Key person insurance is generally not tax deductible. A business that owns a life insurance policy on an owner or essential employee, and stands to collect the death benefit, pays the premiums with after-tax dollars. In exchange, the payout usually comes in free of income tax, which is often the more valuable half of the deal.
That tax-free payout depends on paperwork many small companies never hear about. Below is how the tax rules work, who should own the policy, what can go wrong, and how key person coverage fits with the rest of an owner’s plan.
Why Key Person Insurance Is Not Tax Deductible
Federal tax law blocks the deduction whenever the business paying for a policy is directly or indirectly a beneficiary of it.
The reason for the coverage does not change that result. The premiums stay nondeductible even when the policy protects the company’s revenue, and even when a bank requires the policy as collateral for a loan. On a permanent policy, the cash value shows up as a company asset on the balance sheet.
How Is a Key Person Life Insurance Policy Taxed
The death benefit is generally free of federal income tax when the business receives it, provided the company met the federal rules for policies employers own on their workers.
Those rules come from a 2006 law. For a policy the business owns on an employee, federal law caps the tax-free amount at the premiums the company paid, unless two conditions hold:
- An exception applies. The insured was an employee at some point in the 12 months before death, or was a director or highly compensated employee when the insurer issued the policy. A separate exception covers proceeds paid to the insured’s family, estate, or trust, or used to buy the insured’s ownership interest from them.
- Notice and consent came first. Before the insurer issues the policy, the company must tell the employee in writing that it intends to insure him or her, for how much, and that the company will be a beneficiary. The employee must also consent in writing, including to coverage continuing after leaving the job.
IRS Notice 2009-48 fills in the details, and a few of them catch owners off guard:
- An owner-employee of a wholly owned corporation still needs written notice and consent. Knowing about the policy does not count.
- The consent works only if the insurer issues the policy within one year of signing and before the employee leaves.
- A company can fix an honest miss only by the tax return due date for the year the insurer issued the policy, and never after the insured has died.
- The company must file Form 8925 every year it owns these policies.
The cost of a miss adds up quickly. Say a company collects a $1,000,000 death benefit after paying $60,000 in premiums, with no valid consent on file. Only the $60,000 comes in tax-free, leaving $940,000 taxable. For a C corporation at the flat 21% federal rate, that is $197,400 of tax on money meant to steady the business.
The death benefit also adds to what the company is worth. That matters when the insured owner’s shares pass through an estate large enough to owe estate tax. In the Connelly case the Supreme Court decided in 2024, the estate conceded that $500,000 of company-owned coverage above the buyout amount counted toward the company’s value. Owners who want to keep buyout insurance out of the company often choose a cross-purchase buy-sell agreement instead.
Who Owns a Key Person Life Insurance Policy
The business does. It applies for the policy, pays the premiums, and names itself as the beneficiary, while the insured person holds no ownership rights.
Deciding who should own a given policy is a core part of life insurance planning, because ownership changes the tax result:
- Company-owned key person coverage. No premium deduction, a generally tax-free payout, and the employer-owned life insurance rules above.
- Employee-owned coverage through a bonus plan. The company deducts the bonus as pay, and the employee owns the policy and pays tax on the bonus. Our guide to Section 162 bonus plans walks through that structure.
- Owner-owned coverage in a buy-sell plan. According to the IRS, a policy an owner holds personally to buy out another owner is not an employer-owned contract, so the notice and consent rules do not apply to it.
What Are the Disadvantages of Key Person Insurance
The main drawbacks are cost, the missing deduction, and compliance steps that are easy to miss.
- No deduction. Every premium comes from after-tax profit.
- Paperwork with real consequences. Missing consent can turn most of the payout into taxable income, and Form 8925 comes due every year.
- A higher company value. The death benefit raises what the business is worth, which can matter for an owner’s estate.
- Creditor exposure. Cash value in a company-owned policy belongs to the company, so business creditors can reach it.
- Coverage that goes stale. Key people change roles or leave. A material increase in the death benefit counts as a new policy and needs fresh consent.
- Price and underwriting. Premiums rise with the insured person’s age and health, and term coverage ends when the term does.
Is Key Person Insurance Worth It
For a company that would lose revenue, credit, or a pending sale if one person died, it usually earns its cost.
A few signs point toward coverage:
- Major customer relationships run through one person.
- A lender or investor requires the coverage.
- Your business succession planning depends on that person staying in place until an exit.
- Replacing the person would take a long search and a long ramp-up.
Many companies size coverage by estimating the profit they would lose during a replacement period, plus the cost to recruit and train a successor. Term coverage fits a defined window, such as a loan term or the years before a planned sale. Permanent coverage fits a longer need or a plan that relies on cash value.
Frequently Asked Questions
What Type of Insurance Is Key Person Insurance
It is life insurance, either term or permanent, that a business owns on someone whose death would hurt the company. Some businesses also buy key person disability coverage for the same people.
How Much Does Key Person Insurance Cost
Price depends on the insured person’s age and health, the coverage amount, and whether the policy is term or permanent. Quotes from several carriers give the clearest picture.
Are Life Insurance Premiums Deductible If I Am Self-Employed
No. Premiums on a policy covering your own life are a personal expense. The IRS also notes that a policy a sole proprietor owns on his or her own life is not an employer-owned contract.
Does the Business Owe Tax If It Cancels a Permanent Policy
It can. If the company surrenders a policy for more than it paid in premiums, the gain is taxable.
How We Coordinate Key Person Coverage at Global Investment Strategies
We have worked with Tucson business owners since 2009. Your attorney drafts the agreements, and your CPA files Form 8925 and handles the reporting. Our role is making sure the coverage matches the risk and the company meets the rules before anyone signs an application.
That means comparing policies across carriers, getting the notice and consent forms in place before issue, tracking coverage amounts as roles change, and lining key person coverage up with your buy-sell agreement and estate plan.
Check Whether Your Key Person Coverage Still Fits
Policies bought to protect against losing one leader often outlast the plan that created them. A quick review can confirm the consents, the coverage amount, and the fit with your exit timeline.
We work with business owners across Tucson, Oro Valley, Marana, and the Catalina Foothills. Request a private conversation and we will review your coverage alongside your attorney and CPA.
Global Investment Strategies provides educational planning concepts and works alongside your qualified legal, tax, and financial professionals. This article is educational and is not individualized tax, legal, or financial advice. Tax rules described here reflect federal law as of September 2026 and change over time. Review any insurance or tax decision with your attorney and CPA before acting.
