Is Key Man Insurance Tax Deductible? Premiums, Loans, and Payouts

Key man life insurance premiums are generally not tax deductible. Federal tax law blocks the deduction whenever the business owns the policy and stands to collect the death benefit, because the eventual payout comes to the company free of federal income tax. One structural workaround exists, and a narrow interest deduction is available on loans against these policies, but the default answer for a business paying premiums on a policy it owns is no.

Why the Premiums Aren’t Deductible

IRC Section 264(a)(1) bars a deduction for life insurance premiums whenever the taxpayer is a direct or indirect beneficiary of the policy.¹ The Treasury regulation applies the rule squarely to key person coverage: if a company buys a policy to protect itself from the financial hit of losing that person, the company is treated as a beneficiary and loses the deduction.²

The reason is the offsetting benefit on the back end. Death proceeds paid to the business are generally excluded from gross income under IRC Section 101(a)(1).³ Allowing a current deduction on premiums and a tax exclusion on the payout would give the business a double benefit Congress never intended. So premiums are paid with after-tax dollars, and in exchange, the company keeps the full death benefit without owing federal income tax on it. That is the bargain of business-owned life insurance, not a technicality.

The One Way to Make Premiums Deductible

Premiums can be deducted, but only if the business gives up the policy entirely. Under IRC Section 162(a)(1), a business can deduct reasonable compensation paid for services actually performed.⁴ If the company pays the premium as a bonus to a key employee, and the employee owns the policy and names their own beneficiary, the payment is treated as compensation rather than a life insurance expense. Because the business has no beneficial interest, Section 264(a)(1) doesn’t apply.

These are commonly called Section 162 bonus plans. The company pays the premium directly to the carrier. The amount is reported on the employee’s W-2 as additional wages. The employee owns the policy outright. Some employers also gross up the bonus to cover the employee’s added tax bill, and the gross-up is deductible on the same reasonable-compensation basis.

Two limits matter. First, the employee’s total pay package — salary, bonuses, benefits, and the premium — has to be reasonable for the role, and the IRS can disallow deductions for compensation it considers excessive. Documenting how the total compares to market pay for similar positions helps. Second, and more importantly, the business no longer receives the death benefit. If the insured dies, the money goes to whoever the employee named. That is why this structure works as an executive retention tool, not as protection against losing the person.

Interest on Policy Loans: A Small Deduction That Does Exist

There is one narrow deduction connected to key person policies. IRC Section 264(a)(4) generally blocks interest deductions on debt tied to life insurance, but it carves out an exception for policies covering a key person. A business can deduct interest on up to $50,000 of borrowing per insured individual.¹

The statute defines “key person” narrowly here: the insured must be an officer or a 20-percent owner. The number of individuals a company can treat as key persons is capped at the greater of five people or the lesser of 5% of total employees and 20 individuals.¹ The deductible interest rate is also capped at the Moody’s Corporate Bond Yield Average, so anything charged above that benchmark isn’t deductible. The dollar cap keeps this modest, but for companies using permanent policies with cash value, it’s worth knowing.

Protecting the Death Benefit’s Tax-Free Status

The non-deductibility of premiums only pays off if the death benefit actually comes in tax-free. For policies issued after August 17, 2006, IRC Section 101(j) imposes strict notice and consent rules before the policy is issued. Miss them, and the company can only exclude the premiums it paid — everything above that becomes taxable income.³

Before the policy takes effect, the business has to complete three written steps with the insured employee:

Written notice that the company intends to insure the employee’s life, including the maximum face amount of coverage.
Written consent from the employee to be insured, acknowledging that coverage may continue after they leave the company.
Written disclosure that the business will be a beneficiary of the death proceeds.

All three must happen before the carrier issues the contract.³ Retroactive paperwork won’t fix a miss.

One boundary worth flagging: even with proper notice and consent, the full exclusion under Section 101(j)(2) requires that the insured was an employee within the 12 months before death, or was a director or highly compensated employee when the policy was issued.³ If a covered person left the company more than a year before death and didn’t fit those categories at issuance, the business is back to excluding only premiums paid. Companies should review coverage when key employees leave.

Annual Reporting on Form 8925

Businesses that own life insurance on their employees have to file IRS Form 8925 with their annual return. The form reports the number of employees covered by employer-owned policies issued after August 17, 2006, and the total coverage in force at year-end.⁵ The larger risk from noncompliance isn’t a filing penalty; it’s the loss of tax-free treatment on the payout under Section 101(j).

Basis Effects for S-Corp and Pass-Through Owners

For S corporations, LLCs, and partnerships, non-deductible premiums flow through to the owners in a specific way. Under IRC Section 1367(a)(2)(D), non-deductible expenses reduce each shareholder’s stock basis, and those reductions appear on the K-1.⁶ When a death benefit is later received, the tax-exempt income increases basis.

Over the life of a policy the net effect is usually positive, because the eventual basis increase from the payout dwarfs the yearly reductions from premiums. But in the years between purchase and claim, ongoing basis reductions can limit an owner’s ability to deduct other pass-through losses. Owners should track these adjustments annually rather than discovering a basis problem at filing time.

If the Policy Is Surrendered Instead

The tax-free treatment applies to death benefits, not to living proceeds. If the company surrenders the policy for its cash value, gain on the surrender is taxable as ordinary income under IRC Section 72(e). The tax applies to the difference between the cash surrender value and the total premiums paid.⁷ The premiums that were never deductible on the way in are recovered as basis, but any gain above them is fully taxable.

1
Office of the Law Revision Counsel. 26 USC 264 – Certain Amounts Paid in Connection With Insurance Contracts
2
Internal Revenue Service. 26 CFR 1.264-1 – Premiums on Life Insurance Taken Out in a Trade or Business
3
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
4
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
5
Internal Revenue Service. About Form 8925, Report of Employer-Owned Life Insurance Contracts
6
Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders
7
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts