Key Person Insurance When an Owner Steps Back

When an owner steps back, the key person policy usually keeps running. You have three main paths: keep the policy, transfer its ownership, or surrender it for cash value. This guide explains what to do with key person insurance when an owner steps back, one option at a time.

NR CPAs & Business Advisors is a Miami CPA firm. Nischay Rawal acts as the licensed insurance agent on this page.

Why a Retirement or Step-Back Changes Your Key Person Policy

A step-back does not end a key person policy on its own. The policy stays in force as long as premiums are paid. What changes is the reason the policy exists.

The Insurance Information Institute describes key person coverage as protection for a business against financial losses from a key employee’s death or disability. The business usually owns and pays for the policy, and the business receives the benefit.

When the person leaves the daily role, the loss the policy was meant to cover may look different. A smaller face amount may fit better. A larger one may still be needed to fund a buyout.

Many owners make one mistake here. They assume the policy ended with the step-back and stop tracking it. Premiums keep coming due, and the ownership and beneficiary details still control who gets paid.

So the first step is to confirm those details. This guide then covers three choices: keep, transfer and surrender. For each one, it covers the paperwork and the tax points to check.

Step 1: Pull the Policy and Confirm the Key Facts

The first step is to confirm the insurer, the policy owner, the insured person, the beneficiary, the face amount and the premium. No option is safe to choose until these facts are clear.

Find the policy form number and the most recent annual statement. Write down who owns the policy, who is insured and who receives the death benefit. Note who pays the premium and how long the payments run.

Next, identify the policy type in plain words. FINRA explains that term life insurance covers a limited period. Whole or permanent life insurance covers the insured for life and includes a cash value feature.

Term policies have no cash value. Whole life policies build cash value over time. That cash value is the amount the insurer pays on surrender, after charges and loans.

Ask for the statement that separates guaranteed values from non-guaranteed values. Dividends, where a policy pays them, are not guaranteed. Keep that split in your file, because you’ll need it for every option below.

Option 1: Keep the Policy After the Owner Steps Back

Keeping the policy means the business keeps paying premiums. The business stays the owner and the beneficiary, so the death benefit still goes to the business. This is the simplest path, but it still needs a review.

Start with the face amount. Compare it with the role the insured person plays now and with any buy-sell funding need. If the amount no longer fits, any change should go through the insurer in writing.

Check any policy loans as well. Under IRC § 264, the law limits the interest deduction on debt tied to life insurance. The key person exception applies only up to $50,000 of aggregate indebtedness on that person’s policies.

Finally, look at how the policy behaves over time. Term policies can end at a set term, and premiums may change with age. Confirm the renewal and cancellation terms in the contract before you decide to keep the coverage.

Option 2: Transfer Ownership of the Policy

A transfer moves ownership to a new owner. That owner might be the retiring person, a remaining owner or an entity tied to a buy-sell arrangement. The insurer’s forms and signatures are needed for the change to count.

Tax rules matter here. Under IRC § 101, a transfer for valuable consideration limits the amount excluded from income. The limit is the actual value of the consideration plus later premiums and amounts the new owner pays. The law also lists exceptions, so the facts of the transfer matter.

Estate rules matter too. Under IRC § 2042, insurance can count in a decedent’s gross estate to the extent the executor receives it as insurance on the decedent’s life, or to the extent other beneficiaries receive it on policies where the decedent held incidents of ownership at death. If the retiring owner keeps any ownership rights, the death benefit may still count in that person’s estate, but a reversionary interest counts only if its value exceeded 5 percent of the policy’s value immediately before the decedent’s death.

The IRS explains how the taxability of life insurance proceeds is assessed on the facts. Use that framework when you review a transfer.

Paperwork usually includes a written assignment or ownership change on the insurer’s forms. Update the beneficiary designation if needed. Send copies to the insurer and place them in the business’s records.

Option 3: Surrender the Policy for Its Cash Value

Surrender ends the death benefit. The insurer pays the cash surrender value, after any surrender charges and policy loans. Once the policy is surrendered, the business cannot get that death benefit back.

