Overview

Key-person and buy-sell insurance are complementary risk-management strategies that convert an illiquid, operational risk into predictable liquidity. Used correctly, these policies preserve business continuity, protect equity value for remaining owners, and give management time to recruit, train, or reorganize. In my practice advising closely held companies, policies paired with written agreements have repeatedly prevented emergency sales and family disputes after unexpected events.

Why these tools matter

  • Liquidity: Insurance proceeds provide cash quickly so the business can pay for recruitment, bridge loans, debt service, or to buy out heirs without selling productive assets.
  • Value preservation: Prearranged buyouts (funded with life insurance) stop ownership stakes from passing to uninterested heirs or outside parties who may demand liquidation.
  • Credibility for lenders and partners: A documented continuation plan can maintain bank and vendor confidence after a shock.

Authoritative context: life insurance proceeds are generally excluded from gross income under IRC §101 and IRS guidance (see IRS Topic No. 552) when received because of the insured’s death; consult a tax advisor for exceptions such as transfer-for-value rules (irs.gov/taxtopics/tc552).

How each policy works (simple breakdown)

Key-person insurance (business-owned policy)

  • Purpose: Compensate the business for measurable losses resulting from the death, disability, or extended departure of an employee whose absence would cause material harm.
  • Typical coverages: Term life (most common for short-term risk), or permanent policies if there’s long-term replacement or executive compensation planning needs.
  • Who owns and pays premiums: Usually the business owns the policy, pays premiums, and is the beneficiary.
  • Typical uses of proceeds: Replace lost revenue, pay recruiting and training costs, cover debt payments, or buy temporary management support.

Tax note: Premiums for key-person life insurance generally are not deductible as a business expense, and death benefits received by the business are usually income tax–free, per IRS guidance (irs.gov). Always confirm current tax treatment with your CPA.

Buy-sell insurance (funding the agreement)

  • Purpose: Provide cash to effect a planned transfer of ownership when an owner dies, becomes disabled, or leaves under defined circumstances.

  • Common structures:

  • Cross-purchase: Co-owners buy policies on each other; surviving owners purchase the deceased owner’s shares.

  • Entity purchase (redemption): The business owns policies on each owner and redeems the deceased owner’s shares.

  • Hybrid (wait-and-see): Combines features and lets parties decide who buys when the event happens.

  • Who typically owns policies and who benefits affects tax and estate outcomes; drafting choices should involve legal and tax counsel.

Legal/tax tip: If the business owns the policy and is the beneficiary (redemption), proceeds received by the company are generally tax-free under IRC §101 but will affect the deceased owner’s estate value; consult your attorney and tax advisor about basis adjustments and estate tax implications.

Example scenarios (realistic, practical)

  • Small manufacturing firm: A lead engineer with unique process knowledge dies unexpectedly. The company had a $750,000 key-person term policy. The proceeds funded contract engineers and an expedited hiring process, preventing a major client from walking.

  • Medical partnership: Three partners used an entity-purchase buy-sell; the practice owned life policies on each partner. When one partner died, the practice used policy proceeds to buy the deceased partner’s share and paid the estate — avoiding a disruptive sale of equipment or a forced change in practice management.

In my experience, buy-sell funding with life insurance prevents musicianship-level disputes in family businesses and provides survivors with a clear, cash-settled transaction rather than a complicated, contested estate transfer.

How to estimate coverage amounts

  • Key-person insurance: Quantify direct and indirect losses — lost profits attributable to the person, cost to recruit/train a replacement, increased borrowing costs, and a reasonable transition period. A common method: multiple of the key person’s salary (often 3–10x) plus an estimate of lost profits and replacement costs.

  • Buy-sell insurance: The policy amount should match the agreed buyout price in the signed buy-sell agreement. If the agreement uses a formula (Earnings × multiple, appraised value, or percentage of equity), insure for that figure and revisit it after major business changes.

