Business Owner Life Insurance: Key Person Coverage and Buy-Sell Agreements

Most small-business owners have personal life insurance. Far fewer have thought through two separate — and equally important — business needs: key person coverage, which protects the company if a critical employee or owner dies, and buy-sell agreement funding, which determines who owns your business after you're gone. Neither is optional if you have partners, investors, or SBA loans.

Key person life insurance: protecting the company

Key person insurance (also called key man insurance) is a life insurance policy that a business owns on the life of a person whose death would materially damage the company — typically a founder, top revenue producer, lead technician, or any individual whose loss would be difficult or expensive to replace. The business is both the policy owner and the beneficiary. If the key person dies, the death benefit flows to the company tax-free.

Common triggers for needing key person coverage:

• A sole proprietor or LLC owner whose client relationships, contracts, or technical expertise are the primary source of revenue
• A sales lead or business development person responsible for a large share of new revenue
• A specialized technician or professional whose work cannot easily be contracted out on short notice
• Any person named as a guarantor on business debt, particularly SBA loans (banks routinely require coverage as a condition of the loan)

How much key person coverage do you need?

There is no universal formula, but two approaches are commonly used:

These methods often lead to different answers. A consultant billing $600K/year might need $3M–$6M under the compensation-multiple approach, but only $800K under a replacement-cost approach if her practice could be wound down gracefully and clients transitioned. Run both scenarios and discuss with your financial advisor — they'll help you model the actual business disruption, not just apply a multiple mechanically.

Tax treatment of key person insurance premiums

Key person insurance premiums are not tax-deductible. Under IRC §264(a)(1), a business cannot deduct premiums on a life insurance contract covering the life of an officer, employee, or financially interested person if the business is the direct or indirect beneficiary of the policy.¹ The IRS's rationale: if you could deduct premiums and then receive the death benefit tax-free, you'd get a double benefit — taxable income reduced going in, untaxed cash coming out.

The flip side: the death benefit is received tax-free by the business under IRC §101(a), which excludes life insurance proceeds from gross income.² That tax-free treatment is the primary economic advantage of life insurance over other business continuity funding mechanisms (bank lines of credit, sinking funds).

IRC §101(j): the consent requirement you can't miss

For policies issued after August 17, 2006, IRC §101(j) adds a critical requirement for employer-owned life insurance (EOLI): the death benefit is only tax-free if the insured employee was given prior written notice that the employer intends to insure their life and the maximum face amount, and the employee provided written consent before the policy is issued.³

Additionally, for the death benefit to remain tax-free, one of the following must be true at the time of death:

• The insured was an employee of the employer at the time of death, or within the prior 12 months
• The insured was a director or "highly compensated employee"
• The proceeds are paid to family members of the insured, or used to purchase a financial interest from family members of the insured

If the consent form is missing — even if the employee knew about the policy informally — the death benefit above premiums paid becomes ordinary income to the business. On a $1M policy with $20,000 in cumulative premiums, that's $980,000 of ordinary income, taxed at up to 37% (plus state rates). A $50,000 omission becomes a $362,600 tax bill.

Annual reporting: Employers who own EOLI contracts must file Form 8925 with their annual tax return each year, certifying that consent requirements were met and disclosing the number of employees covered and total face amount.⁴ This is the IRS's ongoing audit trail for EOLI compliance. Make sure your CPA knows about any key person policies on file.

Buy-sell agreements: who owns the business when you're gone

A buy-sell agreement is a legally binding contract among co-owners (or between an owner and the business entity) that governs what happens to an ownership interest when a trigger event occurs — typically death, disability, divorce, or a departing partner. The agreement sets the price (or pricing mechanism) and the buyer in advance, so there's no dispute when the event happens.

Without a funded buy-sell agreement, a deceased owner's interest passes through their estate to their heirs. Those heirs may not want to be business owners. They may want a buyout price the surviving owners can't afford. Courts can force a liquidation. Banks can call loans if ownership changes cross a covenant threshold. A well-drafted, funded buy-sell agreement eliminates all of this.

Life insurance is the most common funding mechanism for buy-sell agreements because the death benefit arrives exactly when the liquidity is needed, is tax-free under IRC §101(a), and the premium cost is predictable.

Cross-purchase vs. entity redemption: the structure matters

There are two ways to structure a life-insurance-funded buy-sell agreement. The choice has significant tax consequences, particularly for businesses eventually sold:

Cross-purchase agreement

Each owner personally owns and pays premiums on a life insurance policy covering the other owner(s). When Owner A dies, Owner B receives the death benefit personally and uses it to buy Owner A's interest from the estate.

Key advantage — basis step-up: The surviving owner's basis in the acquired interest equals the purchase price paid (the death benefit received). This matters enormously at a future business sale. If Owner B later sells the business, they have a higher tax basis, which reduces their capital gain.

Key disadvantage — administrative complexity: With N owners, you need N × (N − 1) policies. With 3 owners, that's 6 policies; with 4 owners, 12 policies. Tracking premiums, ownership, and beneficiary designations across all of them is manageable with good records but cumbersome.

Entity redemption (stock redemption) agreement

The business entity owns and pays premiums on a policy covering each owner. When Owner A dies, the company receives the death benefit and uses it to buy back Owner A's interest from the estate.

Simpler administration: N owners requires only N policies, all owned by the same entity. Premiums are paid from business cash flow.

