Borrowing Against Key Person Life Insurance Cash Value

Yes, a company can sometimes borrow against key person life insurance cash value. The loan comes from the insurer, not from a bank, and only if the policy builds cash value and the contract allows a loan. This guide explains how that works for Florida businesses, what a loan does to the death benefit, and which tax questions a CPA should review first.

The Short Answer: When a Company Can Borrow From a Key Person Policy

A company can borrow from a key person policy only when the policy is permanent, has cash value, and the insurer’s contract allows a loan.

Key person life insurance pays a death benefit to a business if an important officer or owner dies. A key person life insurance policy can be term or permanent. Term policies cover a set period and usually do not build cash value, so there is little to borrow against. Whole life policies do build cash value, and the policy contract sets the loan terms.

Florida law sets baseline rules for policy loans. Under Fla. Stat. § 627.458, the loan provision applies after the policy has a cash surrender value and while 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.” The same section does not apply to term policies or to term benefits added by riders.

The loan is not a bank loan. The company asks the insurer, and the insurer lends against the policy itself. Whether a loan is available depends on the specific policy, its age, its cash value, and the insurer’s terms.

What Cash Value Is and Which Key Person Policies Build It

Whole life policies generally build cash value. Term key person policies generally do not.

Cash value is a reserve the insurer holds under a permanent policy. It is separate from the death benefit, which is the amount paid when the insured dies. The policy’s terms decide how the cash value grows.

Not every part of a whole life policy is guaranteed. Some policies pay dividends, and dividends are not guaranteed. The policy illustration and annual statement should show guaranteed and non-guaranteed values separately. The Florida Department of Financial Services guide explains cash value and policy loans in plain terms.

The policy owner holds the contract rights, including the right to ask for a loan. In most key person arrangements, the owner is the company, and the insured is the key employee or owner. That is why the company, not the employee, makes the loan request.

How a Policy Loan Works

A policy loan is money the insurer advances to the policy owner, with the policy as the only security.

Florida law describes the advance as being made on the policy itself, on the sole security of that policy. The insurer checks the policy’s loan value and applies the contract’s terms. The company then receives the advance, and interest starts under the policy.

Interest is charged under the contract. If interest is not paid when due, the unpaid amount is added to the loan. That added amount then bears interest at the same rate. Balances can grow quickly if interest goes unpaid for years.

Timing can matter too. Under Fla. Stat. § 627.458, a policy shall reserve to the insurer the right to defer granting a loan for 6 months after application. The only exception is a loan used to pay a premium to the insurer. A company that needs cash soon should check this point first.

How Much Can a Company Borrow From Its Key Person Policy?

A company can generally borrow up to the policy’s loan value, minus what it already owes.

Under Fla. Stat. § 627.458(1), the loan value must be at least equal to the cash surrender value at the end of the current policy year. The insurer may subtract any existing indebtedness not already deducted in determining the cash surrender value. It may also subtract interest that has built up but is not yet due, any unpaid premium for the current year, and interest on the loan to the end of that year.

The company does not have to take the full amount. The statute lets the party entitled to the loan choose an advance equal to the loan value or a smaller one. 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.”

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.” An existing loan can still reduce what the company can actually take out, because the insurer may deduct any existing indebtedness not already deducted in determining such cash surrender value. 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.” Confirm the current loan value with the insurer before the company plans around it.

What Happens to the Death Benefit When the Loan Is Not Repaid

An unpaid loan generally lowers what the policy pays at death. The balance owed, with interest, comes out of the total.

Here is a simple illustration with round numbers, not a projection. Suppose a policy has a $1,000,000 death benefit. Suppose the loan plus accrued interest totals $200,000. The amount left for the business would be about $800,000, before any other contract terms.

The risk goes further than a smaller payout. Under Fla. Stat. § 627.458, if total debt, including interest, equals or exceeds the loan value, the policy may terminate and become void. The insurer must mail at least 30 days’ notice first to the last known address of the insured or policyowner, and to any assignee of record.

For a business, this is more than a personal matter. Key person coverage exists to help a company handle the financial loss from losing an important person. If the policy ends, that protection ends too.

Loan Interest, Dividends, and What Is Not Guaranteed

Loan interest comes from the policy contract. Dividends, where a policy pays them, are not guaranteed.

Florida law caps loan interest at 10 percent per year for policies issued before October 1, 1981. For newer policies, the contract sets the rate. The company should read the interest terms in its own policy.

A company should not plan on dividends to repay a loan. Dividends are not guaranteed, so they may be smaller than expected or may not be paid.

Any illustration of cash value or loan results rests on assumptions. Those assumptions and their limits should be read with the same weight as the figures. The NAIC Life Insurance Buyer’s Guide lists questions to ask before buying, including how to compare policies and their costs.

Tax Consequences of Borrowing From a Policy

Tax results turn on the policy’s classification and how the company uses the money. Treat the points below as a starting map for a CPA review, not a final answer.

First, interest deductions are limited. Unborrowed policy cash value is the cash value minus any loan on the policy.

Second, the policy may be a modified endowment contract. Under 26 U.S.C. § 7702A, a contract fails the 7-pay test when the accumulated premiums in its first 7 contract years exceed a set limit. That limit is based on net level premiums for paid-up benefits after 7 level annual premiums. A policy that fails the test is a modified endowment contract, and that label matters for how section 72 treats money taken out of the policy.

Third, reporting can apply. Under 26 U.S.C. § 6039I, every applicable policyholder owning 1 or more employer-owned life insurance contracts issued after the date of the enactment of this section shall file a return (at such time and in such manner as the Secretary shall by regulations prescribe), and each applicable policyholder owning 1 or more such contracts during any year shall keep such records as may be necessary for purposes of determining whether the requirements of this section and section 101(j) are met. For each year such contracts are owned, the return shows the number of employees of the applicable policyholder at the end of the year, the number of those employees insured under the contracts at the end of the year, the total amount of insurance in force at the end of the year, the policyholder’s name, address, and taxpayer identification number, the type of business in which it is engaged, and whether it has a valid consent for each insured employee (or the number of insured employees for whom such consent was not obtained) (26 U.S.C. § 6039I).

Finally, ending a policy with a loan on it can create its own tax questions. Review that point before any decision.

Questions to Settle Before Borrowing, and Next Steps

Before borrowing, a company should confirm its cash value, loan value, existing loan balance, interest terms, and modified endowment status. It should also settle how it plans to use the funds.

Check these items with the insurer and your CPA:

• Current cash value and loan value
• Existing loan balance and unpaid interest
• Loan interest rate and how interest is added
• Whether the policy is a modified endowment contract
• Whether employer-owned reporting rules apply
• The business reason for the loan and how it will be repaid

If your company holds a whole life key person policy and is weighing a loan against it, ask for a coverage review of that policy. Insurance is offered by Nischay Rawal, acting as a licensed insurance agent, separately from the accounting practice of NR CPAs & Business Advisors. Start by reaching out through our contact page.

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