Overview
Family businesses often concentrate decision-making, client relationships, or technical know-how in one or a few people. That concentration creates two related risks: an operational shock if a key individual dies or becomes disabled, and an ownership dispute or liquidity problem if a family owner’s equity must be transferred on short notice. Key person insurance and buy-sell insurance are complementary risk-management tools that convert those risks into financial solutions.
Below I combine practical steps I use with clients and clear guidance on legal and tax considerations so you can evaluate whether and how to implement these protections in your family business.
How each policy type works (simple)
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Key person insurance: The business buys a life (or disability) policy on an essential person, pays the premiums, and is the beneficiary. If the insured dies (or becomes disabled, for disability policies), the business receives a lump sum to replace lost revenue, hire interim leadership, service debt, or cover recruitment and retention incentives.
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Buy-sell insurance: The business owners enter a documented buy-sell agreement that defines triggers (death, disability, retirement, divorce, bankruptcy) and the buyout method (fixed price, formula, appraisal). Life insurance policies are commonly used to fund the buyout so cash is available immediately to purchase the departing owner’s interest under the agreed terms.
For practical examples of buy-sell agreement structures and funding choices, see FinHelp’s guide on Understanding a Buy-Sell Agreement.
(Internal link: Understanding a Buy-Sell Agreement: https://finhelp.io/glossary/understanding-a-buy-sell-agreement/)
Common buy-sell structures
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Cross-purchase: Owners buy policies on one another and directly purchase the deceased owner’s shares. Works best for a small number of owners and when owners prefer personal ownership of the insurance.
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Entity-purchase (redemption): The business owns a policy on each owner and the company redeems the deceased owner’s shares. Simpler to administer when many owners exist.
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Hybrid: Mix of the two; may be used in family groups with related individual and corporate ownership.
Each structure has different tax consequences and administrative complexity—your attorney and tax advisor should sign off on the final design.
Who needs which coverage?
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Key person insurance is appropriate when an individual’s loss would: materially reduce revenue, impair customer relationships, damage credit lines, or create regulatory/operational gaps (for example, a physician in a small practice).
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Buy-sell insurance is essential when ownership interests might transfer to heirs who are not involved in operations, when owners want a guaranteed price mechanism, or when owners need funding to acquire shares quickly to maintain control.
If the same person is both a major revenue driver and an owner, consider both protections.
How to size coverage: practical rules of thumb
While every business is unique, here are conservative starting points I use:
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Key person life coverage: 2–5 years of the annual profit contribution plus immediate cash needs (debt service, payroll, temporary management costs). Example: If the key person drives $400,000 of gross profit annually, consider $800,000–$2,000,000 depending on replacement timeline and indirect costs.
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Buy-sell coverage: Set the buyout amount per the buy-sell agreement (pre-agreed fixed price, formula tied to EBITDA/multiple, or appraisal-based). Fund the full agreed value for the largest ownership shares so liquidity is available at the trigger event.
Valuation methods used in agreements include fixed-price, book-value, formula (e.g., X times trailing EBITDA), or periodic appraisal. Fixed-price is simple but must be reviewed regularly to avoid outdated values.
Tax and accounting considerations (high-level, 2025)
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Premiums: In general, premiums for business-owned life insurance (BOLI) are not deductible as a business expense. There are exceptions for certain group life benefits for employees—consult your CPA. (IRS guidance on life insurance taxation: irs.gov.)
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Death benefits: Life insurance death proceeds are generally excluded from gross income under IRC §101(a) when paid due to the insured’s death. However, exceptions (transfer-for-value, interest, etc.) and basis rules can change tax results. Always verify with your tax advisor. (See IRS publications on life insurance taxation.)
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Buy-sell funding structure can affect basis and step-up: how the proceeds are used and who owns the policy affects estate tax planning and basis for the purchaser. Work with an estate attorney and tax professional to coordinate insurance with estate plans.
