Life insurance for a business you own: key person and buy-sell

Most owners meet business life insurance in one of two moments. A lender asks what happens to the company if the founder dies. Or partners sit down to write out who buys whom out, at what price, with what money. Both moments produce the same mistake. The policy gets bought. The agreement gets signed. And the two pieces of federal law that decide how the money is taxed never come up. The person selling the policy is not the person drafting the agreement, and neither of them does the tax return.

One rule is a 2006 law most owners have never heard of. The other is a Supreme Court decision from June 2024 that every justice agreed on. This article explains both in plain English, with the law’s own words where they help. It describes no insurance product, because we are not licensed to. The last section says who is.

No. 01What is key person insurance?

In shortA policy the company owns and pays for on someone whose death would hurt it. The company, not the family, gets the money.

Key person insurance is a life insurance policy a business owns on an employee whose death would hurt it. Think of a founder, or the salesperson who brings in half the revenue. The company applies for the policy. It pays the premiums, meaning the regular payments that keep the policy in force. And it is the beneficiary, meaning the one who gets the money when the insured person dies. The family gets nothing from this policy. The company gets all of it, and every tax rule below hangs on that fact.

Who counts as an “employee” here is a legal question, and the tax code’s answer is wider than the payroll list. Section 101(j)(5)(A) says the term “includes an officer, director, and highly compensated employee.” The IRS adds that a director counts even though directors are independent contractors (Notice 2009-48, A-5). Owners who work in their own companies count as employees here too.

No. 02Is key person insurance tax deductible?

In shortNo, as a rule. When the company is the one who gets the money, the tax code will not let it deduct the premiums. They are paid with money that has already been taxed.

No, as a rule. Section 264(a)(1) denies a deduction for “premiums on any life insurance policy” when the taxpayer is directly or indirectly a beneficiary. A company that owns a policy on its founder and names itself beneficiary is that taxpayer. So the premiums come out of money the company has already paid tax on.¹

There is a trade. Section 101(a)(1) says amounts paid under a life insurance contract “by reason of the death of the insured” are excluded from gross income. In plain words, the payout does not count as income, so no income tax is owed on it. Not deductible going in, not taxed coming out. It is the same deal most people get on a policy they buy on their own life at home. Since 17 August 2006 that deal has had a condition attached.

No. 03What is a buy-sell agreement funded with life insurance?

In shortA contract that fixes who buys a departing owner’s share, at what price, and with what money. Two shapes: the company buys (called a redemption) or the other owners buy (called a cross-purchase).

Two roommates sign a lease together. If one moves out, the other is stuck with the rent, and the one leaving wants their deposit back. A sensible pair writes down ahead of time what happens. A buy-sell agreement is that, for a company. It is a contract among the owners (and sometimes the company itself) that says what happens to an owner’s share when a set event happens. Death is the most common one. Disability, retirement, and divorce are often on the list too. The contract fixes who must buy, who must sell, how the price is set, and where the money comes from. U.S. Bank’s planning page puts the insurance part this way: “life insurance proceeds can be used to purchase the business shares from the deceased partner’s estate.”

Two shapes are common. The difference is who owns the policies.

In the first shape, the company owns a policy on each owner, pays the premiums, and collects the death benefit, meaning the money the insurer pays out when the insured person dies. The company then buys back the dead owner’s shares from the estate, meaning from whoever is handling what that owner left behind. Buying back your own shares is called redeeming them. So this shape is an entity redemption (also called an entity purchase).

In the second shape, the owners own policies on each other. When one dies, the survivor collects the death benefit personally and buys the shares straight from the estate. The company never touches the money. This shape is a cross-purchase. Two owners means two policies. Five owners who each insure the other four means twenty policies, which is the usual reason people reach for the company-owned version instead.

No. 04What is section 101(j), the notice and consent rule?

In shortFor company-owned policies issued after 17 August 2006, the employee must be told, and must agree in writing, before the policy is issued. Without that paper, everything the policy pays above the premiums is taxed as income.

