By Harry Prabandham · Updated September 28, 2026
Personal Finance
Key Person Insurance: How It Works, Sizing, and Tax Treatment
Key person insurance is a policy a business owns on an essential person. Premiums aren't deductible, and IRS notice rules decide if proceeds are tax-free.
Key Person Insurance: How It Works, Sizing, and Tax Treatment
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What is key person insurance?
- It's a life or disability policy a business buys on someone whose loss would cause it financial harm, with the business as owner and beneficiary.
- Proceeds can fund recruiting, cover lost revenue, repay debt, or pay for an orderly transition.
- It differs from buy-sell funding, where policies pay for a departing owner's shares, though coverage can be designed to serve both purposes.
- It doesn't replace the person; it provides cash while the business adapts.
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Full Guide
What is key person insurance?
- It's a life or disability policy a business buys on someone whose loss would cause it financial harm, with the business as owner and beneficiary.
- Proceeds can fund recruiting, cover lost revenue, repay debt, or pay for an orderly transition.
- It differs from buy-sell funding, where policies pay for a departing owner's shares, though coverage can be designed to serve both purposes.
- It doesn't replace the person; it provides cash while the business adapts.
Which businesses consider it?
- Businesses where one or two people drive revenue, client relationships, or technical know-how.
- Startups and small companies, where lenders or investors sometimes require coverage as a condition of financing.
- Professional firms where clients follow individual practitioners rather than the firm.
How is the coverage amount set?
- Common approaches weigh the person's contribution to profits, the cost to recruit and train a replacement, and debts tied to their involvement.
- Insurers apply their own financial underwriting limits based on the business's finances and the person's compensation.
- How long the disruption would last shapes both the amount and the policy term.
Should the policy be term or permanent?
- Term life is usually simpler and cheaper, matched to the period when the person is hardest to replace.
- Permanent life builds cash value that appears on the balance sheet, at a higher premium.
- Permanent coverage is more often used when the policy also funds a buy-sell agreement or executive benefit.
How is key person insurance taxed?
- Premiums aren't deductible when the business is directly or indirectly a beneficiary of the policy.
- For employer-owned policies issued after August 17, 2006, proceeds above premiums paid are taxable unless the notice-and-consent requirements are met and an exception applies.
- The employee must get written notice and consent in writing before the policy is issued.
- The business must file Form 8925 for each year it owns such policies, and a CPA can confirm the full tax treatment.
When should coverage be reviewed?
- Review annually, since the people most critical to the business change over time.
- If the insured leaves or moves to a less critical role, the policy may no longer serve its purpose.
- New financing, acquisitions, or growth can create new key person exposures.
Key takeaways
- Key person coverage gives a business cash when losing an essential person would hurt it financially.
- Size it from lost profits, replacement cost, and debts tied to the person.
- Premiums aren't deductible, and proceeds are tax-free only if the Section 101(j) rules are met.
- Revisit coverage as the business and its team change.
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