, and nonqualified deferred compensation.
Insurable Interest and Key Person Life Insurance
Businesses face significant financial risk when owners, executives, or highly specialized employees die prematurely. Financial losses from an employee's death can include lost revenue, interrupted operations, lost customer relationships, and recruitment costs. Replacing a specialized worker may involve recruiting fees, a signing bonus, and substantial training costs.
A business must have an insurable interest in an owner or employee when a life insurance policy on that person is issued. A business has an insurable interest when it reasonably expects to suffer a financial loss if the insured person dies. For example, if a firm relies on a lead chemist whose formulas generate half its income, the firm faces a clear financial risk if that chemist dies.
In key person life insurance, the business is typically the applicant, policyowner, premium payor, and beneficiary. The key employee is the insured under the policy. When the insured employee dies, key person death proceeds can be used to stabilize cash flow, reassure nervous creditors, pay off business loans, and provide liquidity to recruit, hire, and train a qualified replacement.
State law may require an employee's written consent, and federal tax law generally requires written notice and consent before an employer-owned policy is issued for its death proceeds to qualify for the income tax exclusion. Furthermore, federal tax law generally requires satisfaction of other statutory conditions for employer-owned life insurance. Premiums paid by a business for key person life insurance are generally not tax-deductible as business expenses. However, a business generally receives key person life insurance death proceeds income tax-free if applicable employer-owned life insurance requirements are met.
Common mistakes
- Assuming that key person life insurance premiums are tax-deductible as general business expenses, when they are actually nondeductible.
- Confusing the policy counts in traditional plans: separate policies held by every owner on every other owner total N times (N minus 1), while an entity purchase plan typically uses one policy per owner.
- Believing that split-dollar life insurance is a unique policy contract issued by an insurer, rather than a specialized method of allocating costs, ownership, and benefits.
- Do not assume a redemption itself gives surviving shareholders basis in their existing shares; S corporation shareholders may nevertheless receive a basis increase from tax-exempt life insurance proceeds, while cross-purchase buyers generally receive cost basis in the shares they acquire.
Key points
- A business must possess an insurable interest when taking out life insurance on owners or workers, which exists when the firm would suffer financial harm upon their death.
- In a typical key person policy, the business is the owner, premium payor, and beneficiary; premiums are generally not deductible, and death proceeds are generally income tax-free if all applicable employer-owned life insurance requirements are met, including notice, consent, and a statutory exception.
- A buy-sell agreement sets purchase obligations and a price or valuation method, but funding and performance are not guaranteed; a traditional separate-policy cross-purchase plan uses N times (N minus 1) policies and generally gives buyers cost basis in the interests acquired, while an entity purchase plan typically uses one policy per owner and a corporate redemption generally does not increase surviving shareholders' basis in their existing shares.
- Section 162 executive bonus plans allow businesses to deduct premium bonuses as compensation, while the employee owns the policy and reports the bonus as ordinary income.
- Split-dollar is an arrangement rather than a distinct policy type, allocating costs and benefits via either the endorsement method or collateral-assignment method.
- Nonqualified deferred compensation plans allow businesses to selectively provide benefits to top executives, frequently using life insurance as an informal funding vehicle.
- Term life insurance can provide a death benefit for temporary business needs, such as repaying a commercial loan if an insured person dies; some permanent policies build cash value, which a business may be able to borrow against and generally records as an asset if the business owns the policy.
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