Can Your Business Afford Key Person Insurance Premiums?

Can a business afford key person insurance premiums?

A business can afford key person premiums when the payment fits after payroll, debt service, reserves and planned spending are covered. Affordability is a cash flow question. It is not a judgment about whether the policy has value.

Key person insurance is a life insurance policy that the business owns on someone whose death or disability would cost the company money. The Insurance Information Institute explains that this coverage compensates a business for financial losses caused by the death or disability of a key employee. Because the business pays the premium, the cost must fit the budget every month or every year.

A simple cash flow test

• Start with the cash left after payroll, rent, loan payments and taxes.
• Subtract the reserve you want to keep for slow months.
• Compare the premium, on the schedule you would pay it, with what remains.
• Ask how many months of shortfall the business could absorb if revenue dipped.

If the premium uses most of what remains, the policy may strain the business. Test that before you commit.

What sets the premium

The insured person’s age and health, the death benefit size, the policy type and the payment schedule set most of the premium.

• Underwriting. The insurer’s underwriting process decides the rating class. Health questions are required, and issue may depend on insurability.
• Death benefit (face amount). A larger face amount raises the premium. Size it to the financial loss, not to the most the business could pay.
• Term or whole life. Term covers a set period. Whole life is designed to last as long as the contract stays in force. The NAIC Life Insurance Buyer’s Guide explains the differences between term and permanent coverage.
• Payment mode. Annual, semi-annual, quarterly or monthly payments change the total you pay in a year.
• Changes over time. Term premiums can change at renewal or at age-based points. The contract states whether and when.

Read the premium next to the limitations, exclusions, renewability and cancellability. A low early premium tells only part of the story. Whole life cash values show guaranteed and non-guaranteed amounts separately, so read both.

Building premiums into the business cash flow plan

Whether a business can afford key person insurance premiums depends on how the payment fits your calendar. Put the premium in the operating budget on the same schedule as your other bills. Accrue it monthly so no single payment hits all at once.

• Match timing to revenue. Plan larger payments around quarterly tax dates and slow months.
• Use term for a defined need. Term can fit while a key person is central to a loan or growth plan with a clear end date.
• Plan whole life across years. Whole life is a longer commitment. Stopping payment can end coverage or change the values, so model that before you start.
• Know the grace period. Florida law requires a grace period of at least 30 days for any premium after the first, and the policy stays in force during it. The insurer may charge interest of up to 8 percent per year for that period (Fla. Stat. § 627.453).
• Keep dividends out of the budget. Dividends, where a policy pays them, are not guaranteed. Do not count them as cash.
• Run a stress test. Ask how the business would pay premiums during a revenue dip, and what happens if a payment is missed.

How premium payments are treated for tax purposes

Federal law generally denies a deduction for life insurance premiums when the taxpayer is a beneficiary. For a key person policy the business owns, the premium is usually an after-tax cost (IRC § 264).

• Death benefits. The exclusion of death benefits from gross income is described in the IRS life insurance proceeds FAQ, not in IRC § 264. IRC § 264 says no deduction is allowed for premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract. For an employer-owned life insurance contract, such as many key person policies, that exclusion is limited to the premiums and other amounts the policyholder paid, unless the written notice-and-consent requirements of IRC § 101(j) are met before the policy is issued and an exception applies. Interest paid on proceeds left with the insurer is taxable (26 U.S.C. § 101).
• Employer-owned rules. Under 26 U.S.C. § 6039I, a policyholder owning employer-owned life contracts issued after the date of the enactment of this section must file a return for each year the contracts are owned.
• Ownership and beneficiary. Transferring an existing policy to a new owner can change the tax result under the transfer-for-value rule in 26 U.S.C. § 101.
• The facts decide. The tax result depends on the entity type, ownership and policy terms. Our team reviews those facts in the coverage review, next to the cash flow test.

Matching coverage size to what the business can carry

Size the death benefit to the financial loss the business would face, then test whether the premium fits. Starting from the loss keeps the policy tied to the actual risk.

Estimate the loss using these items:

• Lost profit during the gap while the business recovers.
• The cost of hiring and training a replacement.
• Loan terms that depend on the key person.
• Revenue tied to one customer or to one person’s relationships.

Then compare options. Show the premium for each face amount and each term. If the full amount does not fit the cash test, a lower face amount or shorter term may still address the largest exposure.

Florida rules also apply. Under Fla. Stat. § 627.404, a business entity has an insurable interest in the life, body, and health of its owners, directors, officers, partners, managers, and key employees or key persons (as defined in IRC § 101(j)), if consent is obtained in writing from the key employees or persons before the insurance is purchased. The business may not retaliate against a key person who refuses consent.

Review the coverage on a schedule. Revenue, debt and the key person’s role change over time.

What a coverage review involves and why NR CPAs & Business Advisors

A coverage review is the first meeting, where we gather the numbers and test whether the premium fits. The review follows these steps:

1. Gather financial statements, loan terms and a description of the key person’s role.
2. Define the financial exposure from losing that person.
3. Run the cash flow test with payroll, debt and reserves.
4. Compare term and whole life at the face amounts under consideration.
5. Review the illustration, limitations, exclusions, renewability and cancellability.

The timeline depends on your documents and on the insurer’s underwriting process. The insurer, not the firm, makes underwriting decisions.

NR CPAs & Business Advisors is a Miami CPA firm. We help families, professionals and business owners across the United States, including Indian-American households and business owners, with life insurance and a CPA’s view of tax and cash flow. Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the firm’s accounting practice. Our support staff help with scheduling and documents.

Frequently asked questions about key person premiums

Talk through your premium numbers with us

If a key person premium has just landed on your desk, that is the moment to run the numbers. Protecting the people your business depends on starts with a clear cash picture. Please contact our team to set up a coverage review with Nischay Rawal.