What’s Included in Key Person Insurance?
Key person insurance usually offers several coverage options to help protect your business if you lose a key employee or executive. The main part is life insurance, which pays a lump sum to your business if the insured person dies. This money can help cover immediate losses, keep your business running, and pay for hiring and training a replacement.
Some insurers offer critical illness or disability coverage as a separate policy or optional rider, allowing the business to receive a payout if the key individual becomes seriously ill and is unable to work. This means the business can receive a payout if the key individual is diagnosed with a serious illness that prevents them from working, such as cancer or a stroke.
Coverage amounts are flexible and can be tailored to the specific financial risk the individual represents to the business. Whether it’s to offset lost revenue, protect a financing deal, or reassure investors, the policy value can be customized accordingly.
Scenarios in Which Key Person Insurance is a Must
While there’s no one-size-fits-all solution in business, there are many situations where key person insurance is a must. Here are a few to better illustrate the impact of not having this coverage:
How Losing a Key Person Affects Business Valuation
A key person is often someone who drives a large portion of the business’s revenue. Their sudden loss can dramatically affect your business’s value, whether you’re planning to sell your business, raise capital, or simply work on sustaining long-term growth. Here’s how:
CRA Tax Implications
While key person insurance can provide crucial protection, it needs to be structured thoughtfully to ensure the business receives the maximum financial and tax benefit from the Canada Revenue Agency (CRA). Let’s break down the key areas where tax implications come into play.
In most cases, premiums paid for key person life insurance are not tax-deductible when the business owns the policy and receives the benefit. Premiums for life insurance used for key person coverage are not typically tax-deductible as a business expense. If your corporation is both the owner and beneficiary of the policy, the premiums are considered a capital expense, not an operating expense. These premiums do not reduce your taxable income in the year they are paid.
The real advantage of key person coverage is seen at the time of a claim. The death benefit from a corporate-owned life insurance policy is generally received tax-free by the corporation, though the policy’s adjusted cost basis (ACB) affects how much can be credited to the Capital Dividend Account (CDA).
However, the amount credited to the corporation’s Capital Dividend Account (CDA) is generally the death benefit minus the policy’s adjusted cost basis (ACB).
For permanent policies with a cash value, it gets more complicated. If there’s an investment component, the ACB can impact how much of the death benefit qualifies for CDA credit, and a portion of the policy’s growth could potentially trigger a taxable gain under certain conditions, depending on how the policy was structured.
This is why it’s essential to work with both a tax advisor and a licensed insurance professional to ensure your key person policy is properly designed, not just for protection, but also for tax efficiency.
Key Advice from MyChoice
- When determining coverage amount for key person insurance, consider the cost of replacing the person, potential lost revenue, and the time it would take to get back to normal operations.
- While key person insurance isn’t a tax deduction in the traditional sense, it can be an incredibly tax-efficient financial planning tool when used correctly. Consult a tax advisor or your insurance advisor to structure a plan for tax-free dividends and a tax-free death benefit.
- As your business grows, so do your risks. Review your key person insurance policy every year, or even sooner if you experience major staffing changes, raise capital, or plan to expand.