Key Person Life Insurance: How It Works, What It Costs and the IRS Rules

Key person life insurance is a policy a business buys on someone whose death would cost the company money: a founder, a top salesperson, the engineer who holds the client relationships. The business owns the policy, pays the premiums and receives the death benefit. That cash can cover lost profit, recruiting or a loan payoff. This guide explains who should own and benefit, three ways to value a key person, the IRS notice-and-consent rule that can make the payout taxable if it is missed, Form 8925, and the SBA loan life insurance requirement.

This page is general information, not tax or legal advice. Ask your CPA and business attorney to review any arrangement before you sign.

What is key person life insurance?

Key person life insurance is ordinary individual life insurance with a business as the owner and beneficiary. Nothing about the policy form is special. What makes it “key person” coverage is the purpose: protecting the company, not the insured’s family. You may also see it called key man insurance, which is the older name for the same idea.

The payout gives the business time and money after a loss. Common uses include:

• Replacing profit while sales or production recover.
• Paying a recruiter, a temporary executive or overlapping salaries during training.
• Reassuring a lender, investors or major customers that the company can carry on.
• Paying down business debt that the key person personally guaranteed.
• Funding part of a buyout of the person’s ownership stake, if they were an owner.

Key person life insurance is different from group life. A group life plan pays an employee’s family. Key person coverage pays the employer. Many businesses carry both, and they solve different problems. If you are building a wider benefits package, see our employee benefits guide.

Who owns, pays and benefits?

The structure is simple, and getting it right matters for taxes. In a standard key person life insurance arrangement, one entity fills three roles.

The insured person has no ownership rights. The policy is a business asset. That is the point: the business has the insurable interest, because it stands to lose money if the person dies. The NAIC explains that only someone with an insurable interest can buy insurance on your life, which generally means family or people with a financial stake.

Variations exist. A lender may take a collateral assignment, so it is paid first. A business may later transfer the policy to the employee when they retire. Each change has tax effects, so plan them with your adviser rather than improvising.

Who counts as a key person?

There is no legal list. A key person is anyone whose sudden absence would cut revenue, raise costs or put financing at risk. A quick test: if this person died tomorrow, would the business lose money it could not easily replace within a year?

People businesses often insure:

• Founders and owner-operators, especially in firms of one or two owners.
• Rainmakers who bring in a large share of revenue or hold key client relationships.
• Technical specialists with licenses, patents or know-how the business depends on.
• Executives who personally guarantee loans or leases.
• Managers in a small team where one departure stalls operations.

Be selective with key person life insurance. Insuring everyone with a title adds premium without adding real protection. Start with the one to three people whose loss would hurt most, and write down why. That memo also helps if the IRS or a lender later asks why the coverage exists.

Wholly owned businesses are not exempt from the paperwork. IRS Notice 2009-48 says written notice and consent are still required even when the insured is the sole owner of the corporation. Knowing about the policy is not enough.

How much key person life insurance? Three valuation methods

There is no single formula for key person life insurance. Underwriters want to see that the amount is tied to a real financial loss. Most owners and advisers use one or more of these methods and pick a figure they can explain.

Write the reasoning down. Insurers usually ask for financial details on large amounts, and a clear rationale helps the application move faster. It also helps you set the “maximum face amount” you must disclose under the IRS notice rule, explained below.

Insurers set their own limits on how much they will issue relative to income and business value. Those limits vary by carrier, which is one reason to compare several before you apply.

Hypothetical example: sizing coverage for a sales manager

Hypothetical example. A 14-person HVAC company in Worcester County depends on Dana, its sales manager. Dana earns $140,000 a year. Her accounts generate about $1,200,000 of revenue at a 25% gross margin. The owners estimate it would take two years to rebuild those accounts after her death. Here are the three methods side by side.

The methods range from $290,000 to $700,000. The owners settle on $600,000, the profit-based figure, because it reflects what the business would actually lose. They buy a 10-year term policy, because they expect to have a trained successor in place within that time.

Now the tax side. Suppose the company pays premiums for six years, totaling $9,000, and Dana then dies. If the §101(j) notice and consent were signed before issue and an exception applies, the $600,000 is generally excluded from income. If the consent was never signed, the exclusion is capped at the premiums paid. The company would include $600,000 − $9,000 = $591,000 in income. All figures here are made up for illustration.

