Key Employee Life Insurance FAQs

There are questions surrounding the key employee life insurance plans. Life insurance is a big deal in any household. Without it, you’d have to worry about your loved ones. There are many options to choose from when it comes to buying life insurance. Our experts answer some questions revolving around this topic.

Question – Is there a way around the nondeductibility of insurance premiums for key employee life coverage?

Answer – As a practical matter, the answer is no. This limitation extends to both term and permanent coverage. As a general rule, a client will not be allowed an income tax deduction for the payment of key employee life insurance premiums.

Question – How much insurance should be purchased by a business on its key employee?

Answer – A common method of calculating the economic effect of the loss of a key employee is the discount approach. This technique applies a percentage discount to the fair market value of the business. The discount approach requires an appropriate discount factor. Some authorities believe that if the business will survive the loss of the key employee and, in time, will hire a competent replacement, an appropriate discount factor is 15 to 20 percent. But if the business will fail at the death of a specified key person, or will be placed in jeopardy from the loss of the key employee, an appropriate discount factor is from 20 to 45 percent. The officers of the company and the firm’s accounting and legal advisors, however, should determine the exact discount factor.

Consider the following questions when determining the discount factor:

How long will it take the replacement to become as efficient and productive as the lost key employee was?

How much will it cost to locate, situate, and train a replacement, and will the new employee want a higher salary?

Is the replacement likely to make costly mistakes during the training period?

Will the loss of the employee result in a loss of clientele?

What percent of the firm’s current net profits are attributable to the key employee?

While there are other methods of calculating the value of a key employee’s contribution to a corporation, the discount approach illustrated below, courtesy of NumberCruncherTM Software, is a quick and effective method that sidesteps many of the difficulties posed by alternative methods.

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Keep in mind that regardless of what approach is used to calculate the value of a key employee, a life insurance carrier will limit a business’ insurable interest to the loss which the business would sustain in the event of the death of the employee. For financial underwriting purposes, the amount of death benefit that a life insurance carrier will issue is usually evaluated based on multiples of compensation for the number of years needed to replace the person and recover the losses. Generally, a maximum death benefit of five to ten times the key employee’s compensation is permitted.

Question – Should the insurance under a key employee policy be term or permanent?

Answer – As in every business planning problem, the product must match the problem. If the need is for a short period of time, term insurance is indicated. Likewise, if the firm has a cash flow problem or is a recent start-up business, term coverage is generally indicated.

But in most cases the value of the truly key employee to a business increases over time. Therefore, the need is long-term. Often, key employee coverage will be converted to solve a long-term need such as funding a buy-sell agreement with an indeterminate time span or to finance the employer’s obligation under a nonqualified deferred compensation plan. Thus, the preferred coverage is almost always some form of permanent insurance.

Question – How does a business account for key employee life insurance coverage?

Answer – Accounting for key employee life insurance depends on the type of policy. Term insurance premium payments represent a pure current expense. Such costs should be charged against income rather than retained earnings.

Insurance premiums paid on a permanent (cash value) type of policy are bifurcated. To the extent a premium payment generates an increase in the policy’s cash value, a charge should be made to an asset account. To the extent the premium paid exceeds the increase in the policy’s cash value, a charge should be made to expense.

The firm’s balance sheet should show policy cash values as a non-current asset. When an insured dies, the gain upon the receipt of the insurance payment is typically reflected as a special entry for nonrecurring amounts on the Annual Statement of Operations. Alternatively, a corporation’s gain on the receipt of death proceeds may be carried directly to the Retained Earnings Account.

It is the opinion of the authors that the method of accounting described above is antiquated and does not reflect the economic reality of the transactions over time considering the present products and riders available to businesses in the late 1990s and early twenty-first century.

An alternative method of accounting, called the ratable charge method, seems to provide a more realistic approach and has been used by a number of accounting firms even though it is not officially accepted. In essence, under the ratable charge method total premiums to be paid over a predetermined period (such as for ten years or to age fifty-five) are determined on the assumption that the insured is likely to live and will continue to remain an employee of the business that long. The guaranteed cash surrender value at the end of the selected period is then subtracted from the total premiums to be paid. The result is a net cost which is then amortized (ratably) as a level annual charge over the premium paying period.

This prime assumption upon which the ratable charge method relies becomes more likely if the policy in question contains what is often called a policy exchange rider, which is an option the client’s firm has to continue the policy on another life if the insured employee should decide to leave the firm. In other words the company could substitute a new key employee for the one no longer employed. (In most cases the rider allows the exchange with no additional costs to the client’s company.) The existence of an exchange rider would seem to offer an answer to the criticism that if the policy is discontinued prior to the end of the selected premium payment period, the ratable charge method would result in a large write-off of an unamortized deferred charge.

Question – Is there an income tax problem where a policy on the life of a controlling shareholder is payable to someone other than the corporation or its creditor?

