Spokane Journal of Business

Using 'key employee' insurance to protect your business

Such a life policy can help sustain a company hit by unexpected loss of worker

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One way to use life insurance in the business scene is in the area of "key employee" protection. It's a strategy under which an employer takes out a life insurance policy on a key employee so the business is protected financially, should something happen to that person.

Adding what are called "golden handcuffs," or agreeing to provide a portion of the life insurance policy proceeds to the employee's family if that employee dies, also can be a way to encourage a key employee to stay with the business.

For many employers, the office manager or billing person might be key to the survival of their business. Keeping up with the latest regulations and all of the paperwork can be a nightmare. For those reasons, it's worth considering insurance-related options to minimize turnover among valued employees and to help cover financial needs if one of them dies unexpectedly.

So how does it work? First know this: "Key person" and "golden handcuffs" refer in this context just to a way of using life insurance, not specific types of life insurance.

The policy can be set up as almost any common type of insurance, such as conventional term, whole life, or indexed universal life. Also, it doesn't matter how the person dies. In other words, this isn't just an accidental death policy. It's just basic life insurance, 24/7.

The employer is the applicant, owner, payer, and beneficiary of the life insurance policy on the key employee's life. It makes no difference whether the company is big or small. If the employee provides a significant value, and the business would be harmed if that person dies, then life insurance can make sense.

The premiums paid by the business aren't tax deductible, because the death benefit paid later on the employee's death is tax free. Occasionally I hear people object to this until I point out the following: If they were a farmer, what would they rather have a tax deduction on the seed, or no income tax on the crop after harvest? The harvest because it's so much larger, right? In this case, the premium is the seed, and death benefit, which hopefully is never paid out, is akin to the harvest.

As to the cost of the premium, and whether it is worth it, this really will depend on how essential the person is to a business. After all, while protecting your family might be more of a no-brainer, the need for business insurance is more closely examined. The saying goes, "If you don't have an employee worth insuring, you don't have a key employee."

However, if you go without the insurance, and try to save and self-insure, it could take years, time you might not have, and it likely would be impossible for your savings plus interest to ever come close to what the life insurance policy can pay out.

The main purpose of the key-person concept is to create tax-free cash for the employer at the employee's death. The employer can use this money to attract, hire, and train a replacement, or just to pay bills and stay in the black.

For this purpose, a simple term life insurance policy will do. If pure cost and cash flow is the main issue, term is the way to go, as everyone knows it's relatively cheap, depending on the age and health of the insured.

A healthy 45-year-old male might cost about $700 per year for a $500,000 death benefit for a 20-year term with a quality carrier. However, don't necessarily stop at cheap term insurance because there are many other advantages and this could be short sighted.

The employee might be thinking, "What's in it for me?" Other than getting a life insurance exam, which includes submitting to a blood and urine test, and providing a death benefit to the employer, the employee might not see value in it.

The earlier-mentioned "golden handcuffs" are one way to give the key employee something special, of value, that only they receive as a perk. This is not a group benefit. The employer can make a written arrangement with the key employee, stating that as long as they stay with the business, the employer will pay a certain amount or portion of the life insurance policy to the employee's family at their death. However, if the employee leaves, the perk is forfeited.

There is one important tax-advantage for the employer that should be re-emphasized: the tax-free death benefit. Rather than list the employee's beneficiaries outright on the policy, it may be better to have all of the death benefit proceeds come to the employer, income tax free, because the employer then can pay the employee's listed beneficiaries, per their agreement, and call it a tax-deductible expense.

While term life is cheap, it's limited. A cash value policy, such as whole life, or universal life, or indexed universal life, can take the golden handcuffs concept to a different level.

While we can't go into the nuances of various cash value policies, it's good to know that these policies can build significant cash value that grows on a tax-deferred basis.

Similar to the tax-free death benefit, the employer can access these cash values tax-free in future years and pay them out to the key employee as an added bonus and call it a tax-deductible expense.

Golden handcuffs come into play because that money is forfeited if the employee leaves. Also, if you find the right policy, the death benefit is transferrable, so if the key employee leaves and the employer finds a replacement, provided the new employee is insurable, the policy can remain intact, with all the cash value in place and the new employee can be renamed as the insured. In other words, you don't have to start over.

However, cash value policies, while they do have significant advantages, are more expensive and do require more cash flow. If paying for that type of policy seems like a financial stretch, maybe this isn't the best time to go with a cash value policy. Stick with term, but not just any term. Make sure it allows you to convert to a cash value policy at a later date without another medical exam and underwriting again. After all, no one has a lease on good health and things can change.

  • Todd Radwick

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