Key Aspects Of Key-Person Insurance

Published Thursday, June 5, 2014 at: 7:00 AM EDT

Life insurance is a crucial part of most personal estate plans, but it also could be very important for your business. "Key-person" insurance can help ensure continuity and solvency if someone who plays a top role in your company should die unexpectedly. The proceeds could cover the cost of hiring and training a replacement and pay off outstanding bills or loans called in by anxious creditors.

Key-person policies usually cover the owner and the president of the business--often the same person--and can be especially helpful if surviving family members plan to continue running the business. You also might want coverage for other employees who are essential to the operations.

Like other life insurance benefits, the proceeds from a key-person policy are exempt from income tax and generally won't be considered part of the key person's taxable estate. However, if the insured employee is the sole or controlling shareholder, the proceeds may be taken into account in determining the value of company stock for estate tax purposes.

How much key person insurance is needed for your business? Consider the following three methods for determining an appropriate amount:

1. Replacement costs. For these purposes, you'll need to calculate what your company would have to spend to train someone thoroughly to do the job of the person who died. That process is likely to take at least a year and may include salary as well as other expenses.

2. Multiple of salary. There are various rules of thumb about multiples of salary but you'll probably want to use at least a multiple of three. So if someone is making $250,000 a year you would need a key-person policy that would pay a minimum of $750,000.

3. Contribution toward earnings. Estimate what portion of your company's earnings can be attributed to the key person and then multiply that amount by the number of years needed for protection. For instance, if you attribute roughly $100,000 of annual earnings to a key employee, you would need $500,000 of coverage to protect that employee for a five-year period.

What happens if the key person leaves your company while the policy is in effect? Your business might sell the policy to the departing worker, or surrender it for its cash value, assuming that it is permanent insurance. There's no cash value available with a term-insurance policy, but term insurance is generally less expensive than whole life coverage and is usually preferable to having no insurance at all.

Your situation may include special circumstances affecting how much insurance you need. Work with your financial and insurance advisors to choose an appropriate policy.

This article was written by a professional financial journalist for Fleming Wealth Management, LLC and is not intended as legal or investment advice.

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