Recently a popular chef at a local restaurant died in a car accident and business began to fall off sharply. Were it not for key man life policy, which enabled the owners to use the death benefit to secure the services of another top-rated chef, the restaurant likely would have gone out of business.
What would happen if a key employee suddenly died? Do you have a plan in case of the sudden death of a key employee, whose loss would be catastrophic to your company’s profitability or survival? With the right insurance that is properly structured, your equity in the business can be enhanced, as the insurance provides financial protection, says Phil Ruggeri, Cetera investment executive at First State Bank.
“Key man insurance is suitable for businesses of all sizes, from small to large, but it is more important for small- or medium-sized businesses to have it because of their limited financial resources,” says Ruggeri. “Unlike a large company, small- and medium-sized businesses have less flexibility and fewer resources to cover the devastating loss of an employee.”
However, the IRS rules and requirements surrounding key man insurance make it a dangerous area to tread alone. You should work with a qualified tax and insurance professional to structure a program to suit your needs.
Smart Business spoke with Ruggeri about how key man life insurance can protect your business when managed correctly.
How does key man life insurance work?
Key man life insurance is company-owned life insurance (COLI) on an employee who provides a significant contribution to the success of the business. This creates an insurable interest and a company, as the beneficiary of the policy, is able to acquire a life insurance policy in which both term and permanent policies can be used. In addition, companies can use COLI to offset the cost of providing employee benefits and retirement benefits.
What should employers consider when purchasing COLI?
There are two important concerns — the tax deductibility of the annual premium and the tax treatment of the death benefit. As an employer, you need to make sure you follow IRS guidelines to get the maximum tax benefit from key man life insurance.
Generally, the death benefit of a life insurance policy is tax free when the premium is paid with after-tax dollars, although premiums are not deductible. However, under COLI, the deductibility of annual life insurance premiums depends on the purpose of the life insurance. Current tax laws are unclear on this, especially relating to COLI for the purpose of a buy/sell agreement that is funded with life insurance, split dollar arrangements and instances in which a part of the death benefit is not paid to the company. Consult with a qualified tax professional to determine the tax deductibility of COLI premiums.
How can employers plan for favorable tax treatment of a death benefit?
Before obtaining the policy, the board of directors must authorize the purchase and record it in the board minutes, and the employee to be covered must be notified in writing and give written consent and acknowledge that the employer is the sole beneficiary of all death benefit proceeds. It is very important that this be done before the policy is issued. If written notice and consent are given after the policy is issued, the death benefit of the life insurance policy will be taxable. To satisfy the notification requirements, the insurance industry has created a standard IRS-approved form called a ‘Notice and Acknowledgement of Consent to Life Insurance’ that can be provided to the employee at the time of the application for key man COLI. In addition, other IRS conditions and restrictions may apply.
If you fail to meet IRS guidelines, this will limit the amount of death proceeds the company as beneficiary can receive income tax free. For COLI issued after Aug. 17, 2006, the company only can exclude from income the amount not exceeding the total of premiums and other amounts paid on the policy up to that point. Any excess death benefits received over those amounts must be reported, and taxed, as gross income.
In addition, the IRS requires that a company file Form 8925 (Report of Employer-Owned Life Insurance Contracts). This form requires information including the number of employees at year end, the number of employees who are under a COLI arrangement, the total amount of insurance in force and a sworn statement certifying that employee consent and acknowledgement were properly obtained.
In what other ways can COLI help a business?
Many companies view COLI as a financial arrangement in which they can be reimbursed for employee benefit expenses. It is not uncommon for a company to secure COLI on key employees, pay premiums on the policy — even after termination of employment — and receive the death benefit after the death of the insured.
A company could also structure a retirement benefits package for a key employee and fund it with COLI. Upon the death of the insured, the company receives the death benefit to offset the cost of retirement benefits it has paid to the employee. For example, this arrangement may help a smaller company attract talented employees by promising to make a life payment of $10,000 per month in retirement payments for five years after normal retirement age and the company will then be reimbursed through the COLI when the employee dies.
As a business owner, CFO or board member, you have a responsibility to your company to make sure that your business risk is minimized, and COLI may help you accomplish that.
Insurance products are offered by licensed agents of Cetera Investment Services, located at First State Bank. Consult your legal or tax counsel for advice and information concerning your particular circumstances. Neither Cetera Investment Services nor any of its representatives can provide legal or tax advice. Securities and Insurance Products are Not a Deposit — Not FDIC Insured – Not Insured by Any Federal Government Agency — Not Bank Guaranteed — May Lose Value.
Phil Ruggeri is an investment executive. Reach him at (586) 445-4769 or [email protected].
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