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Disability buyouts: Disability buyout insurance is typically structured differently and may have different tax treatment. Premium deductibility and benefit taxation depend on whether premiums were deductible or whether benefits are considered income—get specialist advice before implementation.
The above is a summary and not tax advice—consult a CPA or tax attorney for your situation.
Practical implementation steps (checklist)
- Identify key people and ownership stakes. Rank the business impact if each person leaves unexpectedly.
- Draft a buy-sell agreement (attorney-drafted) that specifies triggers, valuation method, funding method, and dispute resolution.
- Choose funding: life insurance policies (term or permanent), disability buyout insurance, escrow, or company lines of credit. Insurance is often the fastest source of cash at death.
- Select the agreement structure: cross-purchase, entity purchase, or hybrid—document ownership of the policies according to that structure.
- Determine coverage amounts and get quotes from multiple insurers; term life is inexpensive for pure death protection; permanent policies have higher costs but can help long-term planning.
- Review beneficiary designations, policy ownership, and change-of-control clauses to prevent unintended outcomes.
- Obtain medical underwriting early—insurability can fail later and break plans if an owner develops a serious condition.
- Integrate the buy-sell with the estate plan and update wills and trusts so that the intended liquidity and control outcomes match family goals.
- Schedule formal reviews every 2–4 years or when ownership, profitability, or personal circumstances change.
Real-world scenarios and lessons learned
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Scenario A — The small retail firm: Owners adopted an entity-purchase funded by company-owned life insurance. When one owner died, the company used the policy death benefit to redeem shares, avoiding family conflict and keeping operations stable.
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Scenario B — The specialist practice: The practice bought key person insurance on its lead physician to protect cash flow while recruiting and to pay deferred compensation and buyout obligations if needed.
Lessons: (1) Without documented agreements, families often face drawn-out valuation fights; (2) Underinsurance is common—regular valuation reviews prevent shortfalls; (3) Buy-sell agreements that lack clear funding create risks despite good legal language.
Common mistakes to avoid
- Not having a buy-sell agreement at all.
- Funding a buy-sell with insufficient or improperly owned policies (ownership and beneficiary mistakes are frequent).
- Choosing a valuation method and never updating it—fixed prices grow stale.
- Treating insurance premiums as trivial without coordinating tax and accounting impacts.
Questions to ask your advisors
- Who will own each policy, and who is the beneficiary?
- What triggers will force a buyout, and how is disability defined and certified?
- How often will valuations be refreshed or the buy-sell reviewed?
- What is the impact of an owner’s divorce, bankruptcy, or change in estate plan on the buy-sell?
- Are there estate tax consequences we need to plan for?
Where to read more (authoritative sources)
- IRS — guidance on life insurance taxation and taxability of policy proceeds: https://www.irs.gov
- U.S. Small Business Administration — guidance on business succession planning and buy-sell agreements: https://www.sba.gov
- Consumer Financial Protection Bureau — consumer protection and business finance guidance: https://www.consumerfinance.gov
And for practical implementation of key person coverage, see FinHelp’s glossary entry on Key Person Insurance.
(Internal link: Key Person Insurance: https://finhelp.io/glossary/key-person-insurance/)
For integrated succession planning, see our Business Succession Planning resources at FinHelp.
(Internal link: Business Succession Planning: https://finhelp.io/glossary/business-succession-planning/)
Final considerations and professional disclaimer
Key person and buy-sell insurance are powerful tools to protect family business continuity and preserve value for both the operating owners and heirs. In my 15 years advising family businesses, I’ve seen well-funded, legally consistent plans prevent destructive disputes and provide breathing room during transitions.
This article is educational and summarizes common practice as of 2025. It is not legal or tax advice. Before implementing insurance or drafting buy-sell agreements, consult a qualified attorney, estate planner, and tax professional to tailor a solution to your family’s financial, legal, and interpersonal context.