Key person insurance cost: what drives the premium

Key person insurance cost is priced like any individual policy. The business is the buyer, but the insured’s age, health and habits drive the rate. The main factors are:

• Age and health of the insured, including tobacco use and medical history.
• Amount of coverage.
• Type and length: term for a set number of years, or permanent coverage that builds cash value.
• Underwriting path: fully underwritten with an exam, or a faster no-exam route for smaller amounts.
• Carrier: each insurer prices risk classes differently.

Term usually fits key person life insurance. The need is tied to a period, such as until a successor is trained, a loan is repaid or the owner plans to sell. A term life policy covers that period at the lowest premium per dollar of coverage. Many term policies can later be converted to permanent coverage, which our term conversion guide explains.

Permanent coverage can fit when the business wants the policy to last for the insured’s lifetime, or to fund a buyout at retirement as well as at death. It costs much more per dollar of coverage. We don’t publish sample key person insurance cost tables, because quotes depend on the insured’s health. Request real quotes before deciding.

The §101(j) notice-and-consent rule

This is the step many businesses miss when they buy key person life insurance. Life insurance proceeds are generally excluded from income under IRC §101(a)(1). But §101(j) limits that exclusion for “employer-owned life insurance contracts.” If no exception applies, the business can exclude only the premiums and other amounts it paid. The rest of the death benefit is taxable income.

An employer-owned contract is one owned by a business that is directly or indirectly a beneficiary, covering someone who was an employee when the policy was issued. The statute’s definition of employee includes officers, directors and highly compensated employees.

To keep the full exclusion, two things must be true. First, the notice and consent requirements in §101(j)(4) must be met before the policy is issued. Before issue, the employee must:

1. Be told in writing that the employer intends to insure their life, and the maximum face amount they could be insured for.
2. Consent in writing to being insured, and to coverage that may continue after they leave the job.
3. Be told in writing that the employer will be a beneficiary of the proceeds.

Second, an exception must apply. The two main groups are:

• Insured’s status. The insured was an employee at any time in the 12 months before death, or was a director or highly compensated employee or individual when the contract was issued.
• Payments to heirs. The proceeds are paid to the insured’s family, designated beneficiary, a trust for them or their estate, or are used to buy the insured’s ownership interest from those people.

IRS Notice 2009-48 adds practical detail:

• The maximum face amount can be stated in dollars or as a multiple of salary. Vague wording does not count.
• If total coverage later exceeds the amount disclosed, new notice and consent are needed.
• One consent can cover several policies on the same person, up to the disclosed maximum.
• The policy must be issued within one year after the consent is signed, and before the employee leaves.
• Electronic notice and consent are allowed if the system meets the Notice’s conditions.

What if it was missed? Notice 2009-48 says the IRS will not challenge the exception if the failure was inadvertent, the business made a good-faith effort, and it was discovered and corrected by the due date of the tax return for the year the contract was issued. It also says a missing consent cannot be corrected after the insured has died.

Form 8925: the yearly report

Most key person life insurance is employer-owned, so the reporting rule follows. Businesses that own employer-owned policies issued after August 17, 2006 have a filing duty. Under IRC §6039I, the policyholder attaches Form 8925, Report of Employer-Owned Life Insurance Contracts, to its income tax return each year. The IRS lists the current revision as September 2017.

According to Notice 2009-48, the form reports:

• The number of employees at the end of the year.
• The number of those employees insured under employer-owned contracts.
• The total amount of employer-owned insurance in force on them.
• The policyholder’s name, address, taxpayer ID and type of business.
• Whether the business has a valid consent for each insured employee, and if not, how many lack one.

Only the business that actually owns the policy files the form, even if related companies also count as “applicable policyholders.” Keep signed consents with your corporate records. Your tax preparer will need them each year, and the Notice requires an electronic system to be able to produce a paper copy on IRS request.

Policy changes can restart the clock. The Notice says a material increase in the death benefit, or another material change, makes the policy a new contract. A §1035 exchange with a material change is treated the same way. Get fresh consent first unless an existing valid consent already covers the new amount.

How key person life insurance is taxed

For a C or S corporation, partnership or LLC that owns key person life insurance, the general federal tax picture is:

IRS Publication 525 says the same in plain terms: an employer that owns a policy on an employee and is the beneficiary generally must include proceeds above the premiums it paid, unless the employee was notified and consented in writing and an exception applies.