Sample calculation (buy-sell): If a partner’s share is contractually 25% and the business valuation formula sets the company at $2,000,000, the buyout is $500,000. Each co-owner or the entity needs policies that, collectively, provide $500,000 at the triggering event.

Steps to implement (practical checklist)

  1. Identify key roles and owners — create a short list of positions and people whose loss would materially harm the business.
  2. Choose the buy-sell structure (cross-purchase, entity purchase, or hybrid) with counsel.
  3. Draft or update a written buy-sell agreement that defines triggering events, valuation method, and funding mechanics.
  4. Determine coverage amounts using valuation data and replacement-cost calculations.
  5. Select policy types and insurers; compare term vs permanent based on timing and cash-flow considerations.
  6. Assign ownership and beneficiary designations consistent with the agreement.
  7. Periodically review (at least annually or after ownership changes) and adjust coverage and valuation clauses.

Common mistakes to avoid

  • No written agreement: Insurance without a signed buy-sell is a wasted asset; the agreement and the policy must align.
  • Wrong policy ownership or beneficiary designations: Misalignment can cause unexpected tax or estate complications.
  • Outdated valuation: Many buy-sell agreements specify formulas that become stale; update annually or after material growth/decline.
  • Failing to consider disability: Buyouts triggered only by death leave gaps when an owner is permanently disabled — consider disability buyout insurance.

Tax and legal considerations (brief, authoritative)

  • Tax treatment: Generally, life insurance death benefits are excluded from income under IRC §101; premiums are typically nondeductible for policies owned by the business (IRS Topic No. 552). Transfer-for-value exceptions and other rules can create taxable events.
  • Estate impact: Life insurance proceeds may affect the insured owner’s estate value depending on policy ownership — for example, policies owned by the insured may be includible in the estate; policies owned by an ILIT may avoid inclusion.
  • Valuation clauses and dispute resolution: An agreement should include a valuation method (formula, periodic appraisal, or independent valuation) and a dispute process to prevent litigation.

Citations: IRS Topic No. 552, “Life Insurance Proceeds” (https://www.irs.gov/taxtopics/tc552); consult Publication 544 and a qualified tax advisor for detailed tax planning.

Practical tips from practice

  • In my practice I recommend documenting the buy-sell first, then matching insurance to the contract. This order avoids mismatches between stated buyout amounts and available proceeds.
  • Consider term for short-term funding needs and guaranteed-universal or whole life if you require permanent funding combined with estate considerations.
  • Keep an ownership chart and beneficiary worksheet in your governance folder to avoid surprises at claim time.

Interlinks and further reading

Frequently asked questions (short answers)

Q: Who should pay premiums?
A: It depends on ownership structure and tax strategy. For key-person policies the business usually pays premiums; for cross-purchase buy-sell models, individual owners may pay premiums. Tax effects vary, so coordinate with a CPA.

Q: Can buy-sell insurance cover voluntary departures?
A: Yes, if the agreement lists voluntary termination as a triggering event. Many agreements include clauses for retirement, disability, death, or voluntary sale, but the funding mechanics and valuation must address each scenario.

Q: Are proceeds taxable?
A: Death benefits are generally income tax–free under IRC §101, but exceptions and estate inclusion rules can apply. Always confirm with a tax advisor.

Final checklist before you act

  • Have a written buy-sell agreement aligned with policy ownership.
  • Confirm the valuation method and schedule reviews (annually or after key events).
  • Coordinate policy ownership, beneficiary designations, and premium payment with legal and tax counsel.

Professional disclaimer: This article is educational and does not provide legal, tax, or investment advice. Discuss your specific situation with a licensed attorney, CPA, or insurance professional.

Authoritative sources and further reading: IRS Topic No. 552 — Life Insurance Proceeds (https://www.irs.gov/taxtopics/tc552); FinHelp articles linked above for applied buy-sell drafting and owner-risk planning.