Answer – Yes. There is a potential adverse tax consequence in this situation. If a policy death benefit that otherwise could (and should) have been paid to the corporation is, in fact, paid to the beneficiary of a shareholder, in the opinion of the authors, the IRS is almost certain to argue that the entire amount was constructively paid to that shareholder and is taxable as a dividend. If this argument should fail, the IRS is likely to claim the entire proceeds should be taxed to the recipient as compensation. Should that argument be deflected, the IRS could also argue that premiums for any open tax years should have been charged to the insured as dividends or at least as compensation.

Question – What are the tax implications where a corporation attaches a disability income rider to a key person life insurance policy?

Answer – If the disability income policy is payable to the policyowner corporation, the premium payments for the disability portion as well as the life insurance portion will be nondeductible. Income, when paid to the corporation upon the disability of the insured key employee, is income-tax free to the corporation. Upon the payout to the disabled key employee, assuming the amount and terms of the payout are reasonable, the corporation should be able to deduct the payments as ordinary and necessary business expenses. Upon receipt by the key employee, the payments would be considered salary rather than proceeds from a disability income policy and therefore subject to ordinary income tax.

If the employee is named directly as payee of the disability income generated from the rider on a policy owned by the corporation, the taxation will probably be as follows:

Premiums paid by the corporation for the disability coverage should be deductible by the business as an ordinary and necessary business expense.

The key employee should not have to report as income premiums paid by the corporation on the disability coverage.

Income, when payable to the disabled key employee, would be treated as salary and subject to ordinary income tax when and as received.

Question – Does a business have an insurable interest in a key employee?

Answer – Insurable interest is essentially the expectation of a financial benefit from the continued life of the proposed insured. The question in basic terms is, “Does the business expect to benefit financially from its relationship with the proposed insured?” Generally, a business has an insurable interest in the life of a key employee if the continued success of the business depends upon the special skills and talents of the key employee, and the policy is purchased to protect the business against loss in the event of the key employee’s death. The insurable interest is not unlimited though – it is limited to the loss which the business would sustain in the event of the death of the key employee (generally the maximum death benefit is 5 to 10 times the key employee’s compensation).

Generally, if a business has insurable interest in an individual when the policy is purchased, the issue is not again raised when the insured dies. However, the definition of insurable interest and its requirements is determined by state law. Practitioners must look to the law of the proposed insured’s domicile to determine if the business does in fact have an insurable interest. If there is no insurable interest, the IRS might claim that the proceeds are not paid by reason of the insured’s death but instead are paid from a wagering contract and therefore are taxable at ordinary income rates.

Question – What is a policy exchange rider and how is it used in key employee insurance?

Answer – A policy exchange rider (often called a substituted insured rider or exchange of insureds option) provides that at the termination of the insured’s employment, a new key employee can be substituted as the insured under the original policy (assuming the new person can provide evidence of insurability). Of course, appropriate adjustments in premium, cash value, or face value are made to the policy reflecting differences in age or insurability between the original insured and the new insured. Typically, there is no additional charge by the insurer at the time the new insured is substituted nor are commissions paid to the agent at that time. For these reasons, the corporate owner of the key employee coverage saves both underwriting and commission costs and receives an actuarially equivalent policy on the life of the new key employee.

Unfortunately, to be protected by Internal Revenue Code section 1035, an exchange must be on the life of the same insured. So the substitution of one insured for another under a policy exchange rider on a corporate-owned key employee life insurance contract will be taxed as if the corporation sold the first policy and used the proceeds to purchase the new contract. The corporation will have to report gain at ordinary income rates on the difference between the fair market value of the policy at the time of the exchange and the net premiums it had paid to that date.

Question – If an S corporation or other type of pass-through entity purchases a policy on the life of a key employee, are the tax implications different from those of a C corporation?

Answer – In an S corporation, partnership, or limited liability company (LLC) taxed as a partnership, the income of the business flows through directly to its owners. Generally, when a policy’s proceeds are paid to the business as death proceeds, they are received income-tax free, and each owner’s pro rata share of the proceeds flows through income-tax free. The basis of each owner’s interest in the business is increased by his or her share of the tax-free proceeds.

Question – Can a federally regulated bank purchase a life insurance policy on the life of a key employee?

Answer – A national bank may purchase key employee life insurance for the benefit of the bank if the bank has an insurable interest in the key employee’s life. According to the Office of the Comptroller of the Currency (OCC), key employee life insurance on the lives of executives and directors of banks is an appropriate investment when purchased as a funding mechanism for nonqualified deferred compensation plans. The OCC held that it was appropriate for banks to purchase the insurance to meet the bank’s contractual obligations of payments upon early, normal, or late retirement as well as to families of covered employees at their deaths. It also held that life insurance could be properly held by a federal bank to serve as an actuarial cost recovery vehicle.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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