Two smaller rules can matter. Under §264(e), interest on up to $50,000 of policy-related debt per key person (an officer or 20% owner) may escape the loan-interest disallowance, subject to a rate cap. And §264(f)(4)(A) exempts a policy covering one individual who was a 20% owner, officer, director or employee from a separate pro rata interest rule.

State taxes, entity type and ownership changes can all change the result. That is why your CPA should see the plan before the application goes in.

The SBA loan life insurance requirement

Many owners first hear about key person life insurance from a lender. The SBA’s lending rules are in SOP 50 10. Version 8.1, effective October 1, 2026, covers life insurance in Section A, Chapter 5.

The SBA loan life insurance requirement under that SOP works like this:

• Standard 7(a) loans. Lenders may follow their own policy for similar non-SBA loans. But if the loan is not fully secured, life insurance is required in the amount of the collateral shortfall for principals of sole proprietorships, single-member LLCs, or businesses otherwise dependent on one owner’s active participation.
• 7(a) Small Loans, SBA Express and Export Express. Lenders may follow their internal written policy for similar commercial loans.
• 504 loans. The CDC must assess whether the business depends on one person. When the loan is not fully collateralized, the required amount is the gap between the net debenture and the discounted collateral. The minimum term is 10 years for a 10-year debenture, or 20 years for a 20- or 25-year debenture.

Rules that apply to every required policy:

• A collateral assignment naming the lender (or the CDC/SBA for 504) as assignee, acknowledged by the insurer’s home office.
• The borrower pays the premiums.
• An existing policy may be pledged.
• Credit life or whole life insurance should not be required.
• If the principal is uninsurable, the lender needs written documentation of that from a licensed insurer.

A collateral assignment is not the same as naming the lender as beneficiary. Lender-required coverage and key person life insurance can be the same policy or separate ones. The lender is paid what it is owed, and the rest goes to the beneficiary you chose. Confirm the exact form with your lender, because it may have its own requirements on top of the SOP.

Key person life insurance: frequently asked questions

Is key man insurance the same as key person life insurance?

Yes. Key man insurance is the older name. Both mean a policy owned by a business, on a person whose death would cost it money, with the business as beneficiary.

Are key person premiums tax-deductible?

Generally no. IRC §264(a)(1) disallows a deduction for premiums when the business is directly or indirectly a beneficiary. Confirm your situation with a CPA.

Is a key person life insurance payout taxable to the business?

Generally not, if the §101(j) notice and consent were signed before the policy was issued and an exception applies. If not, only the premiums paid are excluded and the rest is income.

What happens to the policy if the key person leaves?

The business still owns it. It can keep it, surrender it, or transfer it, for example by selling it to the departing employee. The §101(j) consent covers coverage that continues after employment ends, but the 12-month employee exception may no longer apply. Ask your adviser before any transfer.

Can a business insure an owner who holds 100% of the shares?

Yes, but Notice 2009-48 says written notice and consent are still required. There is no exception for sole owners.

Does an SBA loan always require life insurance?

No. Under SOP 50 10 8.1 it depends on the program, whether the loan is fully secured, and whether the business depends on one owner. Lenders can also apply their own policies.

Is term or permanent better for key person coverage?

For key person life insurance, term fits most needs that end, such as training a successor or repaying a loan. Permanent coverage can make sense for lifetime needs or buyouts, at a much higher premium.

Get key person life insurance quotes from an independent agency

Octans Insurance is an independent life and health insurance agency based in Massachusetts. Our licensed agents compare key person life insurance across the 120+ carriers we work with, help you match the amount and term to your loan or succession plan, and coordinate with your lender’s assignment form. There is no fee for our help. Call (617) 935-9220. Your CPA and attorney should handle the consent documents and tax review.

Keep Reading: Related Guides

• Buy sell agreement life insurance
• Employee benefits
• Term life insurance
• Whole life insurance
• Survivorship life insurance

Important: Octans Insurance agents are licensed in the states in which they operate. Coverage availability and rates may vary by state. Premium examples, when provided, are illustrative samples from published sources, not quotes. Final rates are determined by the insurance carrier based on underwriting and applicable policy criteria. Policy terms, exclusions, limitations, riders, and availability vary by carrier and state.

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