Key person and buy-sell coverage

Two different jobs

They are often discussed together and they solve different problems.

Key person insurance protects the business against the financial disruption of losing somebody it genuinely depends on. The company owns the policy, pays the premiums, and is the beneficiary. The money is there to keep the business going.

Buy-sell funding provides the money to buy a deceased owner’s shares from their estate, so the survivors keep control and the family gets fair value in cash rather than an illiquid interest in a company they cannot run.

A business with two shareholders and a critical technical lead might need both, and each owner still needs the personal coverage their own household relies on.

Key person insurance

The test is not seniority. It is whether the business would suffer measurable financial harm without this specific person.

That might be a founder whose relationships hold the client base together, a salesperson responsible for a large share of revenue, or someone with technical knowledge that is not documented anywhere else.

What the coverage is meant to do: keep the business solvent while it recovers, fund recruiting and training a replacement, reassure lenders and major customers, and buy time.

Sizing it is a judgement rather than a formula. Common approaches are a multiple of the person’s contribution to profit, the estimated cost of replacing them, or an amount a lender requires. Lenders sometimes require key person coverage as a condition of a loan and will specify the amount.

The company owns the policy and receives the proceeds. Premiums are generally not deductible, and proceeds are generally received free of income tax, with the amount above the policy’s adjusted cost basis typically credited to the capital dividend account.

Buy-sell agreements

Without an agreement, the death of an owner is genuinely messy. The shares pass to the estate, which means the surviving owners may find themselves in business with a spouse or adult children who have no involvement in the company and no interest in running it. The family, for their part, holds an asset they cannot sell and which produces nothing.

A buy-sell agreement fixes the terms in advance: on death, the surviving owners or the company will buy the deceased owner’s shares, at a price determined by an agreed method.

Funding is what makes it real. An agreement obliging surviving owners to buy shares they cannot afford is a promise nobody can keep. Life insurance is the standard funding mechanism because it produces the money at exactly the moment the obligation arises.

The two main structures

Cross-purchase. Each owner holds a policy on each other owner. On a death, the survivors receive the proceeds personally and use them to buy the shares. Simple with two owners. With four owners it requires twelve policies, which is why it becomes impractical as the number grows.

Corporate redemption. The company owns policies on each owner and uses the proceeds to buy back the deceased owner’s shares. Fewer policies, and the tax treatment is more involved, particularly around the capital dividend account and the interaction with the deceased’s final return.

There are hybrid structures too. Which is right depends on the number of owners, the corporate structure, the adjusted cost basis of the shares, and the tax position of each owner. This is a question for an accountant and a lawyer working together, not one to settle from a general description.

The valuation problem

The most common failure is not the absence of an agreement. It is an agreement whose valuation has gone stale.

An agreement drafted eight years ago naming a fixed dollar value, on a business that has since tripled in size, produces an outcome nobody would now agree to. The family receives a fraction of what the shares are worth, or the survivors are obliged to pay far more than the coverage provides.

Options are a fixed price reviewed on a schedule, a formula based on earnings or book value, or an independent valuation at the time. Each has trade-offs, and all of them need revisiting periodically.

Coverage amounts should be reviewed alongside the valuation. Insurance sized to a valuation from years ago underfunds the obligation it exists to meet.

Term or permanent

Depends on the horizon.

If the owners expect to sell or wind up within a defined period, term coverage matched to that period is the efficient choice.

If the obligation has no end date, or if the shareholders will hold the business into old age, permanent coverage is the honest answer, since term coverage expiring at 70 does not fund an obligation arising at 82. See permanent life insurance.

Make the documents agree

This is where these arrangements most often fail, and it is entirely preventable.

The shareholders’ agreement, the policy ownership, and the beneficiary designation all have to describe the same plan. A cross-purchase agreement funded by corporately owned policies does not work. A beneficiary designation naming a spouse on a policy intended to fund a share purchase defeats the arrangement entirely.

Review all three documents together, and review them again whenever ownership changes, someone joins or leaves, or the valuation is updated.

Your accountant and your lawyer need to be part of this. Nothing on this page is a substitute for either.