How to Protect Your Business, Profits, and Livelihood with Key Person Insurance
Every firm should consider the impact of suddenly losing a partner or key employee. The unexpected death or disability of a key member of your staff can cripple your operations. Along with losing a valued member of your management team, you would also be losing the manager’s skill, “know-how” and, perhaps, the important business relationships he or she had cultivated over the years.
Navigating the Shoals
Although it is impossible to prevent the sudden and unexpected loss of a critical employee, you can receive compensation through insurance to protect against the loss of a key person. A key person policy covers or “indemnifies” a company against the loss of a valued team member’s skill and experience. The proceeds help: provide funds to recruit, hire, and train a replacement; replace lost profits; assure customers that business operations will continue; and reassure lenders that funds will be available to help repay business loans.
Generally, the firm owns the policy, the premiums are not deductible, and the death proceeds are received by the company income tax free, although there may be alternative minimum tax (AMT) consequences for businesses structured as C corporations.
Charting a Course
Needless to say, it is not easy placing a value on a key employee. Generally, there are three different approaches used to determine the amount of insurance that is necessary:
- The “multiple” approach uses a multiple of the key person’s total annual compensation, including bonuses and deferred compensation. The popularity of this method may reflect the difficulty business executives have in quantifying a key employee’s value. On the other hand, the disadvantage is that the estimate, typically for five or more years’ annual compensation, may or may not relate to actual needs.
- The business profits approach is a more sophisticated method. It attempts to quantify the portion of the business’s net profit that is directly attributable to the key person and then multiplies that amount by the number of years it is expected it will take for a replacement to become as productive as the insured. For example, if net profit attributable to the key employee is estimated at $250,000 annually, and it is expected that it would take five years to hire and train a replacement, then the policy’s face amount would be $1.25 million.
- The present value approach calculates the present value of the profit contributions of the key employee over a specified number of years. This amount is then used as the face value of the policy. For instance, with an anticipated profit contribution of $250,000 per year for the next five years and a discount rate of 8%, the policy’s face value would be about $1 million. This method assumes insurance proceeds can be invested at a given rate of return and will be expended over a given period of years.
Regardless of which method is best suited for your practice, key person insurance is a vital component in protecting your firm from the loss of your most valuable assets—the people who help it grow and prosper.
Disclosure: You should consult with and rely on your own independent tax and legal advisors regarding your particular situation and the concepts presented herein. Eddy Financial, LLC does not provide tax or legal advice. Although care has been taken in preparing this material and presenting it accurately, Eddy Financial, LLC disclaims any express or implied warranty as to the accuracy of any material contained herein and any liability with respect to it. Eddy Financial, LLC is not a licensed insurance entity. Insurance services are offered through Andrew Eddy, an individually licensed life insurance agent in the state of California. Andrew Eddy’s California Insurance License is № 0K02163.