Start with what happens to the money. Say a company paid premiums for years and the policy pays out far more than it paid in. If the paperwork was done, none of the payout is taxed as income. If it was not, the company gets back untaxed only what it paid in premiums, the way a landlord hands back a deposit. Everything above that is taxed as ordinary income, the same as sales revenue. That is the whole of section 101(j). The rest is detail.

Section 101(j) came in with section 863 of the Pension Protection Act of 2006. It applies to life insurance contracts issued after 17 August 2006. It covers any “employer-owned life insurance contract.” That means a policy owned by a business that is “directly or indirectly a beneficiary,” on the life of its employee. A key person policy fits that definition exactly. So does a redemption policy on an owner who works in the business.

The general rule is harsh. Under 101(j)(1), the amount kept out of income “shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract.” Everything above the premiums is ordinary income to the company.

Section 101(j)(2) switches that rule off in a few cases. One: the insured was an employee “at any time during the 12-month period before the insured’s death,” or was a director or highly compensated employee when the policy was issued. Two: the money goes to the insured’s family or estate. Three: the money is “used to purchase an equity (or capital or profits) interest in the applicable policyholder” from them. That third case is the buy-sell clause. But the switch works only if “the notice and consent requirements of paragraph (4) are met.” Under 101(j)(4), “before the issuance of the contract,” the employee:

1. is “notified in writing” that the company intends to insure the employee’s life, and is told “the maximum face amount” it could buy,
2. “provides written consent to being insured,” including that “coverage may continue after the insured terminates employment,” and
3. is “informed in writing” that the company “will be a beneficiary of any proceeds.”

Three items, in writing, before the policy is issued. Notice 2009-48 fills in the detail. The notice must state an amount “either in dollars or as a multiple of salary” (A-12). The consent runs out if the policy is not issued within a year, or if the employee leaves first, whichever comes first (A-9). And an owner signing for his own company gets no pass. There is “no exception that would excuse a wholly-owned corporation and its employee-owner” (A-7).

So the sole shareholder writes the notice to himself and signs the consent. It feels odd, and it is required. Only a sole proprietor insuring his own life, with no separate company owning the policy, is outside the rule (A-3).

What happens when the notice and consent were not done

The law has no fix. Notice 2009-48, A-13: “Section 101(j) does not contain a provision for correcting an inadvertent failure.” The IRS says it will not challenge an honest, accidental miss that is “discovered and corrected no later than the due date of the tax return for the taxable year” the policy was issued. That is roughly one filing season.

Then comes the sentence that belongs taped inside the policy folder: “failure to obtain such consent cannot be corrected after the insured employee has died.” The policy still pays. But the payout above the premiums paid is ordinary income in the year the insured dies. That is the moment the company needed every dollar of it.

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Three pieces of paper, signed before the policy is issued, decide whether the payout is tax-free or taxed as income.

No. 05What is Form 8925?

In shortA one-page report attached to the company’s tax return every year it holds company-owned life insurance. It lists how many policies, how much coverage, and whether the consent paper exists.

Form 8925, “Report of Employer-Owned Life Insurance Contracts,” is a one-page form. A company attaches it to its income tax return for “each tax year during which the policyholder has employer-owned life insurance contract(s) in force.” It carries out section 6039I, the part of the tax code that requires the report. The form asks five things: how many employees the company had at year end, how many were insured under company-owned policies issued after 17 August 2006, the total coverage in force on them, whether the company has a valid consent for each insured employee (line 4a), and if not, how many lack one.

Line 4a is the point. It makes the company say, on its own tax return, whether the 101(j) paperwork exists. The instructions require records to back up the answer. Think of a receipt you have to keep. The form is where you tell the IRS you have it, and you had better be able to produce it. The IRS estimates 2 hours 23 minutes of recordkeeping, 1 hour of learning the law, and 1 hour 4 minutes of filling in five lines. We think the first figure is the honest one.

Key person and redemption policies both go on the form. Cross-purchase policies do not. A policy “owned by the owner of an entity engaged in a trade or business,” for instance to pay for buying another owner’s share, is “not an employer-owned life insurance contract” (Notice 2009-48, A-1).

