Is Key Person Insurance Tax Deductible? Premiums, Payouts, Form 8925

Key person insurance premiums are generally not tax deductible when the business owns the policy and names itself as beneficiary. Federal tax law blocks the deduction because the same business stands to collect the death benefit. The trade-off written into the code is that the payout itself usually arrives tax-free, provided the company clears specific notice, consent, and qualifying-employee requirements before the policy is issued.

Why the Premiums Aren’t Deductible

Under 26 USC 264(a)(1), a taxpayer cannot deduct premiums on a life insurance policy when the taxpayer is directly or indirectly a beneficiary of that policy.¹ A standard key person policy fits that description exactly: the business owns it, pays the premiums, and receives the money if the insured employee dies. Premiums are paid with after-tax dollars, and no deduction reduces the company’s taxable income.

The restriction reaches further than the premiums themselves. If a business borrows to fund the premium payments, it generally cannot deduct the interest on that borrowing either, particularly when the debt is part of a systematic plan to finance the policy through its cash value.¹ Both costs need a place in the annual tax plan.

The One Way Premiums Become Deductible

Premium payments can shift into deductible territory in a single arrangement: the business is not the beneficiary, and the premiums are treated as compensation to the insured employee. In that structure, the payments qualify as an ordinary business expense under 26 USC 162(a).² The employee must be the policy beneficiary, or must be free to name their own beneficiary such as a spouse or family member.

The premium then functions like a bonus. The business deducts it as compensation, and the employee reports the premium amount as part of gross income.² Because the payments count as wages, they carry payroll consequences too: Social Security and Medicare taxes apply on both sides. The employee’s total compensation package must also be reasonable for the role, measured against what similar businesses pay for similar services. An inflated package can prompt the IRS to disallow the excess.

The catch is obvious. In this structure the company loses the death benefit. It works as an employee perk, not as protection for the business.

How the Death Benefit Is Taxed

Premiums are non-deductible, but the payout side is friendlier. Under 26 USC 101(a)(1), amounts paid under a life insurance contract by reason of the insured’s death are excluded from the beneficiary’s gross income.³ A business that collects a $1,000,000 payout can put the entire amount toward recruiting a replacement, settling debts, or bridging lost revenue without owing federal income tax on the proceeds.

For employer-owned life insurance, that tax-free treatment isn’t automatic. Section 101(j) imposes a default cap: unless two conditions are met, the exclusion is limited to the total premiums the business paid into the policy, and anything above that number becomes taxable income.³ To keep the full exclusion, the business has to handle both the paperwork and the qualifying-employee test correctly.

Notice and Consent Before the Policy Is Issued

Section 101(j)(4) requires three written steps before the insurance contract takes effect:³

Written notice to the employee that the business intends to insure their life, stating the maximum coverage amount.
Written notice that the business will be a beneficiary of any death proceeds.
Signed employee consent to being insured, acknowledging that coverage may continue after employment ends.

Consent has a shelf life. The policy must be issued before the earlier of one year from the date consent was signed or the date the employee’s employment ends.⁴ Miss either deadline and the business needs fresh consent before issuance.

Who the Insured Person Must Be

Even with the paperwork in order, the full exclusion applies only when the insured falls into at least one of these categories:³

An employee of the business at any point during the 12 months before their death.
A director of the company when the policy was issued.
A highly compensated employee, meeting the thresholds in Section 414(q) or ranking among the highest-paid 35 percent of employees when the policy was issued.

Most key employees fit somewhere in that list. The risk case is a former employee who left more than 12 months before death and was not a director or highly compensated employee when the policy was originally issued. Paperwork alone won’t rescue that scenario.

What a Compliance Failure Actually Costs

A common misreading of Section 101(j) is that failing the requirements makes the whole payout taxable. It doesn’t. The exclusion is capped at the total premiums the business paid; only the amount above that becomes taxable income.³

On a $500,000 policy where the company paid $50,000 in premiums, $50,000 is excluded and $450,000 is taxable. On a $1,000,000 policy with $100,000 in premiums paid, $900,000 is taxable. The wider the gap between premiums paid and face value, the more expensive the failure.

The Transfer-for-Value Trap

A separate rule can strip the tax-free status when a key person policy changes hands. Under 26 USC 101(a)(2), if a life insurance policy is transferred for valuable consideration, the exclusion on the death benefit is limited to the purchase price plus premiums the new owner pays afterward.³ Everything above that total becomes taxable.

This comes up more often than businesses expect. Buying out a departing partner’s interest in a key person policy can trigger it. So can corporate restructurings and sales of policies between related entities.

The statute lists exceptions. The transfer-for-value rule does not apply when the policy is transferred to the insured person, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. Those exceptions do not cover “reportable policy sales,” where the buyer has no substantial family, business, or financial relationship with the insured beyond the policy itself.³ Verify how the rule applies before buying, selling, or restructuring any key person policy.

Cash Value: Surrender or Borrow

If the business holds a permanent policy rather than term, cash value builds up over time, and what the company does with it drives the tax result.

Surrendering the policy is a taxable event on the gain. The business compares the cash surrender value to its cost basis, which is the total premiums paid. Anything received above basis is taxable as ordinary income.⁵ If the company paid $80,000 in premiums and the cash surrender value is $95,000, the $15,000 gain is taxable.

Borrowing against cash value works differently. A policy loan is not immediate income while the policy stays in force, because there is an obligation to repay. If the policy later lapses or is surrendered with a loan outstanding, the loan balance folds into the taxable calculation and can produce an unexpected bill. Review the tax picture before surrendering a policy with meaningful cash value or an outstanding loan.

The Annual Form 8925 Filing

A business holding one or more employer-owned life insurance contracts issued after August 17, 2006, must file IRS Form 8925 with its income tax return every year the contracts remain in force. The form reports:⁶

Total employees at year-end.
How many of those employees are covered under employer-owned policies issued after August 17, 2006.
Total dollar amount of employer-owned life insurance in force at year-end.
Whether valid written consent has been obtained for each insured employee, and how many lack a valid consent.

The requirement runs every year the business holds the policy, not just the year of purchase. Keep the notice and consent forms with permanent records; because key person policies can stay in force for decades, retaining them for the full life of the policy is the safest approach.⁷

1
Office of the Law Revision Counsel. 26 USC 264 – Certain Amounts Paid in Connection With Insurance Contracts
2
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
3
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
4
Internal Revenue Service. Notice 2009-48 – Treatment of Certain Employer-Owned Life Insurance Contracts
5
Internal Revenue Service. Are the Life Insurance Proceeds I Received Taxable
6
Internal Revenue Service. Form 8925 Report of Employer-Owned Life Insurance Contracts
7
Internal Revenue Service. How Long Should I Keep Records