Why is key person insurance important for your business?

Does your business include someone whose contribution is vital to the survival of your company? If yes, then key person insurance should be a part of your business continuity and succession plan—especially if you’re a small business owner

Life insurance to offset the financial loss

Business owners recognize the benefit of insuring their firm’s valuable assets, such as office equipment and inventory, to cover property loss. Such assets, however, may not be as valuable as key persons.

Consider a top salesperson who is unsurpassed at bringing in new business or an expert manager who handles the day-to-day operation of the business. Key persons are a business’s most valuable resource. Their energy, expertise, and hard work enable the business to be successful in today’s highly competitive marketplace. If a key person dies suddenly, profits could be impacted and there might be considerable costs incurred in recruiting, hiring, and training a suitable replacement.

Life insurance should be part of a business continuity strategy. It can provide the business with tax-free funds when needed to help:

find and train a new person to assume the key person’s role
assure customers that the business will continue as a viable entity
assure creditors that funds will be available to meet commitments
offset expected reductions in sales revenue (after-tax)
pay a death benefit in recognition of the deceased employee’s service to the surviving spouse, other family members, or the estate.

A key person is anyone associated with the business whose special skills make a major contribution to the bottom line. Some examples include the active business owner(s), employees who have strong relationships with valued customers, and any employee who has specialized knowledge and expertise that can’t easily be replaced.

Key Person Disability Insurance

If an owner, co-owner, or a key person became disabled, your business could be faced with the same financial situation as if the person had died—but no life insurance policy would pay out.

However, with a key person disability insurance policy you could use the monthly cash benefit as working capital; to recruit, hire and train a replacement; pay off debts; and much more.

Determining the amount of coverage

Calculating the potential financial impact of the loss of a key person’s services to a business may not be easy, and no set formula or rule can be used for all business situations. In many cases, the amount of key person insurance is established in a somewhat arbitrary fashion. Some questions that may be considered when determining a reasonable coverage amount can include:

What costs would need to be incurred to replace the person in question?
What amount of the firm’s net annual profits does the person generate or contribute to, and how long would these profits be affected if the person died?
How much would it cost the business if this person died today?
How much would it cost for temporary or contract help while finding a replacement?
What proportion of the business’s probable total loss is the business able and willing to insure?
How much debt would have to be repaid to lenders if the person died?

Policy structured for corporate protection

To implement key person life insurance in a corporate context, the corporation is the applicant for the life insurance coverage to be arranged on the life of the key person, and the named owner and beneficiary of any policy that is issued.

The premium is a non-deductible expenditure by the corporation and the life insurance proceeds are non-taxable when received.

Private corporations

For private corporations, another benefit of a key person life insurance policy is the life insurance death proceeds create a credit to the corporation’s capital dividend account, equal to the proceeds less the adjusted cost basis of the life insurance policy. The capital dividend credit can then be used to pay tax-free capital dividends to the shareholder(s).

Professional advice

When considering key person life insurance, clients should always consult with all their professional advisors to help assess the risk involved and the appropriate amount of coverage to be applied for.

*This article provides information of a general nature only and is not intended to provide legal or tax advice. Clients are encouraged to consult with their own professional tax and legal advisors about their particular circumstances.

Key Person Life Insurance