You’ve purchased key person insurance to insure yourself or a key employee in your company – if this is insurance purchased for the business, does it qualify as a business expense?
It’s a fair question, and a logical one for any business owner looking to deduct as much as possible from their taxable income.
There’s a quick answer to this question: no. Key person insurance premiums are not a tax-deductible business expense, but that doesn’t mean there aren’t key tax advantages you can gain from a key person insurance policy. And many of these advantages are ones that CPAs often miss.
We’ll cover why key person insurance premiums aren’t tax-deductible, and what you can do instead to receive a tax-free windfall.
Key Takeaways
- Key person insurance premiums are not tax-deductible as a business expense under Section 264(a)(1).
- The proceeds from a life insurance policy are typically tax-free to the beneficiary.
- Permanent life insurance policies offer unique advantages in that you can take tax-free withdrawals from the policy and borrow against it.
- Employer-owned life insurance policies are subject to specific IRS regulations to prevent corporate abuse.
- Some employer-owned life insurance policies may qualify for tax exemptions, but they must meet certain criteria under IRS guidelines.
Keep reading for a complete breakdown of the above and the tax advantages you can gain from a key person life insurance policy.
How Does Key Person Insurance Work?
Key man insurance, also known as key person insurance, protects a business from financial losses if an essential employee is lost. This type of insurance helps companies stay afloat during challenging times caused by unexpected events, like the death or disability of a crucial team member.
A key person is someone who makes significant contributions to a company and whose death would negatively impact the business. That person could be the company’s CEO or Founder, for example, or the Chief Sales Officer who brings massive revenue to the company.
Like other life insurance policy types, there are three roles you should know about:
- Insured: The insured person is the company’s key contributor and the person whose death or disability would trigger a payout. The insurance premium will depend on this person’s age, health, and lifestyle, among other things.
- Owner: The policy owner is typically the company that takes out a life and disability insurance policy on the key employee. The company pays the policy premium and therefore has the right to change the policy terms or even transfer or sell the policy.
- Beneficiary: This is the person or the company that would receive the benefits in case of the insured’s death or long-term incapacity to work. You should note that, in order for the beneficiary to receive the agreed benefits, the unfortunate event must occur during the coverage period.
Key Person Insurance Policy Types
There are two main types of key man insurance policies: permanent and term life insurance:
- Permanent life insurance policies provide coverage for the entire lifetime of the insured person. The death benefit from a whole-life policy is paid out regardless of when the insured person dies. Permanent life policies also have a cash value component, which grows over time and can be accessed by the policyholder during the insured’s lifetime (more on the tax implications of this later).
- Term life insurance policies provide coverage for a specific period, typically 10, 20, or 30 years. The death benefit from a term life policy is only paid out if the insured person dies during the policy term. Term life policies do not have a cash value component.
Term policies are the most common because they are significantly cheaper and can be extended. Both term and permanent policies offer unique tax opportunities that we’ll cover later.
Why Key Person Insurance Premiums Aren’t Tax Deductible
The federal government and the IRS have, for many years, encouraged both individuals and businesses to purchase life insurance to provide financial security. One of the advantages they allow is that the death benefits, when paid out, are received by the beneficiary of the policy income tax-free.
Because the proceeds of life insurance policies are generally paid to the named beneficiary tax-free, there is no key person insurance deduction allowed for premiums paid. The IRS covers this in Section 264(a)(1) and provides that there is no deduction allowed for premiums paid on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract.
Key person insurance and other employer-owned life insurance are specifically covered under Section 1.264-1(a) and state that the premiums paid for life insurance on the life of any officer, employee, or person financially interested in a business carried on by the taxpayer are not deductible where the taxpayer is directly or indirectly a beneficiary of the policy.
Since key person insurance policy proceeds are generally non-taxable to the beneficiary, no business should be writing off premiums for life insurance paid on key employee or key executive insurance policies. That doesn’t mean there aren’t other tax advantages you can gain, though.
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Key Person Insurance Tax Advantages You Should Know
Just because key person insurance premiums cannot be deducted as business expenses does not mean there are tax advantages available to you.
There are two key points in the IRS tax code that pertain to life insurance that are worth calling out:
- IRC Section §101(a) – Tax-Free Death Benefits: Under IRC §101, life insurance proceeds paid to a beneficiary upon the death of the insured are generally excluded from gross income. This ensures that capital passes to families or businesses intact, without being eroded by income tax when liquidity is needed most.
- IRC Section §7702 – Inside Buildup Protection: IRC §7702 defines what qualifies as a life insurance contract, granting favorable tax treatment to the cash value growth within the policy. This “inside buildup” accumulates on a tax-deferred basis, allowing policyholders to compound wealth far more efficiently than in traditional taxable accounts.
Tax Advantages of Term Life Insurance
According to IRC Section §101(a), life insurance proceeds are generally excluded from gross income. That means that while term and permanent life insurance premiums aren’t business expenses, both offer a windfall in the form of tax-free benefits paid to the beneficiary. This is among the reasons the IRS gives for not allowing the premiums to be deducted.
Aside from that, there are limited tax benefits to a term life insurance policy. Permanent life insurance offers a unique set of advantages that may be worthwhile despite the traditionally higher cost than term.
