Who counts as a key person?

Anyone whose absence would cost the business real money. That's usually the owner, and often a top salesperson, the person who holds the main client relationships, or the one employee who knows how everything works.

How much key-person coverage does a business need?

A common starting point is to estimate what the business would lose while it recovered (profit, revenue that person brings in, and the cost of recruiting and training a replacement) and how long recovery would take. There is no single right multiple; it depends on the business.

Is key-person insurance tax-deductible?

Generally not. Premiums for a policy that names the business as beneficiary are usually not deductible, and the death benefit is usually received free of income tax, provided certain notice-and-consent rules are followed when the policy is bought. Confirm the details for your business with your CPA.

What Is Key-Person Insurance? | Oaks Financial Services

Q: What is key-person insurance?

A life or disability insurance policy that the business owns, pays for and is the beneficiary of, on a person the business depends on. If that person dies or can't work, the benefit goes to the business to cover lost revenue, payroll and the cost of finding a replacement.

The risk most owners don’t plan for

Most owners insure the building, the equipment and the vehicles. Far fewer insure the thing the business depends on most: the people. If you, or the one person who holds the biggest accounts, were suddenly gone for six months, the bills and payroll would keep coming while the revenue slowed. Key-person insurance is how a business plans for that.

The idea is simple. The business buys a policy on the person it can’t easily replace. The business pays the premiums, owns the policy and is the beneficiary. If that person dies, or can’t work under a disability policy, the money goes to the business, which can use it to cover payroll and bills, reassure lenders and clients, and pay to recruit and train a replacement. If you have co-owners, it can also buy time to decide whether to keep going, sell or wind down.

Life and disability: two different events

Key-person coverage comes in two forms, and they protect against different things.

Key-person life insurance pays the business if the key person dies. It’s usually term insurance, which keeps the cost down, although permanent coverage is sometimes used when the policy has a second job, such as funding a buyout or an executive benefit later.
Key-person disability insurance pays the business if the key person can’t work because of illness or injury. A disability is more likely than a death during most working years, and it can be harder on a business: the person is still here, but not working.

A related policy, often called business overhead expense insurance, pays the fixed costs of running the business (rent, utilities, staff salaries) while the owner is disabled. For a small business that depends on one person, it can be the difference between pausing and closing.

How much coverage is enough?

There’s no single right answer, and you’ll hear rules of thumb, such as a multiple of the person’s salary. A more useful way to think about it is to ask what the business would actually lose:

Lost profit. How much profit does this person bring in, directly or indirectly, each year?
Recovery time. How long would it take to replace them and get back to normal? For many small businesses, that’s a year or more.
Replacement cost. What would it cost to recruit, hire and train someone new, and to cover any gap in the meantime?
Debts and guarantees. Are there business loans that a lender could call, or that you’ve personally guaranteed?

Insurers will also want to see that the amount makes sense for the person’s role and the business’s finances.

Taxes, in plain terms

Generally, when a business owns a policy and is the beneficiary, it can’t deduct the premiums. In return, the death benefit is usually received free of income tax, as long as certain notice-and-consent rules are followed before the policy is issued. That means telling the employee in writing and getting their written consent. Disability benefits have their own tax treatment. These rules are detailed, so check how they apply to your business with your CPA before you buy.

Where key-person coverage fits with the rest of your plan

Key-person insurance protects the business. It isn’t the same as the coverage that protects your family, which you’ll want separately (see Life and Disability Insurance). And if you have co-owners, it isn’t a substitute for a funded buy-sell agreement, which decides who ends up owning your share. See What Is a Buy-Sell Agreement? for how that works.

Questions to ask before you buy

Who in this business would cost us the most if they were out for six months?
How long would it really take to recover, and what would it cost?
Do we need life coverage, disability coverage, or both?
How does this coordinate with our buy-sell agreement and our personal coverage?
What does my CPA say about the tax treatment for our type of business?

If you’d like a quick read on where your business stands, the free Business Owner Blind Spot Check takes about two minutes. And when you want to talk it through, we’ll walk through the options with you, at no cost and no obligation. See how we work with owners on Owning a Business.

What Is Key-Person Insurance, and Does My Business Need It?