Key Employee Coverage

What does this mean?

Contact Reichek Financial for Life Insurance QuoteBoth the IRS and the courts have long recognized that the loss of a manager, scientist, salesperson, or other key individual will almost always have a serious affect on the earning power and sometimes the very viability and stability of a business. Although the principle applies in publicly held businesses, it is particularly true in a closely held corporation where profits are dependent on the ability, initiative, judgment or business connections of a single person or small group of owners/employees. The death or disability of a key person at the wrong time can have a dramatic impact in a smaller business.

There is no universally recognized and accepted formula for computing the economic effect of the loss of a key person. One used in several court cases utilizes a discount approach in which a percentage discount is taken from the going concern value of the business.

Determining the Discount Factor

Some authorities feel that if the business will survive the death of the key employee, and in time a competent successor can be found, a discount factor of from fifteen to twenty percent should be used. Where the business is likely to fail, or be placed in serious jeopardy upon the death (or disability) of the key employee, a discount of from twenty to forty five percent is more appropriate. The exact discount factor should be arrived at through consultation with the officers of the company and the firms accounting and legal advisors.

Some questions to ask in determining the factor (or range of factors) to be used include:

  1. How long will it take for a new person to reach the efficiency of the key individual?
  2. How much will it cost to locate and situate a replacement?
  3. Will the new employee demand more salary?
  4. How much will it cost to train the new person?
  5. What mistakes is a replacement likely to make during the "break-in" period and how much are those mistakes likely to cost the company?
  6. What proportion of the firm's current net profit6s are attributable to the key employee?
  7. Is the employee engaged in any projects which, if left unfinished at death or disability, would prove costly to the business? If so, how costly?
  8. Would a potentially profitable project have to be abandoned or would a productive department have to be closed?
  9. Would the employee's death result in lost clientele or personnel attracted to the business because of his or her personality, social contacts, or unique skills, talents, or managerial ability?
  10. What effect would the key employee’s death have on the firm’s credit standing?
  11. What proportion of the firm's actual loss is it willing to self-insure, if any?

Dun & Bradstreet conducted a survey of 17,000 business failures. It revealed that over 95% of the failures studied were due to management weakness such as incompetence, unbalanced or no managerial experience or neglect.

Key person life insurance helps provide a business with protection against the economic loss it could suffer from the death of a key employee. The key employee is the life insured, while the business owns the policy, pays the premiums, and is the beneficiary. At the death of the key employee, the business receives the life insurance proceeds free from federal tax. Unless the key person was the majority owner of the business, there are no estate tax consequences for the insured key person.

Prior to Death

prior to death

At Death

at death

The Dun & Bradstreet study highlights the importance of key people, those individuals able to consistently make the right business decisions. The untimely death or disability of a key employee or a business owner who is also a key employee can have a disastrous effect on a business.

Some of the "costs" of such an event might include:

  1. A weakening of the company's credit rating.
  2. The financial costs (In both time and dollars) to find, hire, and train a replacement.
  3. The distraction of other employees, resulting in deadlines not met, deteriorating morale, or a higher level of personality conflicts.
  4. A need for cash to fulfill promises made to the deceased or disabled employee's spouse of family, such a salary continuation or deferred compensation.
  5. The inability to seize a business opportunity, because cash reserves are being used to recruit and train an new employee.
  6. A loss of confidence among both suppliers and customers.

Additional problems if the key employee is also an owner:

  1. Disagreement among heirs and surviving business owners or key employees.
  2. Lack of cash to buy the interests of the deceased or disabled owner, requiring a sale of the business to an unknown "outside third party"
  3. Surviving owners may be forced to work with someone who is either not competent, or not motivated enough to make the business thrive.
  4. The business may have to be sold to pay estate taxes.

Valuing a Key Employee

There exists no easy mathematical formula to determine the value of a key employee. However, over the years business owners have frequently used three different methods to estimate the worth of an employee to their company.

The Multiple of Compensation Method

Assumes that an employee's value is accurately reflected in his total compensation package. The "multiple" that is used (for example: 2x annual compensation), will depend on the type of business and the estimated difficulty in finding a qualified replacement. This method is perhaps the easiest way to estimate the potential loss to the firm.

The Contribution of Profits Method

Estimates the impact a key employee has on the company's net profit. The firm first estimated the expected profit from a "normal" return on capital, e.g. the net book value of assets. Profits in "excess" of this normal return is assumed to result from the efforts of key employees. An estimate is made of the percentage of profits attributable to each key employee. This percentage is then multiplied by the total excess profit, to determine the dollar amount of profit from each key employee. This sum is then multiplied times the number of years needed to find and train a competent replacement.

The Cost of Replacement Method

Totals the direct, out of pocket costs involved in finding, hiring, and training a replacement, as well as the estimated "loss of opportunity" costs.

