The loss of a key employee can be devastating for any business. A top salesperson, the CFO, director of marketing, or the owner who manages everything all can be invaluable to the successful continuation of a small business. The financial toll a business may have due to the loss of a key person will negatively impact the succession plans of the owner.

The obvious solution to the potential problem of losing a key employee is to use key employee life insurance. In spite of the attacks from Congress and the media on corporate-owned life insurance, the need for pure key employee protection still exists, and the outlook for its continued use in appropriate situations is favorable.

But a financial advisor must keep abreast of the potential changes to COLI and other business-owned life insurance, including the impact of both federal and state law.

Key Employee Life Insurance and Taxes

Key employee life insurance is simply a life insurance policyon the life of an employeethat is owned by a business with the business as the sole beneficiary. The business controls the cash value as well as all other contractual rights to the policy. The individual insured in most states must consent to the purchase but has no interest or rights in the policy.

Under current tax law the life insurance premium is not income tax deductible to the business when the business is “directly or indirectly a beneficiary” of the policy. The death benefit is income tax-free but subject to the corporate alternative minimum tax (AMT) calculation if owned by a C-corporation. Cash value also grows income tax deferred but its net growth in a given year (cash value increase less premiums paid for that year) also is potentially subject to the corporate AMT.

Potential Federal Income Tax Changes

Our industry associations have worked diligently with the Senate Finance Committee members last year and most recently in early 2004 to educate them on the appropriate uses of COLI and all other business-owned life insurance. It is likely that the Senate and House will reconsider the COLI and key employee life insurance question this year. At the time of this writing there is much optimism that final legislation ultimately will preserve the benefits of business-owned life insurance for key employees.

Most recently the Senate Finance Committee drafted and approved a new proposal that would allow business-owned life insurance on key employees as long as the employee receives advanced written notice of the coverage, has given written consent, and understands through an employer disclosure that the coverage may continue after employment ends. It appears that this latest proposal would disallow the income tax-free death benefit for any business-owned life insurance that insured a rank-and-file employee. While this proposal has been approved by the Senate Finance Committee, it is part of a much larger bill which still has not been before the full Senate.

Our industry associations should be applauded for their positive efforts working with congressional staff that should ultimately mean a favorable result for key employee life insurance.

Recent Changes At The State Level

Some states have gotten on the bandwagon to regulate more severely the uses of business-owned life insurance. Most recently, California passed a law effective Jan. 1, 2004, that effectively prohibits employer-owned life insurance on “non-exempt” employees. “Exempt” employees, however, are not subject to the new law. The California Labor Code defines “exempt” employees as executive, administrative and professional employees; anyone earning a monthly salary of no less than 2 times the state minimum wage for full-time employment; primarily engaged (greater than one-half work time) in the duties that meet this exemption; and exercise discretion and independent judgment in performing those duties. Generally most key employees will fall within this exemption.

Other states may follow Californias example and impose similar restrictions under their insurable interest statutes. It is always good practice for a financial advisor to keep state laws in mind whenever advising a client on the use of key employee insurance.

Key employee life insurance as a subset of “COLI” has been the brunt of a few attacks recently. But the value of this coverage is so critical to many small businesses that it is, and in all likelihood will continue to be, a viable way to provide financial protection for a business. Furthermore, it can be combined with other planning strategies to provide nonqualified benefits to the executive or stock redemption funding for the owners.

The versatility and value of key employee life insurance make it a strategy that should always be considered when discussing succession planning with business owners.

Debra S. Repya, J.D., CLU, ChFC, is director of advanced marketing for Securian Financial Network in St. Paul, Minn. Her e-mail address is debra.repya@securian.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 20, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.