Life insurance • Business owners
Key Person Insurance: How It Works, Tax Rules, and How Much to Buy
Key person insurance, sometimes called key man insurance, is a life insurance policy a business buys on an owner or employee whose death would seriously hurt the company. The business owns the policy, pays the premiums, and is the beneficiary, so the payout can cover lost profits, recruiting, or debts while the business recovers. To keep the death benefit tax-free, federal rules require written notice and consent before the policy is issued.
This guide explains how key person coverage works, what the money is used for, how businesses size it, and the tax rules to follow. It is general information, not tax or legal advice; work with your CPA or attorney on your situation.
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How key person insurance works
| Role | Who it is |
|---|---|
| Insured | The owner, founder, or employee the business depends on |
| Policy owner and payer | The business |
| Beneficiary | The business |
Businesses often insure a founder who brings in most of the revenue, a partner whose relationships drive sales, or a specialist who would be hard to replace. Key person disability insurance is a related option that pays the business if the key person can’t work because of illness or injury.
What the payout is used for
- Replacing lost revenue or profit while the business adjusts
- Recruiting, hiring, and training a replacement
- Paying off business loans or reassuring lenders and investors
- Giving owners time to sell or wind down the business in an orderly way
Key person coverage is different from a buy-sell arrangement, where policies fund the purchase of a departing owner’s share. See life insurance for business owners.
How much key person coverage to buy
There is no single formula. Businesses commonly look at:
- The key person’s share of revenue or profit, and how long it would take to replace it
- The cost to recruit and train a replacement
- Business debts the person guarantees or that lenders tie to them
- Any amount a lender or investor requires
Insurers also limit coverage to what they consider financially justified, so expect to document the person’s value to the business. Term life is common for a defined need such as a loan; permanent life can make sense for a longer-term need.
Tax rules: notice, consent, and Form 8925
Employer-owned life insurance has special federal tax rules under 26 U.S.C. § 101(j):
- Notice and consent before issue. Before the policy is issued, the business must notify the employee in writing that it plans to insure their life and the maximum face amount, get their written consent, and tell them the business will be the beneficiary and that coverage may continue after they leave.
- An exception must apply. The insured must, for example, have been an employee within 12 months before death, or have been a director or highly compensated employee when the policy was issued, or the proceeds must go to the insured’s family or be used to buy their ownership interest.
- If the rules aren’t met, the death benefit above the premiums paid can be taxable to the business.
- Annual reporting. Businesses with employer-owned policies generally file IRS: Form 8925 with their tax return.
- Premiums. Premiums are generally not deductible when the business is the beneficiary (26 U.S.C. § 264(a)(1)).
Sources: 26 U.S.C. § 101(j); Plante Moran: 101(j) notice and consent; IRS: Form 8925. This is general information; confirm with your tax adviser.
How to set up key person insurance
- Identify the key people and estimate the financial impact of losing each one.
- Complete notice and consent in writing before the policy is issued.
- Choose term or permanent coverage and an amount you can justify to the insurer.
- Apply with the business as owner and beneficiary; the insured usually completes a medical exam or health questions.
- Keep records and file Form 8925 each year, and review coverage when the business changes.
Key person insurance FAQs
What is key person insurance?
Life insurance a business buys on an owner or employee it depends on. The business owns the policy, pays the premiums, and receives the payout.
Is key person insurance tax-deductible?
Premiums are generally not deductible when the business is the beneficiary, but the death benefit can be received tax-free if federal notice-and-consent rules and an exception are met.
What is the 101(j) notice and consent requirement?
Before the policy is issued, the employee must be told in writing about the coverage and the maximum amount, consent in writing, and be told the business is the beneficiary and coverage may continue after they leave.
How much key person insurance do I need?
It depends on the person’s contribution to profits, replacement cost, and business debts. Insurers limit coverage to an amount they consider financially justified.
Is key person insurance the same as buy-sell insurance?
No. Key person coverage pays the business for the loss of a person; buy-sell coverage funds the purchase of a departing owner’s share.
Related guides
Important information
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Tax information. Tax rules summarized here are general information as of November 2026, not tax or legal advice. Confirm how they apply to your business with a CPA or attorney.
Availability. Coverage, prices, discounts, and eligibility vary by insurer, state, and applicant, and are subject to underwriting. The issued policy controls.
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