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How key person life insurance can help protect your business

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As a business owner, you know that valuable employees are a cornerstone of your success. You may have a key employee who adds unique value to your business through institutional knowledge, essential relationships and sound decision making.

Have you ever wondered how you would protect your business if something happened to this person? How would you minimize business disruptions while giving yourself and your staff time to grieve?

As you worked through the loss, you'd want to shore up your business by searching for someone who could fill that person's role. While no person ever truly can be replaced, key person life insurance can provide support as your company undergoes the recruitment process, trains a new hire and allows them to grow into the role.

Who is a key person?

A key person isn't just who you might immediately think of, like the business's founder, owner or CEO. Here's an easy way to identify your key employees: If you had to shut down your business and start over from scratch, which people would help the most in getting your new company up and running in as little time as possible?

Those are your key people. In addition to executives and partners, they also might be relationship managers, directors, lead engineers or others in critical roles.

What is the purpose of key person life insurance?

Key person life insurance can help you manage the financial side of your company's loss and minimize business disruptions that could impact your customers, your other employees and their families.

With key person life insurance, sometimes called company-owned or employer-owned life insurance, the company owns the contract and pays the premiums. The company also receives the death benefit when the insured dies.

The insured is a key person, and you may have multiple people you want to insure under multiple contracts. Key person coverage generally allows the business owner to purchase a death benefit of up to five times the income of a key employee.

Although it's sometimes called key employee life insurance, key person insurance can also be indispensable for a sole proprietorship or a partnership without employees. The business owners can purchase this coverage for themselves. The contract's death benefit can help pay down business debts and, if necessary, help cover the costs of selling or winding down the business. This way, the business doesn't become a liability for the owner's heirs.

As with other non-group life insurance, key person life insurance requires medical underwriting. This means that the premiums may be based in part on the health of the insured, and some individuals' health status may disqualify them from coverage.

How to decide if your business needs key employee life insurance

Businesses may consider key person insurance if one of more of these situations applies:

  • One person's (or several people's) reputation or skills are a driving force behind the company's ongoing success.
  • The loss of any one of those people would create serious financial hardship for the company.
  • The entire company or that person's ownership interest might need to be sold and debts repaid if that person died.
  • A lender or investor requires it as a condition of funding the business.

How much key person life insurance do you need?

The simplest formula to help determine an appropriate amount is by multiplying the key person’s compensation and benefits package between 5 and 7 times. For example, if a person’s total compensation and benefits package is $200,000, the appropriate insurance amount would land between $1,000,000 and $1,400,000.

Some insurance companies may limit how much coverage an individual is eligible for when considering insurable interest and may cap it at a specific multiple of the employee’s compensation package. When evaluating whether you want to purchase the maximum contract an insurer might offer you, or a lesser amount, here are some factors to consider:

  • Gross profits
  • Value of short-term business assets
  • Return on assets
  • Percent of profits attributable to key employee
  • Length of time to replace key employee
  • Business debts

Types of life insurance contracts for small businesses

If affordability is a priority, a term life insurance contract for your key person may be the best option. You choose the term of the coverage and the coverage amount.

A permanent contract—which can be whole life, universal life or variable universal life—does not expire during a specific time period. It can last for the lifetime of your key employee, and accumulates cash value that the contract holder can use for other financial needs down the road. For example, the company could use it to fund a deferred compensation or salary continuation plan for the key employee.

A key person life insurance contract can protect the business; at the same time, key people also may want the benefits of life insurance for themselves or their families.

That's why small businesses may choose to offer one of these two life insurance options to their highly valued employees:

  • Split-dollar plan. Under this arrangement, the company partially or fully pays the premiums for a permanent life insurance contract that divides the death benefit between refunding the premiums to the company and paying the key person's beneficiaries.
  • Section 162 bonus plan. Through this plan, the company provides additional compensation to the employee that they can use to pay the premiums on a permanent life insurance contract. Since the company does not directly purchase the insurance, you can categorize the expense as a business tax deduction for employee compensation. In addition, the key employee pays the premiums with after-tax dollars, allowing the beneficiaries to receive a tax-free death benefit.

Note that these two arrangements require the insured (key employee) to own the contract whereas key person life insurance coverage is owned by the employer.

With either plan, your employee can take advantage of the contract's cash value. Any earnings grow tax deferred and can be used for purposes such as increasing the contract's death benefit, paying insurance premiums or funding personal expenses as a loan.* If you'd like to explore what might fit both the company and employee's needs, use a life insurance calculator as a starting point.

Protect your business and your people

No amount of money can replace a valuable employee. However, a life insurance contract can help mitigate the financial and operational impact of losing a key employee. Likewise, it can help honor the hard work that person has put into supporting and growing your business.

If you'd like to discuss life insurance options for your business and learn about the protection it could provide, connect with a local financial advisor today.

*Loans and surrenders will decrease the death proceeds and the value available to pay insurance costs which may cause the contract to terminate without value. Surrenders may generate an income tax liability and charges may apply. A significant taxable event can occur if a contract terminates with outstanding debt. Contact your tax advisor for further details. Loaned values may accumulate at a lower rate than unloaned values.

 If requested, a licensed insurance agent/producer may contact you and financial solutions, including insurance, may be solicited.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.