Key Person Insurance for Maryland and DC Businesses: The Empty Chair No One Plans For
Every business has a chair that would be very hard to fill. The salesperson who carries the relationships. The operations lead who is the only one who understands how the whole thing actually runs. The founder whose name is the reason the bank says yes.
Most owners can name that person in about two seconds. Very few have done anything about what happens if the chair empties without warning.
Key person insurance is the thing you do about it. It is not complicated, but it is easy to get wrong in one specific way that turns a tax free payout into a taxable one, and that is worth reading before you buy anything.
Key takeaways
- The business owns the policy, pays the premium and is the beneficiary. The coverage protects the company, not the family.
- Premiums are not tax deductible when the business is the beneficiary. This surprises people every time.
- Death benefits are generally received free of income tax, but only if the notice and consent rules under Section 101(j) were satisfied before the policy was issued. Miss that step and the proceeds above premiums paid become taxable income to the business.
- Compliance is ongoing, not one and done. Businesses have had to report employer owned policies annually on Form 8925 since 2009.
- Key person coverage and a buy-sell agreement do different jobs. Most businesses with partners need both.
What key person insurance actually does
The structure is straightforward. The company applies for a life insurance policy on an individual whose loss would materially damage the business, pays the premium, and names itself as the beneficiary. If that person dies, the company receives the death benefit.
What the money buys is time. Time to recruit a genuine replacement instead of the first available candidate. Time to reassure a lender or an investor who is watching to see whether the business survives the loss. Time to keep paying people while revenue dips, because it usually does. And in a lot of cases, cash to repay a loan that was personally guaranteed or underwritten on the strength of that one person.
That last point catches owners out. Read your loan documents. Many commercial loan agreements contain a key person clause that allows the lender to call the loan or restrict further borrowing if a named individual leaves or dies. If you have one, the amount of coverage you need is not a matter of opinion.
Deciding who is a key person
The test is not seniority and it is not the org chart. It is a simple question: if this person did not come in tomorrow, and never came in again, what would actually break, and how long would it take to fix?
The people who usually qualify are the ones who hold relationships that would leave with them, who possess knowledge that has never been written down, whose name is attached to contracts or licences, or who personally guaranteed the debt. Sometimes that is the owner. Often it is not.
It is worth doing this exercise out loud with your leadership team, because the answers are rarely unanimous and the disagreement is informative.
How much coverage
Three approaches get used, and in practice we usually test all three and then talk about the range.
A multiple of compensation. Crude but fast, typically five to ten times. It is a starting point rather than an answer, because compensation is a poor proxy for contribution in a small business.
Contribution to profit. Estimate what share of gross profit is attributable to this person, then multiply by the number of years it would realistically take to replace that contribution. More defensible, and it forces a useful conversation.
Cost to replace. Recruiter fees, a signing premium over market, the ramp period before the new person is productive, and the revenue lost in the meantime. This is the number that tends to land with owners, because every component is something they can picture.
If there is a lender requirement, that sets a floor regardless of what the three methods produce.
The tax rules, including the one people miss
Premiums on key person coverage are not deductible. The business is the beneficiary, so the tax code treats the premium as a non deductible expense. There is no way to structure around this while keeping the company as beneficiary.
The death benefit is generally received free of income tax, which is the trade. But since the Pension Protection Act, that treatment is conditional.
For any employer owned policy issued or materially modified after August 17, 2006, Section 101(j) requires that before the policy is issued, the employee is notified in writing that the business intends to insure their life, told the maximum face amount, and gives written consent, including acknowledging that the coverage may continue after their employment ends.
If those steps were not completed before issue, the death benefit above the premiums paid is taxable income to the business. It cannot be fixed afterwards. The company discovers it at the worst possible moment, having lost a key person and now owing tax on the money meant to replace them.
There is an ongoing piece as well. Since 2009 businesses have been required to report employer owned life insurance contracts annually on Form 8925, filed with the income tax return, which asks specifically whether valid consent exists for each insured.
If you have policies that predate your current CFO or your current accountant, the paperwork is worth finding. We have reviewed accounts where nobody could locate a consent form and nobody had filed an 8925 in years.
Key person coverage is not a buy-sell agreement
These get conflated constantly. They solve different problems.
Key person insurance replaces lost economic value so the business can keep operating. A buy-sell agreement determines what happens to the deceased owner ownership stake and provides the money to buy it from their estate.
If you have partners, you almost certainly need both, and the buy-sell side changed meaningfully after a 2024 Supreme Court decision that we wrote about separately. Coverage bought for one purpose does not quietly serve the other.
What we would look at
When we review this for a business, we are checking four things. Whether the right people are insured, which is often not the people who were insured five years ago. Whether the amount reflects the business as it is now rather than as it was. Whether the 101(j) notice and consent paperwork exists and can be produced. And whether Form 8925 has been filed.
Two of those four are compliance items that cost nothing to fix now and a great deal to discover later.
We are an insurance brokerage rather than a law or accounting firm. Your CPA should confirm the tax treatment for your entity and your attorney should review the documentation. Nothing here is tax or legal advice.
Frequently Asked Questions
What is key person insurance?
A life insurance policy a business owns on an individual whose death would materially damage the company. The business applies, pays the premium and is the beneficiary. It is designed to protect the company balance sheet and operations, not the individual family, which is a separate need met by personal coverage.
Who counts as a key person?
Anyone whose sudden absence would break something that takes real time and money to repair. Typically that is someone holding client relationships that would leave with them, undocumented operational knowledge, a professional licence the business depends on, or a personal guarantee on company debt. It is frequently not the most senior person on the org chart.
How much key person coverage does a business need?
There is no single formula. A multiple of compensation, usually five to ten times, gives a quick starting point. Estimating the person contribution to gross profit and multiplying by the years needed to replace it is more defensible. Calculating the full cost to replace them, including recruitment, ramp time and lost revenue, is usually the most persuasive. If a lender has a key person clause in your loan documents, that sets a minimum.
Are key person insurance premiums tax deductible?
No. Because the business is the beneficiary of the policy, the premiums are a non deductible expense. That is the trade off for receiving the death benefit free of income tax, and there is no way to structure around it while the company remains the beneficiary.
Is the death benefit taxable to the business?
Generally no, but only if the rules were followed. For employer owned policies issued or materially modified after August 17, 2006, Section 101(j) requires written notice to the employee and their written consent before the policy is issued. If that did not happen, the proceeds above the premiums paid are taxable income to the business, and it cannot be corrected after the fact. Businesses must also report these contracts annually on Form 8925.
How is key person insurance different from a buy-sell agreement?
Key person insurance replaces economic value the business loses so it can continue operating. A buy-sell agreement governs the transfer of an owner stake and funds the purchase from their estate. They are separate arrangements solving separate problems, and a business with multiple owners usually needs both.
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