One reason companies purchase key-man life insurance is to cushion themselves financially during the search for a new leader. But what many business owners don't realize is that there are other ways a typical key-man policy can be useful, ranging from improved estate planning to additional tax breaks for the business.
Take the example of a business owner who dies and leaves a $2-million estate, half of which comprises stock in the company he founded. His personal estate will be hit with a federal estate tax bill of about $300,000, estimates Curtis Fithian, manager of financial planning at Brewer & Lord, an insurance agency in Boston. Paying that tab will be much easier if the corporation has prearranged a partial redemption of 30% of the stock from the estate. Now the estate has money to pay its taxes, while the corporation has bought back nearly a third of its stock with the proceeds of the key-man policy. Suppose the corporation has a $1.4-million policy; there will be money to pay the decedent's spouse $50,000 for 10 years -- called "salary continuation" -- and still leave money for shoring up the business and hiring a new chief executive.
According to Fithian, Section 303 of the Internal Revenue Code allows for a tax-free exchange of stock for cash by an estate, providing the redemption price is not more than the amount of the estate-tax bill. Cash payments from a key-man insurance policy are likewise tax-free to the corporation under current tax laws; the company also gets to deduct the cost of payments to the surviving spouse. The key-man policy itself would not include such agreements between a corporation and its owner, but merely would provide the money to pay for them. Fithian suggests that the stock-redemption plan should be an oral agreement, so as not to invite unfavorable scrutiny from the Internal Revenue Service.