Key Person Life Insurance in Texas: Sizing, Ownership, and Deductibility

What key person coverage protects against

The death of a critical employee in a small Texas business can trigger: lost revenue during the search and ramp of a replacement, recruiter and relocation costs, loan covenant violations (many SBA and commercial loans require key person coverage), customer flight, and interruption of a specific technical or client relationship. Key person insurance provides tax-free liquidity to bridge that gap.

The policy is a straightforward asset of the business. The business is applicant, owner, premium payer, and beneficiary. The insured signs a written consent under IRC §101(j) — critical for preserving the tax-free death benefit — and receives the required annual notice.

How much key person coverage does a business need?

Three common methods: (1) multiple of compensation, typically 5–10x the key person's total comp; (2) contribution to profit, estimating the annual profit attributable to the key person and multiplying by the projected replacement period (often 3–5 years); (3) loan-covenant driven, matching the face amount to specific SBA or bank covenant requirements.

For a $200K-comp key salesperson at a $5M-revenue Texas company, method (1) suggests $1M–$2M of coverage. Method (2), if the key person drives $600K of gross profit annually and replacement takes 3 years, suggests $1.8M. Use the higher of the applicable methods.

IRC §101(j) — the notice and consent rule

Since 2006, employer-owned life insurance must satisfy IRC §101(j): (a) written notice to the insured that the employer intends to insure them, stating the maximum face amount; (b) written employee consent to the insurance; and (c) the insured must be either a director, a highly compensated employee (top 35% by pay or exceeding the §414(q) threshold), or a 5%+ owner.

Miss any of these before policy issue and the death benefit above the sum of premiums paid becomes taxable income to the business. Documentation matters — save the signed notice and consent forms in the corporate records. Any Texas carrier's business e-app should include compliant §101(j) forms; verify before signing.

Who should own a key person policy?

Simplest structure: C-corp, LLC taxed as C-corp, or S-corp is the sole owner and beneficiary. Premiums are non-deductible under §264(a)(1); death benefit is tax-free under §101(a) with §101(j) satisfied. This is 90% of Texas key person cases.

Alternative: split-dollar arrangement where the employer pays premiums but the employee's family shares in the death benefit above the employer's stake. More flexible but adds complexity and current-year income to the employee (economic benefit or loan regime under the split-dollar regulations). Talk to a Texas CPA before going this route.

How to shop key person coverage in Texas

Term is almost always the right product for pure key person exposure — cheaper, aligned with the replacement horizon, and simple to underwrite. Permanent coverage (whole life, GUL) makes sense only if the employer also wants a balance-sheet asset with cash value or is combining the key person need with an executive bonus, split-dollar, or buy-sell arrangement.

Underwriting proceeds the same as personal life insurance — paramed exam, MIB, financial justification. The insured provides consent; the business's CFO or owner signs as applicant. Expect 3–6 weeks to policy issue for $1M–$3M face amounts. For a broader business owner framework, see why Texas business owners need life insurance.

Accounting and balance sheet treatment

Premiums on a term key person policy are a non-deductible business expense for tax purposes but a normal operating cost for book purposes, which creates a permanent book-tax difference your CPA will track. Permanent policies add a second wrinkle: the increase in cash surrender value is recorded as an asset, so only the portion of premium exceeding the cash value increase hits the income statement.

The death benefit is recorded as other income for book purposes and excluded from taxable income under §101(a). For a C-corporation, that untaxed income increases accumulated earnings, which is worth watching if the company already carries a large cash balance.

Lenders read these accounts. A bank evaluating a renewal will look for the key person policy on the asset schedule and for the collateral assignment on file. Keeping the assignment current is a covenant issue as much as an insurance one.

Collateral assignment for SBA and bank loans

Most SBA 7(a) loans above a modest threshold require life insurance on the principals, collaterally assigned to the lender for the loan amount. Collateral assignment means the lender is paid first from the death benefit up to the outstanding balance, and the remainder goes to the named beneficiary — it does not make the lender the owner or the full beneficiary.

Practical points that trip Texas borrowers: the assignment is a separate carrier form that takes one to three weeks to record, the lender usually wants the recorded assignment before funding, and term insurance satisfies the requirement as long as the term outlasts the loan. A ten-year term against a fifteen-year loan will fail the covenant in year eleven.

When the loan is repaid, file a release of assignment with the carrier. Unreleased assignments from paid-off loans routinely delay claims years later.

Insurable interest and what happens when it ends

Texas requires insurable interest at the time the policy is issued, not continuously, so a policy remains valid if the employee later leaves. But keeping a policy on a former employee is awkward at best and, where the company continues to benefit from their death with no ongoing relationship, invites scrutiny.

Three clean exits exist. Let a term policy lapse. Surrender a permanent policy for its cash value, recognizing ordinary income on gain above basis. Or transfer the policy to the insured, which is an explicit exception to the transfer-for-value rule and preserves the tax-free death benefit for their family — often offered as part of a departure package.

Whatever you choose, document the decision in the corporate records and notify the insured in writing. Silence here is how a company ends up paying premium for a decade on someone it no longer employs.