Key Person Insurance or Buy-Sell Agreement? Two Tools, Two Different Jobs

No, they are not the same. Key person insurance protects a business from the money impact of losing an essential person. A buy-sell agreement sets the terms for transferring an owner’s share. The two often work together.

The Short Answer: Two Different Tools That Can Work Together

Key person insurance is a life insurance policy. A buy-sell agreement is a contract among owners. Each one handles a different problem.

Key person coverage pays the business. A buy-sell agreement decides who may buy an owner’s interest and on what terms. Life insurance is one common way to pay for that purchase, but it is not the agreement itself.

The most common mistake is treating them as one document. A policy does not replace a written agreement. A written agreement does not create cash. Owners need both pieces to be clear, and they need to match.

One policy can sometimes serve both roles. Whether it should depends on how the business is organized. That is covered below.

What Key Person Insurance Does

Key person insurance is life insurance that a business owns on an essential owner or employee. The business is named as beneficiary. The Insurance Information Institute describes it as coverage that compensates a business for financial losses caused by the death or disability of a key employee.

When the key person dies, the death benefit goes to the business. The company can use that money to cover lost revenue, recruit and train a replacement, or keep bills paid while it adjusts. The policy does not run the business after that loss.

Insurability matters. The insurer reviews the insured person’s health through health questions and underwriting. Issue depends on insurability.

Florida law also sets rules for who may be insured. Under Fla. Stat. § 627.404, a business has an insurable interest in the life, body, and health of its owners, directors, officers, partners, and managers, of any affiliate or subsidiary of the business, or of its key employees or key persons. For key employees and key persons, that insurable interest exists only if written consent is obtained before the insurance is purchased. The business also may not retaliate against a key person who refuses consent.

What a Buy-Sell Agreement Does and How It Is Funded

A buy-sell agreement is a contract among owners. It lists the events that trigger a transfer, such as death, disability, retirement or leaving the business. It names who may buy the interest and how the price is set.

The agreement answers who buys and on what terms. Funding answers where the cash comes from when the trigger happens. Common funding methods include life insurance, cash reserves and installment payments. The right choice depends on the business, its cash flow and its owners.

When life insurance funds the agreement, the death benefit pays the purchase price for the deceased owner’s interest. Florida courts expect the basic parts of a contract to be present. These include an offer, acceptance, consideration and essential terms stated clearly, as the Florida Supreme Court contract ruling explains. So write the triggers and price method down.

The notation rule in Fla. Stat. § 607.0732(3) applies only to shareholder agreements made under that section; other buy-sell agreements are not governed by it. Under Fla. Stat. § 607.0732, the existence of an agreement authorized by that section must be noted conspicuously on the front or back of each share certificate, or on the information statement for uncertified shares. A purchaser is treated as knowing of the agreement if its existence was properly noted on the certificate or information statement and, for shares without a certificate, the information statement was delivered to the purchaser at or before the time of the purchase. That is true even if the purchaser did not actually know of it, and such a purchaser has no rescission right. A purchaser of shares who did not know of the agreement at the time of purchase, and is not treated as knowing of it under that rule, is entitled to rescission of the purchase, and an action to enforce that right must be commenced within the earlier of 90 days after discovery of the agreement or 2 years after the purchase of the shares. A missing notation does not make the agreement invalid. Failing to note the agreement on the certificate or information statement does not affect the validity of the agreement or any action taken under it; the remedy is the purchaser’s rescission right.

How One Policy Can Serve Both Roles

Sometimes the same death benefit can serve both needs. When the business owns a policy on an owner and receives the death benefit, those proceeds may help replace that owner’s contribution. The same proceeds may also fund the purchase of that owner’s interest.

The dollars are limited, though. The policy amount, the business’s real needs and the agreement’s price decide whether one policy can cover both. Owners must decide which need comes first. A separate policy may be needed for the other.

Documentation matters. The policy, premiums and beneficiary designation should appear in the agreement and in company records. That way the plan works the way the owners wrote it. Gaps in paperwork are where plans often break.

Why the Entity Structure Changes the Answer

Structure decides who owns each policy, who receives the proceeds and who buys the interest. There are three common setups. In a cross-purchase, each owner owns a policy on the others. In an entity redemption, the business owns a policy on each owner and uses it to buy back the interest. A hybrid combines the two.

Ownership affects estate tax too. Under IRC § 2042, life insurance proceeds are included in the gross estate to the extent of the amount receivable by other beneficiaries, when the decedent possessed at death any incident of ownership, exercisable alone or in conjunction with any other person. IRC § 2042 reads: “For purposes of the preceding sentence, the term “incident of ownership” includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent.” An owner who keeps ownership rights in a policy on his or her own life may pull the proceeds into the estate.

Moving an existing policy between owners can also change the tax result. Under IRC § 101, in a transfer for valuable consideration, the tax-free amount cannot exceed the consideration plus the premiums and other amounts the buyer later paid. That rule has listed exceptions. Check the facts before transferring any policy.

How premiums and proceeds are taxed depends on the owner, the beneficiary and the entity type. This depends on the facts of each business.

Questions to Bring to a Coverage Review

Consider a common case. A co-owner has a serious health event. A partner plans to step back. Or two owners are signing their first buy-sell agreement and are unsure how the policies fit together.

A coverage review looks at the entity type, the ownership percentages, the agreement’s trigger events and price method, and each key role in the business. Bring the existing agreement, any policy schedules and the entity’s operating or shareholder documents.

Insurance is offered by Nischay Rawal, a licensed insurance agent, separately from the firm’s accounting practice. Our team at NR CPAs & Business Advisors can walk through how key person coverage and a buy-sell agreement would fit your ownership structure. To start, contact NR CPAs & Business Advisors.

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