The short answer
Key person coverage is life insurance, and sometimes disability coverage, that a business owns on someone it could not easily replace, so the business has money to get through the loss. Buy-sell funding is coverage that gives the remaining owners, or the business, the money to buy a departing owner’s share at a price agreed in advance, so the family is paid and the business stays with the people running it.
For a business with partners or a few indispensable people, a death or a long illness brings two crises at once: a personal loss, and a business that suddenly has a hole in it. Customers worry, lenders ask questions, and the owner’s family may find they have inherited part of a company they never planned to run.
Two pieces of planning address most of this. Neither is complicated, but both need to be set up before they are needed.
Key person coverage
Who counts as a key person
A key person is anyone whose absence would cost the business real money. Often it is the founder whose relationships bring in most of the work. It can also be the licensed professional the business depends on, such as the physician in a medical practice, the dentist in a dental office or the licensed contractor on a building firm’s permits. It can be the partner who personally guarantees the business’s loans, or the one employee who knows how everything works.
How it is set up
The business applies for the policy, owns it, pays the premiums and is the beneficiary. If the key person dies, the death benefit goes to the business, which can use it however it needs: to recruit and train a replacement, cover lost profit while it recovers, reassure lenders or pay down debt.
| Question | Key person coverage |
|---|---|
| Who owns the policy | The business |
| Who pays the premiums | The business |
| Who receives the benefit | The business |
| Whose life is insured | The key person, with their written consent |
The tax details matter. Premiums are generally not deductible. Federal rules for employer-owned life insurance also require that, before the policy is issued, the employee is told in writing about the coverage and agrees to it in writing, among other conditions. If those conditions are not met, much of the death benefit can become taxable income to the business. Businesses that own these policies also report them to the IRS each year. Your tax professional should confirm how the rules apply to you.
How much coverage
There is no single formula. Common ways to size it include:
- What it would cost to find, hire and train a replacement
- The profit the business could lose while it recovers
- Loans the person guarantees, or that a lender requires coverage for
- What the business would need to keep customers and staff confident
Insurers also look at the person’s value to the business when deciding how much they will issue, so the figure needs to be one you can explain.
Do not forget disability
A long illness or injury can hurt a business as much as a death. Key person disability coverage pays the business if a key person cannot work. Business overhead expense coverage pays fixed costs, such as rent and salaries, while the owner recovers. Read more about income protection.
Buy-sell agreements and how to fund them
A buy-sell agreement is a contract among the owners, drafted by an attorney, that says what happens to an owner’s share if they die, become disabled, retire or leave. It sets who buys the share, at what price or by what formula, and how the purchase is paid for.
Without one, the surviving owners may find themselves in business with a spouse or an estate, and the family may hold a share they cannot sell at a fair price. With one, everyone knows in advance what will happen. Insurance is how the agreement is paid for: without funding, the promise to buy can be one the buyers cannot keep.
Two common structures
| Cross-purchase | Entity redemption | |
|---|---|---|
| Who owns the policies | Each owner owns a policy on each of the others | The business owns one policy on each owner |
| Number of policies | Grows quickly: four owners need twelve | One per owner |
| Who buys the share | The surviving owners | The business |
| Worth knowing | Premiums can be uneven when owners differ in age or health | Simpler to run with several owners |
The two structures can be taxed quite differently, for the business and for the surviving owners. Choose with your attorney and your tax professional, who know your entity type and your plans.
Setting the price
The agreement can fix a price, set a formula, or call for an appraisal at the time of the sale. Whichever you choose, review it regularly. A price agreed years ago and never updated can leave the family underpaid, or leave the buyers owing far more than the insurance pays.
Choosing the coverage
Term coverage is often used to fund a buy-sell agreement for a defined period, at the lowest cost. Permanent coverage can fit when the agreement is meant to last for the owners’ lifetimes, or when its cash value is meant to help fund a buyout when an owner retires. Disability buy-out coverage funds a purchase if an owner becomes permanently unable to work.
Two partners each own half of a made-up business valued at $2,000,000 in their buy-sell agreement. They choose a cross-purchase structure.
- Value of the business, as agreed
- $2,000,000
- Each partner’s half
- $1,000,000
- Coverage each partner owns on the other
- $1,000,000
If one partner dies, the other receives $1,000,000, pays it to the family for the half share, and owns the business outright. The family receives money rather than half of a business.
Now suppose the business grows and the agreed value is updated to $3,000,000, but the coverage is not. The surviving partner would owe $1,500,000 with only $1,000,000 of insurance, and would need to find the rest.
Made-up, rounded figures to show the method. Not a quote, an illustration of any policy, a prediction, or anyone’s real situation.
Your own family still needs a plan
Business coverage protects the business. Your family needs its own protection, sized to your household, not to the company. The free Life Insurance Needs Calculator gives you a first estimate in about a minute, and our guide to how much life insurance you actually need explains the method. If part of your wealth is the business itself, it is also worth reviewing your beneficiary designations and estate plan with your attorney; see legacy and estate planning.
Business owners also use life insurance in other ways, such as executive bonus plans to reward key employees. These are covered in our overview of planning for business owners.
Where to start
A short checklist for your next partners’ meeting:
- List the people the business could not easily replace.
- Find your buy-sell agreement, if you have one, and note when it was last updated.
- Check that the price or formula still reflects what the business is worth.
- Compare the coverage in place with what the agreement would require today.
- Book time with your attorney and your tax professional to confirm the structure.
Opulence LD works alongside your attorney and tax professional. It does not draft agreements or give legal or tax advice. If you would like help sizing and comparing coverage, a free strategy session is a good first step.
