Key person insurance
Example: The XYZ Corporation wishes to protect itself against the financial consequences associated with the death of J, a shareholder/employee. The corporation estimates what it will cost to replace J's contribution to the company, and insures J's life for that amount.
Key Person Insurance provides tax-free dollars to replace the loss of a valuable asset — J's management skills and experience. Cash value accumulations may be used for any business purpose.
Tax treatment
- Key person insurance premiums are not deductible.
- Death proceeds are received by the employer tax free, except for the alternative minimum tax.
- If the employee dies, death benefits paid to the surviving family would be taxed as ordinary income.
- Benefits paid by the employer to the employee's family upon death are deductible by the employer.
- Proceeds from a properly arranged key person policy would not be includable in the insured's estate. However, if the insured owns the business, the death proceeds may increase the estate tax value of the business interest.
- Post-retirement benefits paid by the employer to the employee are deductible by the employer.
- There is no transfer-for-value problem if the insured/employee leaves the company and buys the policy from the employer.
The tax-free surplus created by a key person plan may be used to fund a stock redemption plan at death, disability or retirement, as well as to informally fund a deferred compensation arrangement.
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