For a closely held business, the death of an owner or a critical employee isn’t just a personal loss — it can be an existential threat to the company itself. Roughly half of small businesses don’t survive past five years, and succession and continuity gaps are frequently cited as contributing factors.¹ Two of the most common life insurance strategies address this risk directly: key person insurance and buy-sell agreement funding. This post covers both, plus the tax rules that govern them.
These are typically more involved than a personal planning discussion and require a broker who is familiar with this specific type of line insurance to have the best experience possible.
Key Person Life Insurance
Key person (sometimes called “key man”) insurance is a policy the business itself owns, pays for, and is the beneficiary of, insuring the life of an owner or employee whose loss would cause significant financial harm. Typically a founder, a top producer, a specialized technician, or anyone whose relationships or expertise are difficult to replace quickly. If that person dies, the business receives the death benefit income tax-free and can use it to recruit and train a replacement, cover a revenue shortfall during the transition, pay down debt, or simply reassure lenders, vendors, and remaining employees that the company can weather the loss.
There are special disclosures required in most states when an employer owns a policy on an individual. There are also additional steps required to outline why the business needs this life insurance on that employee so that “insurable interest” is established with the insurance company.
A common benchmark for coverage amount is 5–10 times the key person’s annual compensation to the business, though a more precise figure typically accounts for their specific contribution to revenue and the realistic cost and timeline of replacing them. This is another piece of the story that needs to be articulated to the insurance company, especially if higher amounts of life insurance are needed.
The type of life insurance that is used can vary and needs to be linked to the business objectives. A pharmaceutical company that has an upcoming product launch in 6 months would likely require a different type of product than a retail outlet that wants to protect against the risk of any of their executives passing away over the next 5 years.
| TAX NOTE — Premiums the business pays for key person coverage are generally not deductible under IRC §264(a)(1), since the business is a direct or indirect beneficiary. This is a frequent point of confusion, confirm the deductibility (or non-deductibility) of any business-owned policy with your CPA. |
Buy-Sell Agreements Funded by Life Insurance
A buy-sell agreement is a legally binding contract between business owners that determines what happens to an owner’s interest if they die, become disabled, or otherwise exit the business. Without one, a deceased partner’s shares typically pass to their estate or heirs. This can leave surviving owners running the business alongside people who they didn’t choose to be business partners, or worse, in a dispute over valuation and control. Life insurance is the most common funding mechanism for buy-sell agreements because it guarantees the cash will be there exactly when it’s needed, regardless of the business’s financial condition at the time.
There are two primary structures for an insurance-funded buy-sell agreement:
| Structure | How It Works |
| Cross-purchase | Each owner personally owns and is the beneficiary of a policy on each other owner; proceeds are used to buy the deceased owner’s interest directly from their estate |
| Entity redemption (stock redemption) | The business itself owns and is the beneficiary of a policy on each owner; the business uses proceeds to redeem (buy back) the deceased owner’s interest |
Choosing between these structures involves tradeoffs in cost basis, number of policies needed (cross-purchase requires more policies as the number of owners grows), and needs to match the business structure & goals.
A Critical Case: Connelly v. United States (2024)
In Connelly v. United States, the Supreme Court held that when a company redeems a deceased owner’s shares using proceeds from a company-owned life insurance policy, that death benefit generally increases the company’s value for estate tax purposes on the deceased owner’s shares. Without an offsetting reduction for the company’s contractual obligation to redeem those shares.² In plain terms: an entity redemption buy-sell funded with corporate-owned life insurance can produce a larger taxable estate for the deceased owner than many business owners and their advisors previously assumed. This ruling has made it more important than ever to have your buy-sell structure reviewed by a CPA or estate attorney. In some cases, a cross-purchase structure, an insurance LLC, or a properly drafted redemption agreement with a formal valuation mechanism can better manage this exposure.
| TAX NOTE — Connelly v. United States changed how corporate-owned life insurance can affect a deceased owner’s estate tax valuation. This is a significant, fact-specific area of law. Please have your buy-sell agreement and its funding structure reviewed by your CPA and business/estate attorney in light of this ruling. |
Matching Insurance to the Agreement
A buy-sell agreement is only as reliable as its funding. We consistently see two problems in practice: the insurance amount was never updated as the business grew in value, and the policy’s definitions or provisions don’t line up with the agreement’s actual terms (valuation method, triggering events, or payout structure). Both problems can leave a business significantly underfunded exactly when the agreement is triggered — which is why we recommend reviewing coverage amounts alongside your buy-sell agreement on a regular cycle, not just at the time the agreement is signed.
