Can a Business Borrow Against Key Person Life Insurance?

Can a business borrow against key person life insurance? Usually only when the policy has cash value, which is typical of a whole life or other permanent policy. Key person term coverage has no cash value, so there is nothing to borrow against. This guide explains how a policy loan works, what it does to the death benefit, and which tax questions a business should review first.

The short answer: only a policy with cash value can be borrowed against

A business can usually borrow against a key person policy only if that policy builds cash value. Cash value is an amount that builds inside a permanent policy over time, and the owner may borrow against it or receive it on surrender, under the policy’s terms. It is separate from the death benefit, which is the amount paid when the insured dies.

Key person term life insurance works differently. It pays a death benefit for a set period and builds no cash value. Without cash value, there is no loan base.

Key person insurance protects the business if an important person dies or becomes disabled. The Insurance Information Institute describes it as a way to compensate a business for financial losses caused by the death or disability of a key employee.

Florida law ties policy loans to cash value. Under Fla. Stat. § 627.458, the loan provision applies after the policy has a cash surrender value and no premium is in default. Fla. Stat. § 627.458 reads: “The loan value of the policy shall be at least equal to the cash surrender value at the end of the then-current policy year, except that the insurer may deduct, either from such loan value or from the proceeds of the loan, any existing indebtedness not already deducted in determining such cash surrender value, including any interest then accrued but not due, any unpaid balance of the premium for the current policy year, and interest on the loan to the end of the current policy year.” It does not apply to term policies or to term insurance benefits provided by riders.

Before you act, check the policy contract. It shows the policy type, the insurer, and who owns the policy.

How a policy loan works when the business owns the policy

When the business owns the policy, the business borrows from the insurer. The insurer lends against the policy itself, not against the key person’s health or income.

Florida law says the insurer advances the money on assignment or pledge of the policy, as the sole security. The loan value must be at least equal to the cash surrender value at the end of the current policy year. Cash surrender value is the amount the owner could receive by surrendering the policy. The insurer may subtract existing debt not already deducted in determining the cash surrender value, plus accrued interest and any unpaid premium for the current policy year. The loan provisions are set out in Fla. Stat. § 627.458.

Under Fla. Stat. § 627.458(1), for policies issued prior to October 1, 1981, the insurer will advance a policy loan at a rate of interest not exceeding 10 percent per year, and as a condition for approval of a policy loan interest rate in excess of 6 percent per year, the office shall require the insurer to furnish such assurances as the office deems necessary. Fla. Stat. § 627.458 reads: “The loan value of the policy shall be at least equal to the cash surrender value at the end of the then-current policy year, except that the insurer may deduct, either from such loan value or from the proceeds of the loan, any existing indebtedness not already deducted in determining such cash surrender value, including any interest then accrued but not due, any unpaid balance of the premium for the current policy year, and interest on the loan to the end of the current policy year.” See Fla. Stat. § 627.458. Under Fla. Stat. § 627.458(3), the policy shall reserve to the insurer the right to defer the granting of a loan, other than for the payment of any premium to the insurer, for 6 months after application therefor. Under Fla. Stat. § 627.458(3), the policy may reserve to the insurer the right to defer a loan for 6 months after application, but that deferral does not apply to a loan used to pay a premium to the insurer.

The amount available depends on the cash value and the insurer’s loan terms at the time of the request. Ask for the policy illustration. Review guaranteed and non-guaranteed values separately, because they behave differently over time.

What an unpaid loan does to the death benefit

An unpaid loan lowers the amount the business receives when the insured dies. The loan balance and any unpaid interest come out of the death benefit before the rest is paid.

The loan does not change who is insured or who owns the policy. It changes how much is left after the debt is settled. The sequence works like this. The loan principal and accrued interest are repaid from the death benefit. The remainder goes to the named beneficiary, which may be the business itself.

Interest matters too. Under Florida law, the policy may provide that, if loan interest is not paid when due, it is added to the debt and bears interest at the same rate. See Fla. Stat. § 627.458. A loan that is never paid down can grow larger over time.

When you review a policy, compare the benefit amount with the loan balance. The gap between them is what the business can actually count on.

When borrowing can put the policy at risk of lapse

Borrowing can end coverage when the debt gets too large. Under Fla. Stat. § 627.458(2), the policy may provide that, if interest on any indebtedness is not paid when due, such interest shall be added to the existing indebtedness, and that if and when the total indebtedness on the policy, including interest due or accrued, equals or exceeds the amount of loan value, the policy shall terminate and become void, but not until at least 30 days’ notice has been mailed by the insurer to the last known address of the insured or policyowner and of any assignee of record at the home office of the insurer. The insurer must mail at least 30 days’ notice before termination, to the last known address of the insured or policyowner and any assignee of record. See Fla. Stat. § 627.458.

Premium nonpayment follows separate rules under Fla. Stat. 627.453: the policy must allow a grace period of not less than 30 days for any premium after the first, the insurer may charge interest on the overdue premium at up to 8 percent per year, and the policy continues in force during that grace period. See Fla. Stat. § 627.453.

For a person age 64 or older, Florida law adds another step. For an insured age 64 or older, a policy in force at least one year and issued on or after October 1, 1997, may not lapse for nonpayment after the grace period expires unless the insurer has mailed notice at least 21 days before the lapse; this notice requirement does not apply where premiums are paid monthly or more often and are collected by an agent, by credit card or by automatic debit. The policyowner can also name a secondary addressee. See Fla. Stat. § 627.4555.

A lapse ends coverage. A business that borrows should know its loan balance, its premium schedule, and its notice address before the debt grows.

Tax and accounting questions the business should review

Policy loans can carry federal tax consequences, and the answer depends on the facts. See 26 U.S.C. § 264. This applies when the plan contemplates systematic borrowing of cash value increases. See 26 U.S.C. § 264.

Key person policies get a narrow exception. Federal law also bars a deduction for the part of a taxpayer’s interest expense allocable to unborrowed policy cash values on policies issued after June 8, 1997, subject to exceptions for certain policies and contracts.

For a contract purchased on or before June 20, 1986 that carries a variable interest rate, 26 U.S.C. § 264(e)(2)(B)(ii)(II) measures the rate over an “applicable period,” generally each 12-month span starting on the policy’s issue date. Under IRC § 264, for a contract providing a variable rate of interest, the taxpayer could elect an applicable period of not greater than 12 months, other than the 12-month period beginning on the date the policy is issued, and such an election had to be made not later than the 90th day after the date of the enactment of that sentence.

Our CPA practice reviews the tax and cash flow effects of a borrowing decision alongside the insurance terms. We don’t promise a tax result. Treatment depends on the policy, the business structure, and the year involved.

A coverage review before the business borrows

If a cash need has come up, or a key owner’s health has changed, you may be reading this under pressure. A coverage review helps you see the policy clearly before any decision.

In a coverage review, we look at the cash value, the loan terms, the death benefit left after any loan, and the lapse exposure. We also look at the tax and cash flow effects alongside the insurance terms.

Nischay Rawal offers insurance while acting as a licensed insurance agent, and this insurance work is kept apart from the firm’s accounting practice. Under Fla. Stat. § 626.9531(1), when soliciting or selling insurance products, agents shall clearly indicate to prospective insureds that they are acting as insurance agents with regard to insurance products and identified insurers. The insurer is named for any specific policy.

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