Key Person Insurance Taxation and How to Avoid It

Key Person Insurance premiums are not tax-deductible, and the death benefits paid out from a life insurance policy are generally tax-free. 

Within those two brief points is a world of nuance you need to navigate if you want to avoid IRS penalties. You must pay close attention to your key man and employer-owned life insurance policies to ensure that the death benefits are not taxable. Learn how to do just that, and other pitfalls to avoid, below.

Key Takeaways

• Key person insurance benefits are generally not taxed when paid out. However, employers must provide written notice and obtain written consent from the insured employee before issuing the policy, or the death benefit becomes taxable.
• To keep death benefits tax-deductible, the insured must have been an employee within 12 months of death or a highly compensated employee when the policy was issued, or the death proceeds must go to qualified beneficiaries like family or a trust.
• Employers must file IRS Form 8925 every year detailing insured employees, insurance amounts, and consent status to stay compliant.
• Failing to follow notice, consent, and reporting requirements can result in the entire tax-free death benefit being taxed as income.

How Key Person Insurance is Taxed and What Changed With The Pension Protection Act of 2006

Though you are buying life insurance for business purposes, key person insurance premiums are not tax-deductible as a business expense. 

This is because the death benefits paid out from a life insurance policy are generally paid tax-free. The IRS does this to encourage individuals to purchase life insurance, but there are several key tax advantages to owning a life insurance policy. 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.

If compliant, the death benefits paid out are tax-free. Permanent life insurance gives you access to tax-deferred cash value that you can borrow from or take a loan against. Learn more about the tax advantages of permanent life insurance for a complete walkthrough.

On August 17, 2006, then-President George Bush signed tax legislation containing provisions that have widespread implications for key man insurance taxation and other employer-owned life insurance purchased after August 17, 2006.

The COLI Best Practices Act (which is part of the Pension Protection Act of 2006) includes the proposed IRC Section 101(j). Under this proposed law, life insurance death benefits of employer-owned life insurance policies issued after the effective date of August 17, 2006, are income taxable (to the extent the death benefit exceeds the employer’s premiums paid) unless certain requirements for an exception to taxation are met.

This tax law change applies to all employer-owned policies issued after August 17, 2006, and includes policies used for key person insurance, stock redemption, endorsement split dollar, Corporate Owned Life Insurance, and SERPs. It may also extend to the collateral assignment (economic benefit) regime, split-dollar, and split-dollar loans.

Under this law, all situations where an employer will have full or partial ownership of a life insurance policy issued after August 17, 2006, regardless of the purpose of the policy, must meet certain requirements and follow specific guidelines to avoid potential taxation. We’ll cover those in the next section.

How to Properly Avoid Key Man Insurance Taxation

To avoid key man insurance taxation and prevent the death benefit from being taxable income, either from improper setup or improper deductions, both of the following requirements must be met:

1. Notice and Consent Requirements:

1. The employee must be notified in writing, before the issuance of the life insurance policy, that the employer intends to insure his/her life and disclose what the maximum face amount that can be applied for on his/her life is;
2. The employee provides written consent to be insured under the policy and that the employer may choose to keep the policy in force even after the employee separates services from the employer; and
3. The employee must be notified in writing that the employer is the beneficiary of all or part of the death benefit proceeds.

Unless the employer provides written notice and obtains the employee’s written consent before the issuance of the policy, the death benefit of the life insurance policy will be taxable from day one. Notice and consent may not be obtained after the life insurance policy is issued to remove this taxable death benefit status.

In an effort to help customers meet these rules and regulations, many life insurance companies have created a special Employer Owned Life Insurance Form called a ” Notice and Acknowledgment of Consent to Life Insurance,” which is provided at the time of application for key man and other corporate-owned life insurance situations. This can be shared with legal and tax advisors to help make sure that correct reporting and disclosure are met.

2. Two Exceptions to the Rule: Taxing Death Proceeds, One of Which Must be

Exception #1:

1. The insured was an employee at any time during the 12-month period before the insured’s death OR
2. The insured was a Director or “highly compensated employee” at the time the contract was issued.

Exception #2:

Any amount received by the employer as a result of the insured’s death is paid to:

1. A family member of the insured;
2. A designated beneficiary of the insured under the contract other than the employer;
3. A trust established for the benefit of a family member, other designated beneficiary, or the insured’s estate; or
4. A family member, designated beneficiary, trust, or estate in exchange for any interest they hold in the corporation/employer (i.e., buy-sell agreement).