Financing the Replacement of a Key Employee

There are three methods commonly used to finance replacing a key employee:

  1. Establish an Accumulation Fund: However, dollars kept in a savings account represent lost business opportunities. For example, if each $1.00 put into a marketing campaign returns $10.00 in sales, and the company has a 15% profit margin, the return on each $1.00 invested in marketing is $1.50. On an annual basis, this would yield a 50% return. If the dame dollar (along with the profits) were reinvested two or three times a year, with a similar increase, the ultimate return would be many times that earned in a bank.

  2. Borrow the Funds: This options assumes that the loss of a key employee does not seriously damage the firm's credit worthiness and ability to borrow. Each dollar borrowed must be repaid, with interest. If the loan is amortized over a 10 year period, as 12% interest, for each $1000 borrowed the company would have to repay a total of $1,770.

  3. Life Insurance Policies: Many business owners choose life insurance to protect themselves against the loss of a key employee. The premiums are small compared to the lump sum which would need be to be quickly raised, out of earnings, or by borrowing, when a death does occur. (1)

(1) However, proceeds are included in "adjusted current earnings" to the extent that they exceed the policy's tax basis, for purposes of the Corporate Alternative Minimum Tax. Beginning in 1998, the Taxpayer Relief Act of 1997 repealed the AMT for "small corporations." In general, a small corporation is one which has had average gross receipts of $5,000,000 or less for the previous three years.

Tax Considerations of Key Person Insurance Coverage

  1. Premiums paid by the employer on any key person life insurance policy are not income tax deductible.
  2. Death benefits paid under the policy to the policy owner are generally received income tax free.
  3. Any growth in the life insurance policy cash value is income tax deferred until removed from the policy.
  4. Cash value within a life insurance policy may be accessed by the policy owner on a tax favored basis provided the policy is not a modified endowment contract.
  5. If the life insurance policy is a modified endowment contract, any policy loans, partial surrenders or withdrawals will be subject to income tax to the extent there is gain in the policy values. Further, if the insured is less than age 59 ½, the taxable portion of the distribution may be subject to an additional 10% IRS penalty unless the distribution meets one of the allowable exceptions. Modified endowments are created when the premiums of cash value type policies exceed certain limits.
  6. If the insured key employee possesses any incidents of ownership in the policy at death, or transfers such incidents within three years of death, any death benefit paid to the employer will be included in the insured key employee's gross estate. If the insured key employee is a majority owner of the employer he or she may be deemed to possess such an incident of ownership in the policy (resulting in inclusion of the death benefit in the insured's estate)
  7. If the employer transfers ownership of the policy to the insured key employee the employee will have to include the cash surrender value of the policy in taxable income for the year of the transfer under Section 83 of the Internal Revenue Code.
  8. If the employer accesses the policy cash values to pay income to a key employee in retirement, the employee must pay tax on such income for the year of receipt. The employer may be able to access the policy cash values on a tax favored basis and can deduct the income it pays to the employee for the year it pays such income. (2)
  9. If either of the latter two options are contemplated, the company should not provide assurances to the key employee in advance in order to avoid constructive receipt and taxation of the life policy in the key employee's hands at the time assurances are given, rather than when the transfers or payment occur.

(2) Loans, withdrawals and partial surrenders have the effect of reducing death benefits and cash value. If a policy is surrendered, any outstanding loan balances will be used to determine whether there is a taxable gain in the contract/policy. In certain highly funded cases, life insurance may be considered a Modified Endowment Contract (MEC's). In such cases, distributions will be taxable income to the extent that there is a gain in the contract. In addition, a 10% IRS penalty may be due on any taxable income received prior to age 59 ½.

This is a simplified explanation of the potential benefits of a stated financial strategy. The discussion of legal and tax considerations in this material is an interpretation of current law and is not intended as legal or tax advice. You should seek counsel of you own legal or tax professionals to discuss how these concepts may apply to you financial situation.

Key Employee Disability Plans

Frequently a business owner will retain key employee life insurance coverage. In doing so, the owners express their understanding that a business may suffer financially if a key person dies.

Often overlooked in their decision, however, is what will happen to the business if a key person is disabled. In this instance, the business may confront the same financial issues it would face if the key employee were to die as discussed above.

A key person disability plan will protect the business by providing funs to help cover the potential lost profits and the costs of finding and training a replacement.

Some of the plans offer a replacement benefit which will reimburse the company for some percentage of the replacement costs, up to certain limits, for the first 12 to 24 months after the key persons disability occurs.

Sometimes the key person disability plan will be convertible to individual coverage if the business has no further need for the coverage, if the insured needs additional individual coverage, and if the insured meets certain income and, possibly, physical requirements.

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