How much of your business depends on the knowledge and talents of a small group of people – or even just one person? In a private professional practice, such as that of a doctor or attorney, the firm could fold altogether if something were to happen to that single key employee. Other key employees might include executives, managers, a salesperson or even a shareholder who is actively involved in the business.
If there is a key employee in your company, you might want to consider the repercussions if that person were to pass away suddenly. A business can take out a key employee insurance policy (formerly referred to as key-man insurance) to cover any losses due to the death of that person.
How Much is a Key Employee Worth?
One of the toughest tasks is to determine how much a key employee is worth in terms of dollar value to your business. You should consider what steps you would need to take if that worker died today and assign a monetary amount to each task. For example:
Even if you are able to hire a new employee in a timely fashion, it could take years to replace the skills, knowledge and talents of the deceased worker, which could impact business revenues or cause more expense.
There are several different strategies a business can use to determine the face value of a key employee life insurance policy it needs to purchase. You can calculate the dollar amount the employee contributes to profits each year and multiply it by a factor, such as the number of years it would take for another employee to replicate that value to the business. You could multiply the key employee’s salary by as much as three to 10 times – including the cost of fringe benefits and any periodic raises that employee would have received in bonuses and/or cost of living increases. You should also include the business expenses outlined above in determining the value of a key employee life insurance policy.
How to Structure a Policy
In most cases, a business will purchase life insurance as the owner of record and named beneficiary to receive proceeds upon the death of the key employee. This means the business would also have access to the contract’s cash value, which can be used for any purpose, including taking out a loan against the policy.
Policy premiums are not tax deductible, but death proceeds are income tax free as long as the policy meets the requirements of IRC 101(j) for employer-owned life insurance, which requires a signed notice and consent form. Also note that in the case of a C corporation, life insurance proceeds could be subject to Alternative Minimum Tax.
Bear in mind that should the key employee live to retirement, the business has the option to use the policy’s cash value to fund a nonqualified deferred compensation plan.
The loss of certain employees could be devastating for a small business. It’s important to consider key employee insurance as part of your company’s overall risk-management plan to help minimize the potential expense and disruption that would be caused by the loss of a key employee.