Bonus round: we also regularly see that funding is put in place for the death of a partner but not disability, which is statically more likely to occur. But that’s a whole separate topic for another time.
Term or Permanent for Business Coverage?
Both are used, and the right choice depends on the purpose. Term insurance is common for key person coverage tied to a specific business loan or a defined ownership transition timeline, and for younger businesses managing cash flow. Permanent insurance is often preferred for buy-sell funding meant to last indefinitely (since owners typically don’t know in advance which owner will trigger the agreement, or when), and it offers the added benefit of accumulating cash value the business can potentially access if needed.
Group Term Life for Employees, Briefly
Separately from key person and buy-sell coverage, many businesses also offer group term life insurance as an employee benefit. Under IRC Section 79, the first $50,000 of employer-provided group term life coverage is excluded from an employee’s taxable income; coverage above that amount generally creates imputed income based on IRS-published rate tables. We’ll cover group coverage and its real limitations for higher earners in a dedicated post later in this series. However group term life pays the employee’s beneficiaries which typically means it is not protecting the business!
Carriers We Work With
The typical domestic life insurance market is usually a good starting place for life insurance for business protection as such we look to our panel of more than 40 carriers, including Principal, Ameritas, North American, Pacific Life, Protective and Prudential allowing us to match policy design, underwriting approach, and pricing to your specific business goals. If needed we can move into Lloyd’s of London for more unusual coverage, whether that is due to underwriting issues or unusual benefits amounts or durations.
Frequently Asked Questions
What is Key Person Life Insurance?
Key person (sometimes called “key man”) insurance is a policy the business itself owns, pays for, and is the beneficiary of, insuring the life of an owner or employee whose loss would cause significant financial harm. Typically a founder, a top producer, a specialized technician, or anyone whose relationships or expertise are difficult to replace quickly.
What is Buy Sell Life Insurance?
Buy Sell Life Insurance is life insurance design to fund a Buy-sell agreement. A buy-sell agreement is a legally binding contract between business owners that determines what happens to an owner’s interest if they die, become disabled, or otherwise exit the business.
As buy-sell agreements varies significantly in terms of design, the life insurance also needs to, so they match.
Does the key person need to consent to the business owning a policy on their life?
Yes. Under IRC §101(j), employer-owned life insurance generally requires the insured employee’s written notice and consent before the policy is issued, and the employer must meet certain conditions, in order to preserve the death benefit’s income tax-free treatment. This needs to happen correctly and before issue — not after.
How often should a buy-sell agreement’s funding be reviewed?
We generally recommend a review every 2–3 years, or any time there’s a material change in business valuation, ownership percentages, or the agreement’s terms. Growth is the most common reason buy-sell funding falls behind.
Can a sole proprietor use these strategies?
Key person and buy-sell insurance are designed for businesses with employees whose loss would harm the company, or multiple owners, respectively. A sole proprietor with no partners typically has a different need: personal life insurance sized to replace income and wind down the business, which we cover in our post on how much coverage you need.
The Takeaway
Key person and buy-sell insurance exist to make sure a business survives the loss of the people it depends on most but only if the coverage amount, the ownership structure, and the underlying agreement all line up correctly. Given the added complexity introduced by the changing legal landscape and growth of the underlying business, this is not a set-it-and-forget-it area of planning.
| When was your buy-sell agreement’s funding last reviewed? We’ll review your current coverage against your business’s value and your agreement’s terms, and coordinate with your CPA and attorney on structuring it correctly in light of recent case law. Contact Professional Benefits → https://professionalbenefits.org/contact/ |
Written by Stevan Collins, CLU, CEBS — Professional Benefits, Sarasota, FL
Sources
1. Vouch, “What Is Key Person Insurance? A Complete Guide for Business Owners,” vouch.us, 2026 — small business survival statistics.
2. Connelly v. United States, 602 U.S. 257 (2024), U.S. Supreme Court — summary discussion in The CPA Journal, “Using Buy/Sell Agreements,” cpajournal.com, 2026.
3. 26 U.S. Code § 264(a)(1); 26 U.S. Code § 101(j); 26 U.S. Code § 79 — as published at law.cornell.edu/uscode.