Key disadvantage — no basis step-up for survivors: In a C-corporation, the surviving shareholders don't step up their basis in their existing shares. They now own a larger percentage of the same entity at the same old basis. When they eventually sell, the gain is larger than it would have been under a cross-purchase structure.

Connelly v. United States (2024): The U.S. Supreme Court ruled unanimously that in a corporate entity-redemption arrangement, the life insurance proceeds are an asset of the corporation and therefore included in the business's fair market value for estate tax purposes.⁵ In the specific case, an estate paid significantly more estate tax because the corporation's value included $3.5M in life insurance proceeds that would be used to redeem the estate's shares. For C-corporations specifically, this ruling means entity-redemption buy-sells funded with life insurance can increase the estate's taxable value — a double punch at the worst time. Cross-purchase structures are not affected by Connelly because the insurance is held by the surviving owners personally, not by the entity.

Funding the buy-sell: how much coverage, which policy type

The buy-sell agreement should specify a valuation mechanism — either a fixed price (updated periodically), a formula (e.g., 4× EBITDA), or an agreed appraisal process. Life insurance coverage should equal or exceed that value. Common approaches:

• Term insurance: Most cost-effective for businesses in early growth stages where the value may be uncertain and the owners are younger. A 20-year level term policy provides predictable premiums during the years most owners want coverage. Appropriate when business value is expected to grow beyond coverage limits — you'll need to reassess and potentially increase coverage as equity builds.
• Universal or whole life: More expensive per dollar of coverage, but the cash value grows over time and can be accessed if the agreement is restructured (e.g., a buyout occurs while both owners are alive). Useful when the business value is growing steadily and a predictable funding vehicle matters more than minimizing premium cost.

One practical issue with term buy-sell policies: the agreement should address what happens if an owner becomes uninsurable before the policy term ends, or if the business value grows past the policy face amount. A well-drafted agreement includes provisions for renegotiating coverage amounts periodically (often every 3–5 years).

SBA loan collateral assignments

Most SBA 7(a) loans over $350,000 and SBA 504 loans require the primary owners (20%+ ownership) to personally guarantee the loan and, in many cases, to assign a life insurance policy to the lender as collateral — an amount equal to the outstanding loan balance. The assignment means the lender has a priority claim on the death benefit up to the loan balance; any remainder goes to the named beneficiary.

If you've arranged key person insurance or a buy-sell policy for business continuity purposes, a collateral assignment can be layered onto that same policy — you don't always need a separate SBA policy. But the lender must be listed as a collateral assignee (not a beneficiary), and the assignment must be properly documented with the insurance carrier. Banks that skip this step expose themselves to disputes; business owners who skip this step may be in violation of their loan covenants.

Get matched with a small-business financial advisor

Why a financial advisor — not just an insurance agent — matters here

An insurance agent's incentive is to sell you the policy with the highest commission. A fee-only financial advisor has no product to sell — their value is in coordinating the business structure decisions: how much coverage you need, which structure (cross-purchase vs. entity redemption) fits your entity type and exit timeline, how the buy-sell valuation interacts with your retirement accounts and estate plan, and whether the premiums should be paid personally or by the business.

These decisions connect to every other part of your financial plan: if you're a 52-year-old S-corp owner with a $380K salary, a solo 401(k), and a $1.5M business value, the way you fund a buy-sell agreement affects your taxable income, your cash balance plan contribution capacity (see our cash balance plan guide), and your personal disability insurance coverage (see our disability insurance guide). It's one interconnected system — and the pieces need to be sized together.

If you're thinking about a future business sale, the buy-sell structure also affects your exit-year tax bill — see our business exit tax planning guide for how ownership structure and basis affect what you keep at closing.

1. IRC §264(a)(1) — no deduction for life insurance premiums when the business is directly or indirectly a beneficiary of the policy: 26 U.S. Code § 264 — Certain amounts paid in connection with insurance contracts (Cornell LII). Regulation at 26 CFR § 1.264-1.
2. IRC §101(a) — death benefits received under a life insurance contract are generally excluded from gross income: 26 U.S. Code § 101 — Certain death benefits (Cornell LII). Exclusion applies to the business as beneficiary of a key person policy, subject to §101(j) consent requirements.
3. IRC §101(j) — employer-owned life insurance consent and notice requirements: insured must receive prior written notice of the policy and provide written consent before issuance. Policies issued after August 17, 2006 are subject to these rules. Failure results in death benefit above basis becoming taxable ordinary income. IRS Notice 2009-48 provides guidance on inadvertent failures. Source: 26 U.S.C. § 101(j) (Cornell LII).
4. Form 8925 — annual reporting requirement for employer-owned life insurance contracts. Filed with the employer's annual tax return. IRS — About Form 8925, Report of Employer-Owned Life Insurance Contracts.
5. Connelly v. United States, 602 U.S. 245 (2024) — unanimous Supreme Court ruling that life insurance proceeds held by a corporation to fund a stock redemption are an asset of the corporation for estate tax valuation purposes. Increases the taxable estate for entity-redemption C-corp buy-sell agreements. Kitces — Business Buy-Sell Agreements In The Wake of Connelly V. IRS.

Tax law and legal requirements discussed as of May 2026. IRC §101(j) consent requirements and Form 8925 apply to policies issued after August 17, 2006 and have not been amended since enactment. Connelly v. United States was decided June 6, 2024 and applies to C-corporation entity-redemption structures. Confirm all details with a qualified attorney and financial advisor before purchasing or restructuring any policy.