No. 06What did Connelly v. United States change?

In shortThe Supreme Court held that insurance money a company holds to buy back a dead owner’s shares makes the company worth more for estate tax. The promise to buy the shares does not cancel that out.

Here is the idea before the case. Picture a company as a jar. If an insurance check lands in the jar the day an owner dies, the jar is worth that much more. The company’s promise to spend the check buying the dead owner’s shares does not make the jar lighter, because the shares it gets are worth what it pays for them. That is the whole ruling. Here is the case.

Michael and Thomas Connelly owned Crown C Supply, a building supply company in St. Louis. Michael held 77.18 percent (385.9 of 500 shares) and Thomas 22.82 percent. If one died, the survivor could buy his shares. If he declined, Crown had to buy them back. So Crown bought $3.5 million of life insurance on each brother.

Michael died. Thomas declined to buy. Crown bought back Michael’s shares for $3 million, and the estate reported that figure. The estate’s appraiser valued Crown at $3.86 million. He left out the $3 million of insurance money on the theory that the promise to buy the shares cancelled it out. The IRS disagreed. It said Crown was worth $6.86 million, that Michael’s shares were worth about $5.3 million, and that the estate owed another $889,914.

That bill was estate tax. Estate tax is the federal tax on everything a person owns when they die, once it adds up to more than a set threshold. Michael’s shares were part of what he owned. So what Crown was worth decided what his estate owed.

On 6 June 2024 the Supreme Court sided with the IRS. Every justice agreed, in an opinion by Justice Thomas: “An obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest.” The company became richer by $3 million the day Michael died. His shares were 77.18 percent of that richer company.²

The Court said two more things that matter to anyone drafting a buy-sell. First, it pointed at the other shape: “There were other options.” A cross-purchase agreement “would have allowed Thomas to purchase Michael’s shares and keep Crown in the family, while avoiding the risk that the insurance proceeds would increase the value of Michael’s shares.” Then came the caveat most summaries skip: “every arrangement has its own drawbacks.” Each brother would have had to pay the premiums on the other’s policy, “creating a risk that one of them would be unable to do so,” and the arrangement “would have had its own tax consequences.”

Second, it kept the ruling narrow. Footnote 2: “We do not hold that a redemption obligation can never decrease a corporation’s value.” One that forced a company “to liquidate operating assets,” meaning sell off the things it uses to do business, could. The estate argued the result “will make succession planning more difficult for closely held corporations.” The Court answered that it “is simply a consequence of how the Connelly brothers chose to structure their agreement.”

One note of scale. The federal estate tax reaches only estates above a filing threshold: $13,990,000 for deaths in 2025 and $15,000,000 for 2026, per the IRS. Well under that line, Connelly creates no federal estate tax bill. Near it, a company holding redemption insurance will be valued by the Connelly arithmetic. And the two rules touch different taxes. Section 101(j) is income tax on the insurance money. Connelly is estate tax on the shares. A redemption policy can clear the first and still run into the second.

No. 07Sole owner, partners, or key employee: which rule applies to you?

In shortEach structure answers a different question and trips a different rule. The table maps them. The next step is three licensed people in one room: an insurance professional, an attorney, and an accountant.

The next step

The rules here are federal tax law. A buy-sell agreement is state contract law. The policy that pays for it is a regulated insurance product. Nobody holds all three licenses, and The Kenswick Partners holds none. We are a journal, and this article is education, not legal or tax advice.

The next conversation is with three people, ideally in the same room. A licensed life insurance professional, for what coverage is available and how it would be owned. The company’s attorney, for the agreement and the notice and consent documents. The company’s accountant, for Form 8925 and what the company is worth under Connelly. The agreement decides who owns the policy. Who owns the policy decides which rule applies. So the three of them need to talk to each other.

1. Bring the current buy-sell agreement, if one exists.
2. List every policy the company owns, with the date each was issued.
3. Find whatever notice and consent paperwork exists for each insured person.
4. Check the last three years of tax returns for Form 8925.