Key Person Insurance for Small Businesses: A Practical Guide

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By Elizabeth Kusmider, CFP®

Small business owners spend a great deal of time thinking about what could go wrong with their product, their market, or their operations. Far fewer spend time thinking about what would happen to the business if they, or one of their most essential people, died suddenly. For most small businesses, that scenario would be catastrophic. Key person insurance is designed to address exactly that risk.

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I am Elizabeth Kusmider, CFP® and independent life insurance broker. I work with small business owners to design coverage strategies that protect both the business and the people behind it. Here is a practical guide to key person insurance for small businesses.

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What Key Person Insurance Does

Key person insurance (sometimes called key man insurance) is a life insurance policy that a business owns on the life of a person whose death would create significant financial harm to the company. The business pays the premiums, is the named beneficiary, and receives the death benefit if the insured person dies.

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The proceeds can be used for any purpose the business needs: recruiting and onboarding a replacement, covering lost revenue during the transition, satisfying lender or investor obligations, or providing the business with financial stability while it adjusts to the loss.

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Who Is a Key Person in a Small Business?

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In a large corporation, identifying key people is a structured process. In a small business, it is often more intuitive, but no less important. Common examples include:

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• The founder or primary owner who drives the business and holds the client relationships
• A partner who manages a distinct function (operations, sales, technical delivery) that the business could not absorb easily
• A top salesperson whose departure would directly reduce revenue
• A technical specialist whose expertise is difficult to replace within a short time frame
• Any person whose sudden absence would jeopardize the business's ability to service its customers

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In many small businesses, the founder is the key person. In others, it is a small team. The right coverage strategy identifies the individuals whose loss creates the greatest financial exposure and sizes coverage accordingly.

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How to Size Key Person Coverage

There is no universal formula, but the most practical approach is to estimate the financial impact of losing the key person over the time it would realistically take to find, hire, and bring a replacement up to full productivity.

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For a small business owner, that calculation should include:

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• Revenue at risk if key client relationships do not transfer
• The cost of recruiting, hiring, and training a qualified replacement
• Any personal guarantees on business loans that would need to be addressed
• The potential impact on business valuation if the loss disrupts a sale or succession process in progress

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A common approach is to use a multiple of the key person's annual compensation, typically three to seven times, as a starting point, then adjust based on the business's specific situation. For businesses where a single person generates a disproportionate share of revenue, the coverage amount should reflect that concentration.

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Tax Treatment: What Small Business Owners Need to Know

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Key person insurance premiums are generally not tax-deductible for the business. This is different from many other business expenses, and it surprises some owners.

The trade-off is that the death benefit is received income-tax-free by the business, provided the policy complies with the IRS rules for employer-owned life insurance under Internal Revenue Code Section 101(j). Those rules require: written notice to the insured employee before the policy is issued, written consent from the employee, and an annual reporting requirement on the business's tax return.

These are administrative requirements, but they matter. A policy that does not comply can result in the death benefit being partially taxable. I coordinate with the business's CPA to ensure the documentation is correct at the time the policy is placed.

Term vs. Permanent for Key Person Coverage

Most small business key person coverage is structured as term life insurance. The coverage need is highest during the key person's active working years, and term provides that coverage cost-effectively.

Permanent coverage can be appropriate when the business wants to build cash value in the policy as a business asset. This approach is sometimes called company-owned life insurance. For small businesses, this is less common but worth discussing if the owner has broader planning goals tied to the policy.

The Connection to Your Buy-Sell Agreement

If your small business has multiple owners, key person coverage and buy-sell funding are distinct needs that are often addressed at the same time. Key person coverage protects the business from the operational and financial impact of losing an owner. Buy-sell funding provides the capital to execute the ownership transfer agreed to in the buy-sell document.

Both are important. Neither substitutes for the other. A business that has a buy-sell agreement, but no key person coverage (or vice versa) has addressed part of the risk without addressing all of it.

If you are a small business owner who has not assessed your key person exposure, I am glad to walk through the analysis with you.

Elizabeth works closely with wealth managers and estate attorneys to bring insurance planning into broader client conversations. We are here to help make that process simple, not stressful. To schedule a planning session or discuss a client situation, reach out to Elizabeth Kusmider, CFP® at info@kusmiderconsulting.com.