Write Key Person Insurance Into Your Operating Agreement

A key person insurance operating agreement clause sets the rules for who owns the policy, who pays for it, and what happens when an owner leaves. Without these clauses, the policy can sit outside the agreement, and owners may disagree at the worst possible time. This page covers four clause areas and the tax, cash flow, and coverage questions behind each one. It is written for owners in Florida and across the United States, including Indian-American business owners. It is not legal advice.

Why the Operating Agreement Should Address Key Person Coverage

A key person insurance operating agreement clause sets the rules before a claim or departure happens. Key person insurance is life insurance that a business owns on an owner or key employee. The policy pays the business if that person dies or becomes disabled. The Insurance Information Institute describes it as compensating a business for financial losses caused by a key employee’s death or disability.

Florida’s LLC law fills gaps your agreement leaves. Except as otherwise provided in subsections (3) and (4), the operating agreement governs relations among members and the company. When the operating agreement does not otherwise provide for a matter it governs, the statute’s default rules apply (Fla. Stat. § 605.0105). Silence hands policy questions to those defaults, and the defaults may not match what the owners expected. Your business attorney drafts the operating agreement. For coverage basics, see our key person insurance guide.

Policy Ownership Clause: Who Owns the Policy and Who Is the Beneficiary

The ownership clause should name the policy owner, the beneficiary, and what happens if ownership changes. The most common setup has the company own the policy, pay the premiums, and receive the death benefit. Say so in plain words. Name the insurer and policy type in the clause, or point to a schedule that does.

Florida law sets a consent rule. A business can hold an insurable interest in its owners, officers, partners, managers, and key employees or key persons. For key employees and key persons, written consent is needed before the insurance is bought. The business may not retaliate against a key employee or key person who refuses consent to insurance on his or her life (Fla. Stat. § 627.404). Collect the signed consent before the application, not after.

Some owners hold the policy personally instead. That choice can bring the proceeds into the owner’s estate. Federal law includes insurance receivable by other beneficiaries in the gross estate, to the extent of the amount receivable, when the decedent held incidents of ownership in the policy at death (26 U.S.C. § 2042). The clause should explain how ownership moves if the owner later leaves.

Premium Payment Clause: Who Pays and How the Payments Are Treated

The premium clause should name who pays, where the money comes from, and what happens if a payment is missed. Write it so the cost fits the company’s budget for the full year, not just the first premium.

Tax treatment matters here. No deduction is allowed for premiums on a life insurance policy if the taxpayer is directly or indirectly a beneficiary under it (26 U.S.C. § 264). When the company is the beneficiary, its premiums generally are not deductible. A CPA should confirm this before the first payment, and the agreement should reflect the result.

Missed premiums need a process. The insurer may charge interest of not more than 8 percent per year for the days of grace (Fla. Stat. § 627.453). The clause should require notice to all owners when a premium is late. It should also name who pays or reallocates the amount.

Departure Clause: What Triggers a Transfer, Surrender, or Buyout

The departure clause should list each event that ends an owner’s role and state what happens to the policy. Florida treats an event named in the operating agreement as a cause of dissociation, meaning the member leaves the company. An individual member is dissociated when he or she dies (Fla. Stat. § 605.0602). Name the events you want covered, such as death, disability, retirement, withdrawal, and termination.

Next, pick the outcome for each event. The company can transfer the policy to the departing owner at an agreed value, surrender it, or keep it. Each choice has tax effects. Federal rules can limit tax-free treatment of a death benefit after a policy is transferred for value (26 U.S.C. § 101).

If a surrender is considered, get the facts in writing first. That information includes the estimated surrender charge, possible tax consequences, and any forfeited death benefit (Fla. Stat. § 627.4553). Tie the departure clause to the buy-sell price, so the policy and the purchase work together.

Use of Proceeds Clause: Where the Death Benefit Goes

The proceeds clause should say who receives the death benefit and how the company uses it. Specify whether proceeds go to the company, the surviving owners, or the deceased owner’s estate. Then say whether the money funds a buy-sell purchase, pays company debt, or supports working capital.

Beneficiary choice has legal weight in Florida. For a Florida resident who dies leaving insurance, the proceeds generally go to the person named in the policy. They are exempt from the insured’s creditors unless the policy or a valid assignment provides otherwise. If the insurance is payable to the insured or the insured’s estate, the proceeds become part of the estate (Fla. Stat. § 222.13). Fla. Stat. § 222.13 reads: “Notwithstanding the foregoing, whenever the insurance, by designation or otherwise, is payable to the insured or to the insured’s estate or to his or her executors, administrators, or assigns, the insurance proceeds shall become a part of the insured’s estate for all purposes and shall be administered by the personal representative of the estate of the insured in accordance with the probate laws of the state in like manner as other assets of the insured’s estate.”

Under 26 U.S.C. § 101(a)(1), a death benefit paid by reason of the insured’s death is generally excluded from gross income. For an employer-owned life insurance contract, § 101(j) can limit that exclusion to the premiums and other amounts the policyholder paid, but the statute also sets out exceptions based on the insured’s status, such as directors and highly compensated employees, that can preserve the general exclusion when its notice-and-consent requirements are met. Under 26 U.S.C. § 101, amounts received under a life insurance contract by reason of the insured’s death are generally not part of gross income, subject to the statute’s exceptions. One exception applies to an employer-owned life insurance contract: the amount the applicable policyholder may leave out of gross income cannot exceed the premiums and other amounts it paid for the contract, unless the requirements of subsection (j) are met. Interest paid on proceeds left with the insurer is taxable, though. Your CPA should review how the proceeds are recorded on the company’s books. Lenders may also require proceeds to be assigned or applied a certain way, so check existing loan terms.

Review, Valuation, and Update Clauses

A review clause keeps the coverage amount matched to what the company and its owners are worth now. Require the owners to revisit coverage on a set schedule. Include changes in ownership, company value, and debt in that review.

Changes in an insured’s age or health can affect the policy’s cost and the insurer’s underwriting. The agreement should allow updates when those changes happen. Link the coverage amount to the buy-sell valuation method rather than a default figure.

Review the policy’s guaranteed values and non-guaranteed values separately. They are different, and each needs its own check. Dividends on participating policies are not guaranteed. The NAIC Life Insurance Buyer’s Guide explains the difference between term and permanent life insurance, how much coverage to buy, and questions to ask before buying.

Who Does What: Attorney, CPA, and Insurance Agent

Your attorney drafts the operating agreement. The CPA reviews tax treatment and cash flow. The licensed insurance agent reviews policy structure and the insurer’s terms. Each role answers a different question, so each reviewer checks his or her own part.

Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the accounting practice. Florida law requires a CPA or firm that is engaged in the practice of public accounting and that accepts a commission for selling a product or service to a client to disclose that fact to the client in writing, under board rules (Fla. Stat. § 473.3205). If a commission applies to a policy, you’ll receive that disclosure in writing.

The fee for a coverage review depends on the facts of your business. Those facts include its ownership structure and the number of policies reviewed. The fee is disclosed before work begins.

Bringing Your Operating Agreement to a Coverage Review

Bring your operating agreement to a coverage review if it covers a buyout but says nothing about who owns the key person policy, who pays its premiums, or what happens when an owner leaves. That gap is easier to fix before a claim or departure than after.

Gather these documents before the meeting: the current operating agreement, any buy-sell agreement, recent company tax returns, and any policy statements or illustrations you already have. List each owner and key employee the business wants covered.

Frequently asked questions