If both conditions above are met, key man life insurance proceeds would be received income tax-free if the policy death benefits would otherwise be eligible for favorable tax treatment.

Reporting Requirements for the COLI Best Practices Act

Employers are required to annually report all employer-owned life insurance arrangements to the IRS. The annual reporting requirements imposed under the IRC Sec. 6039I include:

1. The total number of employees at the end of the year.
2. The number of employees insured under the COLI arrangement at the end of the year.
3. The total amount of insurance in force on all insured employees at the end of the year.
4. The employer’s name, address, taxpayer identification number, and type of business.
5. A statement of valid consent for each insured employee (or, if all required consents are not obtained, the number of insured employees for whom consent was not obtained).

The IRS requires this reporting annually on Form 8925, ” Report of Employer-Owned Life Insurance Contracts.” It is a simple form and must be completed to comply with the IRS Code.

Also, an excerpt from the Federal Register Vol. 73, No. 216 contains additional details on reporting requirements for employer-owned life insurance policies issued after August 17, 2006.

If proper recordkeeping and reporting are not maintained, any and all key man life insurance policy proceeds or other corporate-owned life insurance death benefits may be subject to income taxation.

When it comes to key man insurance, compliance with tax regulations is crucial for maintaining your business’s financial security if the insured person dies. Proper financial planning ensures that term life insurance or permanent life insurance policies provide the intended financial protection without triggering unexpected tax liabilities. Failure to meet IRS requirements, such as the Notice and Consent provisions, could result in the death benefit becoming taxable income, which would directly affect your company’s bottom line.

By following the necessary steps for compliance, businesses can avoid the tax implications that come with improperly structured key man life policies, ensuring that the death benefit remains tax-free. This compliance not only protects the business from lost profits or lost revenue due to a key employee passing but also helps maintain the cash value and insurance coverage in the event of a tragedy. Staying compliant with these rules supports business continuity, allowing the business to continue operations smoothly and providing financial protection for the company and its employees.

Have You Set Up a Key Person Insurance Policy to Avoid Taxation?

Employer-owned life insurance policies, including key man policies issued after August 17, 2006, may have death benefits that are subject to income taxation if certain requirements are not met.

The Pension Protection Act of 2006, which includes the COLI Best Practices Act, provides provisions that can have widespread implications for key man and/or other types of employer-owned life insurance purchased after August 17, 2006. You need to understand the Notice and Consent requirements, as well as the Exceptions and Record-Keeping and Reporting requirements, and comply with the IRS so policy proceeds avoid needless taxation when paid out.

If you have a key man policy issued after August 17, 2006, and you have not been compliant, your best bet to avoid potential income taxation is to scrap your current policy and start over.

Frequently Asked Questions about Key Man Insurance Taxation

What is Key Man Insurance Taxation?

Key Man Insurance Taxation refers to the IRS rules that determine whether death benefits from employer-owned life insurance policies, such as those covering key employees, are subject to income tax. Under the Pension Protection Act of 2006 and IRC Section 101(j), if specific notice, consent, and reporting requirements are not met before issuing the policy, the death benefit may be taxed as income when paid to the employer. Proper setup and compliance are essential to ensure these proceeds remain generally tax-free.

What Must an Employer Do Before Issuing a Key Man Insurance Policy to Avoid Taxation of the Death Benefit?

The employer must meet Notice and Consent requirements, which include notifying the employee in writing before the policy is issued, obtaining written consent from the employee to be insured, and informing the employee that the employer will be the policy’s beneficiary.

What Are the Two Exceptions That Can Allow The Death Benefit of a Key Man Policy to Remain Tax-Free?

Exception 1 is if the insured was an employee within 12 months prior to death or was a director or highly compensated employee when the contract was issued. Exception 2 is if the death benefit is paid to a family member, other designated beneficiary, a trust, or estate, especially in relation to a buy-sell agreement.

¹ All of the above tax information is for information purposes only and is provided to explain the basic tax treatment of life insurance based on the Internal Revenue Code. Any individual or entity considering any life insurance policy should consult with their own CPA or tax/legal advisor who understands their particular tax circumstances and the rules governing their state. In no way is this information intended to be tax or legal advice.

¹ Historically, life insurance death benefits paid to a C corporation could increase the corporation’s exposure to the corporate alternative minimum tax. The corporate AMT was repealed for tax years after 2017, and the current corporate AMT enacted in 2022 generally applies only to corporations averaging over $1 billion in financial statement income. Most businesses are unaffected, but any C corporation should confirm its position with a tax advisor.