Florida law adds a safeguard when an agent recommends surrender without recommending a new policy. Under Fla. Stat. § 627.4553, if an agent recommends surrendering an annuity or life insurance policy with a cash value and does not recommend using the proceeds to buy another policy, the agent must give written information before the surrender is carried out. That information includes the estimated surrender charge, lost guarantees, possible tax consequences and any forfeited death benefit.

Tax treatment needs planning too. Under IRC § 72, for certain amounts not received as an annuity, the cash value before the payment is compared with the premiums paid. Pull the premium history before you request a surrender.

Loans carry a separate risk. Under Fla. Stat. § 627.458, a policy may end once total debt, including interest, equals or exceeds the loan value. The insurer must mail at least 30 days’ notice first.

Be careful about using policy values to buy a new policy. Under IRC § 1035, certain exchanges of life insurance contracts are not taxed, but the exchange rules are specific. A new policy should give the business a clear benefit.

Connecting the Choice to Your Buy-Sell Agreement and Succession Plan

A step-back can be the event that triggers a buy-sell agreement. Many buy-sell agreements use key person coverage to fund the purchase of a departing owner’s interest. Check which events trigger the agreement, such as retirement, a reduced role, disability or death.

Line up three things: the timeline of the step-back, the buyout price and the policy ownership. The money and the ownership should match. If the business owns the policy but the buyout is between owners, the paperwork may need changes.

Term coverage can fit a fixed transition window, such as a phased exit over a set number of years. Permanent coverage is often used when the need lasts longer. Which fits better turns on the business’s plan and timeline.

Write the sale, the policy change and the tax steps into one plan. Changes made in one place without the others often leave a gap.

Tax and Records Steps to Keep Your File Complete

Keep the policy statement, the signed ownership change, the beneficiary form and the premium history together. A complete file makes every option easier to report.

Some business-owned policies carry extra IRS reporting. Under IRC § 6039I, an applicable policyholder owning employer-owned life insurance contracts issued after that section’s enactment must file a yearly return. Whether that applies turns on the policy’s details.

Record the cost basis of any policy you transfer or surrender. Under IRC § 72, the basis is generally the aggregate premiums or other consideration paid for the contract, minus certain amounts already received, so keep the premium history current.

Coordinate every change with the business’s tax return preparer. The records should match the insurer’s year-end statements.

Common Questions About Key Person Policies After a Step-Back

Local Considerations for Florida Business Owners

Business owners in Miami, Fort Lauderdale, West Palm Beach, Orlando, Tampa and Jacksonville may hold policies across more than one entity. Run the same review for each entity. Confirm the owner, insured, beneficiary and premium payer for every policy.

Florida’s consent rules apply when a business buys key person coverage. Under Fla. Stat. § 627.404, a business may insure a key person if written consent is obtained before the insurance is bought. The business may not retaliate against a key person who does not consent.

That matters if a new policy is planned on the person who is stepping back. Get the proposed insured’s written consent in the file on or before the time of entering into the contract, and note that a signed application counts as that consent.

Disclosures About Who Is Advising You

Nischay Rawal acts as a licensed insurance agent when insurance is discussed. Insurance is offered by the licensed agent, separately from the accounting practice of NR CPAs & Business Advisors.

The licensed agent may receive commissions on insurance sold. Under Fla. Stat. § 473.3205, a CPA or firm may not accept or pay a commission or referral fee in connection with the sale or referral of public accounting services as defined in s. 473.302(8)(a) and (c). A CPA or firm engaged in the practice of public accounting that accepts a commission on the sale of a product or service to a client must disclose that fact to the client in writing.

Our fees for accounting, tax and insurance work are set out in an engagement letter before any work begins.

Insurer names, policy terms and tax results should be checked against the policy and the insurer’s written statements.

Talk Through Your Policy With Us

If you’re planning a retirement or step-back, and you hold a key person policy on the person leaving, you don’t have to sort out keep, transfer and surrender alone. We can walk through the policy’s facts with you. To set up a coverage review of the policy, its ownership and your buy-sell or succession terms, contact our team.