Key Person Insurance An Important Benefit for Your Business A "key person" is any employee or independent contractor who contributes substantially to the financial well-being of a business. Loss of a key person can mean: - Loss of credit
- Loss of key accounts
- Diminished earnings
- Unexpected replacement costs
- Employee discontent and low morale
How Can You Plan for the Loss of a Key person? - Accept Loss as Current Expense
- Will profits be sufficient to absorb the loss?
- The dollars must come from company funds.
- Current profits may be needed to fund other projects.
- Accumulate a Fund to Cover Loss
- If the key person dies too soon, the fund may be too small to cover the loss.
- Any earnings on the fund may be subject to income tax.
- Purchase Life Insurance
- The funds are available when needed.
- Death proceeds generally received income tax-free.
- May be less costly than building a sinking fund.
- The cash value is an asset on the balance sheet.
Advantages of Life Insurance Income tax-free death proceeds may provide funds to: - Repay loans and maintain credit
- Replace lost profit
- Provide a financial cushion
- Hire and train replacement(s)
- Help continue existing employees' faith in business
- Help maintain vendor confidence
- Helps protect remaining owners from potential forced sale or loss of control
- Support survivors until business is sold
- Help offset value lost due to key person's death
The businesses may utilize cash values or death proceeds for any valid purpose, such as borrowing future cash values or pledging them as collateral for business loans. Key employees must agree to the life insurance application process, which may include taking a physical. How Much Insurance? Life Insurance funding formulas: There are a number of techniques to determine how much key person insurance is needed. A business owner may use one or a combination of these methods. However, only the business owner can truly evaluate the potential loss and the effects of a key employee's death. The following formulas are discussed: - Multiples of Salary
- Replacement Cost
- Contribution to Profits/Earnings
Multiples of Salary This method may be the simplest. The key person's value is estimated based on a multiple of his/her compensation. - Determine the base compensation for the key person.
- Add the dollar value of significant benefits, such as medical, life, and retirement plans.
- Use a multiple of years based on how many years may pass before a new employee will perform as well as the key employee, i.e., replacement time.
($75,000 + $15,000) X 5 Years = $450,000 Base Comp Benefits Replacement Time Life Insurance Amount
Replacement Cost The replacement cost of an employee is more than just expenses incurred. Those expenses do not consider lost revenues, lost customers and other intangibles. Expenses incurred may include advertising costs, executive search firm fees, travel expenses for candidates, temporary housing, etc. The total replacement cost should be based on how much money the company would have to earn to pay the expenses incurred. The number is larger than the expenses because it considers the cost of doing business, and thereby may approximate the intangible costs of replacing an employee. Contribution to Profits/Earnings Due to the unique nature of each business, time must be invested with owners/partners and key employees, to asses a meaningful calculation. Important Points to Consider - The company is the owner and beneficiary of the policy.
- The premiums are non-deductible business expenses.
If the business is a "C" corporation, the death proceeds and cash value increases may be subject to the alternative minimum tax (AMT), which may cause taxes and penalties. |
