Key Person Insurance Tax Deductibility: Understanding the IRS Rules

Your company may own a life insurance policy on an owner or employee it depends on. If that person dies, the tax questions come fast. Key person insurance tax deductibility is generally limited: premiums usually aren’t deductible when the business is a beneficiary, and death benefits are generally excluded from income. The details depend on who owns the policy and who gets paid.

What is key person insurance and why does its tax treatment matter?

Key person insurance is a policy a business owns on the life of someone whose work the company relies on. That person is usually an owner or senior employee, and the business is usually the beneficiary. According to the Insurance Information Institute, this coverage compensates a business for financial losses caused by the death or disability of a key employee.

Tax treatment has two separate parts. The first is the premiums paid while the policy is in force. The second is the death benefit paid when the insured dies. Each follows its own rules, so an answer on one does not settle the other.

For tax purposes, a key person is an officer or a 20-percent owner, with a limit on how many people can count. IRC § 264 reads: “(3) Key personFor purposes of paragraph (1), the term “key person” means an officer or 20-percent owner, except that the number of individuals who may be treated as key persons with respect to any taxpayer shall not exceed the greater of— (A).” See 26 U.S.C. § 264.

This matters most for two readers. One is a business owner or co-owner reviewing a policy already in place. The other is a family member who needs to know what the company’s books should show after an owner’s illness or death.

What tax and compliance risks come with key person premiums and death benefits, including premium deductibility and how proceeds are treated under IRS rules?

Premiums are generally not deductible when the business is directly or indirectly a beneficiary of the policy. Death benefits are generally excluded from gross income, so the payout usually is not taxed as income. Both answers depend on the facts, including ownership, the beneficiary designation and the policy’s terms.

On premiums, the rule is direct. 26 U.S.C. § 264(a)(1) says no deduction is allowed for premiums on a life insurance policy if the taxpayer is directly or indirectly a beneficiary under it. When the business collects the benefit, the premium is a cost of the policy. It is not an ordinary business expense, and the books should show it that way.

On proceeds, the IRS says life insurance death benefits are generally excluded from gross income. Interest the business earns on the proceeds is taxable. See IRS guidance on life insurance proceeds. The general rule comes from 26 U.S.C. § 101, and that section has limits that can change the answer.

Estate tax is a separate question. Under 26 U.S.C. § 2042, insurance is counted in the insured’s gross estate to the extent the executor receives it as insurance on the decedent’s life, and to the extent other beneficiaries receive it when the insured held certain incidents of ownership at death.

Compliance rules that can change the answer for employer-owned policies

Employer-owned policies have extra rules. They can limit the tax-free treatment of the death benefit and add reporting duties.

First, the exclusion for an employer-owned contract cannot exceed the premiums and other amounts the policyholder paid for it. See 26 U.S.C. § 101. Section 101(j) sets this rule for these contracts, except for the exceptions in paragraph (2) for contracts that meet the notice and consent requirements of paragraph (4).

Second, a transfer for value can limit the exclusion. The statute lists exceptions. This matters during buy-sell reorganizations and ownership changes, so check it before any policy changes hands.

Third, interest on policy loans is a common trap. Under 26 U.S.C. § 264, interest on debt tied to life insurance the taxpayer owns is generally not deductible. Don’t assume loan interest is deductible.

Fourth, reporting. Under 26 U.S.C. § 6039I, an applicable policyholder owning employer-owned contracts issued after the date of the enactment of this section must file a return. The return shows whether the applicable policyholder has a valid consent for each insured employee, or the number of insured employees for whom such consent was not obtained. The business must also keep records that show whether the requirements are met.

Records worth keeping include signed consents, premium payment records, beneficiary designations, ownership documents and any policy loan agreements.

How does NR CPAs & Business Advisors review key person policies?

NR CPAs & Business Advisors is a CPA firm. Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the accounting practice.

The first meeting is a coverage review. We look at who owns the policy, who is the beneficiary, how premiums have been paid, and the business’s tax and cash flow picture. When we discuss a specific policy, we name the insurer that issues it.

Here are the plain terms these reviews use:

• Owner: the person or entity that controls the policy.
• Insured: the person whose life the policy covers. For an employer-owned life insurance contract, the insured must be an individual covered by the contract who is a United States citizen or resident.
• Beneficiary: the person or business paid when the insured dies.
• Cash value: in some permanent policies, the value that builds inside the policy. FINRA’s insurance overview explains that term coverage lasts a limited period, while whole or permanent coverage lasts for the insured’s lifetime and includes a cash-value feature.

Our team includes office and administrative staff who help gather policy papers, premium records and ownership documents before the review.

Talk through your business’s key person policy with us

If you’re reading this after a co-owner’s diagnosis or a partner’s death, the tax questions may feel urgent. A bookkeeper may also be asking why premiums were booked a certain way. Those are fair questions to bring to a review.