Suppose you arrive at your company one morning and discover that a key employee died unexpectedly the night before. Have you ever considered how such a turn of events may affect your company? Along with losing a valued member of your team, you may also be losing knowledge, skill, and important professional relationships cultivated over many years.
Understanding the Issues
While you may not be able to predict or prevent the unexpected loss of a top employee, you can receive compensation through key person insurance. A key person policy covers or “indemnifies” a company against the loss of a valued team member’s skill and expertise. The proceeds may be used to help recruit, hire, and train a replacement; replace lost profits; assure customers that business operations will continue as usual; and reassure lenders that funds will be available for repayment of business loans.
Typically, the company owns the policy, the premiums are not deductible, and the death proceeds are received by the company income tax free. However, there may be alternative minimum tax (AMT) consequences for businesses that are organized as C corporations.
What Approach Is Best?
It may be challenging to place a monetary value on a key employee. To help determine the amount necessary, there are generally three approaches:
- The “multiple” approach uses a multiple of the key person’s total annual compensation, including bonuses and deferred compensation. The popularity of this method may reflect the difficulty of quantifying the value of a key employee. The disadvantage of this approach is that the estimate, typically for five or more years’ annual compensation, may or may not correlate to actual needs.
- The business profits approach is a more sophisticated method. It attempts to quantify the portion of the business’s net profit that is directly attributable to the key person and then multiplies that amount by the number of years it might require for a replacement to become as productive as the insured. For example, if net profit attributable to the key employee is estimated at $250,000 annually, and it is expected that it would take five years to hire and train a replacement, then the policy’s face value would be $1.25 million.
- The present value approach calculates the present value of the profit contributions of the key employee over a specified number of years. This amount is then used as the face value of the policy. For instance, with an anticipated profit contribution of $250,000 per year for the next five years and a discount rate of 8%, the policy’s face value would be about $1 million. This method assumes insurance proceeds can be invested at a given rate of return and will be spent over a given period of years.
Business executives should consult with their insurer regarding the company’s specific approach. However, regardless of which method is best for your business, key person insurance is a vital component in protecting your business from the loss of your most valuable assets—the people who help it grow and prosper.
None of us can predict or prevent the loss of a key employee. However, having a policy in place to manage such an event at your business may make all the difference. Be sure to discuss protecting your business with key person insurance with your professional advisors.
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