Introduction
Every successful business relies on more than just a solid product or service; it depends on people. In many small and mid-sized businesses, a few key individuals often drive the majority of sales, innovation, and operational success. These key employees may hold specialized knowledge, unique skills, or critical relationships that are difficult to replace. Their absence—whether due to illness, injury, or death—could leave the business vulnerable to financial disruption, operational setbacks, or even closure.
Key employee life and disability insurance is designed to help business owners manage that risk. These policies provide a financial safety net that can support ongoing operations, cover the costs of finding and training replacements, and help maintain stability during uncertain times. Whether you’re protecting a top salesperson, a founder with proprietary expertise, or a financial officer essential to investor confidence, key person insurance is an integral part of a business continuity strategy. Understanding how these policies work and when they make sense is essential for any business that values resilience and long-term planning.
When bad things happen to good people
Your key employees are those special people with such unique skills and talents that they contribute greatly to the financial success of your business. If a key employee were disabled and out of work, or were to die, your business would suffer a financial loss. Here are some possibilities:
- While the employee is out of work, the revenue that he or she generates may substantially decrease
- You’ll incur unexpected expenses recruiting and training a temporary or permanent replacement
- Less capable or inexperienced employees trying to fill in can make mistakes or cause delays that cost you money
- If a key person dies, a business loan may come due
- Customers or even other employees may look elsewhere, concerned for the future of the business after the loss of a key employee
Key employee life and disability insurance policies can help soften the impact of these blows. Generally speaking, these policies are sold to small or medium-size businesses; it’s in those operations that a single person can make the most difference to the bottom line. If you own a large company that’s better able to absorb the financial losses caused by losing a key employee, you may have difficulty buying the coverage you desire.
If death does you part–key employee life insurance
Typically, your business purchases a life insurance policy on a key employee, pays the premiums, and is the beneficiary in the event of the employee’s death. As the owner of the policy, the business may surrender it, borrow against it, and use either the cash value or death benefits as the business sees fit.
In determining how much insurance you’ll need, putting a dollar value on a key employee’s economic worth may be difficult. Although there are no rules or formulas to follow, several possible methods to determine the insurance amount may be used. The appropriate level of coverage might be the cost of recruiting and training an adequate replacement. Alternatively, the insurance amount might be the key employee’s annual salary times the number of years a newly hired replacement might take to reach a similar skill level. Finally, you might consider the key employee’s value in terms of company profits; the level of insurance coverage might then be tied to any anticipated profit loss.
The premiums you pay for key employee life insurance are not a tax-deductible business expense for federal income tax purposes, since your business is the recipient of the benefits. Prior to August 16, 2006, the death benefits your company receives as the beneficiary of the policy aren’t considered to be taxable income. But for policies issued after August 16, 2006, proceeds from a life insurance policy insuring the life of an employee and payable to the employer-policy owner may be subject to income tax, unless an exception applies. Also, if your business is a C corporation, the death benefits may increase the corporation’s liability for the alternative minimum tax. You should consult a tax professional for information on your circumstances.
Riding out the hurt–key employee disability insurance
The death of a key employee isn’t the only threat to your business. Suppose a key employee is injured or becomes ill, and is out of work for an extended period? Disability insurance on such a key employee is another way you can protect your business against any resultant financial loss.
A critical part of key employee disability insurance policies is the definition of disability. Usually, these policies define disability as the inability of the employee to perform his or her normal job duties due to injury or illness. As with life insurance, your business buys a disability insurance policy on the employee, pays the premiums, and is named as the beneficiary. When the employee is disabled, the insurance coverage pays monthly disability benefits to your business. These benefits can equal a certain percentage of the key person’s monthly salary, up to either a maximum monthly limit or 100 percent of that salary. The benefits may be used to pay the operating expenses of the business and to cover the expense of finding a temporary or permanent replacement for the key employee.
The policies typically offer elimination periods (i.e., the waiting period between the disability and when the benefits begin) ranging from 30 to 180 days. Depending on the policy, your business may receive the benefits for 6 to 18 months–long enough to allow the key employee to return to work or to allow the company to replace the key employee. The policy is normally a noncancelable contract, guaranteeing the premiums and the coverage amount. A waiver of premium option can be an important part of these policies. This option provides that, once the elimination period has been satisfied, the insurance company will pay the premiums as long as the disability lasts or until the benefit period ends.
Sometimes included in the base disability policy coverage (or available as an optional benefit for an additional premium) is personnel replacement expense coverage that pays for the cost of finding and hiring a replacement for the key employee. These benefits are usually payable after the key employee’s disability has lasted at least 6 months. Your business will be compensated for actual replacement expenses incurred, including advertising costs, employment agency fees, and the first 3 months of the new employee’s salary.
As with key employee life insurance, the premiums you pay for the key employee disability policy are not a tax-deductible business expense. As a result, the benefits your business receives are not generally considered taxable income.
Conclusion
Protecting your business means preparing for the unexpected, especially when your success hinges on the talent and leadership of a few key individuals. The loss or prolonged absence of a top-performing employee can significantly disrupt operations, diminish client confidence, reduce revenue, and increase expenses tied to hiring and training a replacement. That’s why key employee life and disability insurance isn’t just a precaution—it’s a strategic component of business continuity planning.
By securing appropriate coverage, you create a financial buffer that allows your business to absorb short-term losses and adapt to long-term changes. Whether through life insurance that provides vital funds in the event of a death or disability insurance that helps sustain operations if a key team member becomes incapacitated, these policies offer peace of mind and operational resilience.
As with any insurance strategy, it’s essential to work with financial and legal professionals to ensure your policies are tailored to your business’s structure, risks, and goals—and to understand the tax implications of owning and benefiting from this type of insurance. Ultimately, investing in key employee insurance is investing in the future stability of your business, helping to ensure that a personal loss does not become an organizational crisis.
Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here. Click here to sign up for our newsletter with the latest economic news.
Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