Tax Advantages of Permanent Life Insurance
This is where IRC Section §7702 comes into effect. Term life insurance has no cash value, making it a pure death benefit. Permanent life insurance does have cash value, though, and because of that, permanent life insurance offers a unique combination of tax advantages not found in other financial products.
These advantages include:
- Tax-deferred cash values
- Tax-free income via withdrawals
- Loans and tax-free death benefits
The chief among these benefits is tax-deferred growth of cash values. That means the cash value can grow year after year – earning interest and dividends inside the policy – without you owing income tax on that growth as it accrues. The IRS doesn’t treat the annual gains as taxable income the way it would in a regular investment account.
With a business life insurance policy, cash values can be listed as assets on the company balance sheet and accessed by the company at any time. You can purchase a permanent life insurance policy and use the tax-deferred cash growth to fund executive compensation plans, create a supplemental retirement income, or fund a corporate stock redemption plan.
Withdrawals are generally not taxable as long as the amount withdrawn does not exceed the policy premiums paid (also called the basis). Once a policy’s basis has been withdrawn, future withdrawals are subject to income tax, though.
You can also take loans against the cash value of the policy. You can borrow from your life insurance policy as soon as you have sufficient cash value built up to borrow against (the minimum amounts vary by insurer). The IRS will not recognize this loan as income, so there won’t be a tax on it (though there are stipulations to be aware of).
Note: Permanent life insurance offers these great tax benefits, but be careful not to pay too much, too quickly. A Modified Endowment Contract (MEC) status is a permanent tax classification given to a life insurance policy when the owner pays too much money into it too fast. Once a policy becomes a MEC, it loses key tax-free loan and withdrawal perks, turning the policy into a mix of insurance and a taxable financial asset.
The IRS limits total funding during a policy’s first seven years (also called the seven-pay test); overfunding will trigger MEC status.
Learn more about the tax advantages of permanent life insurance.
What Changed With the Pension Protection Act of 2006?
Due to corporate abuses with key employee insurance, the IRS has added additional guidelines in the Pension Protection Act of 2006 for all employer-owned life insurance policies issued after August 17, 2006.
The objective of the IRS code change was to prevent large corporations from purchasing life insurance policies on their non-key employees simply to receive a tax-free death benefit when the employee or former employee dies. This is covered under IRC Section 101(j)(1), which states that death benefits from employer-owned life insurance contracts shall be taxable, in excess of premiums paid, unless the employer-owned life insurance contract meets one of the exceptions provided under IRC 101(j)(2).
NOTE: Key person life policies issued prior to August 17, 2006 are grandfathered in and are not subject to these rules.
To keep the death benefit tax-free on business-owned life policies issued after August 17, 2006, you must meet two requirements:
- Before the policy is issued, the insured employee has to be notified in writing that the business is taking out coverage on them and consent to it.
- The business must file IRS Form 8925 with its tax return each year it owns the policy. Miss either step and the death benefit can lose its tax-free status entirely.
For specific corporate-owned life insurance taxable income questions, insurance coverage, key person insurance cost, or any other question about key person insurance, a consult with your CPA is strongly recommended
For more details on the exemptions, see our article explaining key person insurance and taxes.
Are You Taking Strategic Advantage of Key Person Insurance?
Key person insurance plays a critical role in protecting your business from the financial impact of losing a key employee or executive, but the IRS will not allow you to deduct those insurance premiums as a business expense.
Despite that, there are tax advantages you can reap from your key person insurance policy.
You can receive the death benefits as a tax-free windfall, or in the case of permanent life insurance, let the cash value accrue tax-deferred and take tax-free withdrawals.
There is fine print to be aware of, though, which is why it’s important to always consult a CPA or tax professional before taking advantage of some of the benefits we’ve outlined in this guide.
For over 30 years, we’ve advised business owners and professionals on how to get the best policy at the best possible price, and take advantage of every benefit they can. If you are considering using a key person life insurance policy to protect your business and deliver these tax advantages, we can guide you each step of the way.
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Frequently Asked Questions about Is Life Insurance Tax Deductible?
Is Keyman Insurance Deductible?
No, key insurance is not deductible as a business expense. The IRS explicitly states under Section 264(a)(1) that businesses cannot deduct life insurance premiums if they are the direct or indirect beneficiary of the policy. This rule applies to key man insurance because the company purchases the policy to protect itself from financial loss in the event of the insured individual’s death or disability.
What Type of Insurance is Key Person Insurance?
Key person insurance is a type of life insurance policy that a business takes out on a crucial employee, owner, or executive whose absence would significantly impact the company’s operations. The business owns, pays for, and is the beneficiary of the policy, ensuring financial protection in the event of the insured person’s death or disability.
Which Losses Are Covered Under Keyman Life Insurance Policy?
Keyman insurance provides financial protection against several potential losses resulting from the death or disability of a key employee. The most significant covered loss is the financial impact on business operations, including revenue decline due to the absence of the key individual. The policy can also cover the cost of hiring and training a replacement, ensuring business continuity. Additionally, keyman insurance helps businesses meet outstanding loan obligations that may have been personally guaranteed by the insured.
