Key Employee Insurance: Consent, Taxes, and Form 8925

Key employee insurance is a life insurance policy a business owns on the life of someone whose death or long-term disability would cause serious financial harm to the company. The business pays the premiums, owns the contract, and collects the death benefit. Under 26 U.S.C. § 101(j), the full death benefit is received income-tax-free only if the company satisfies specific notice, consent, and reporting rules before the policy is issued and every year it stays in force.¹ Miss any of those steps and the payout can turn into taxable corporate income.

Who the Policy Is Meant to Cover

In practical terms, a key employee is anyone whose absence would create an immediate, measurable financial loss: a founder with specialized knowledge, a top salesperson who owns the most important client relationships, a lead engineer who built the proprietary systems the company runs on. The test is replacement cost in time and revenue.

Federal tax law layers a second test on top. For the death benefit to be fully excluded from income, the insured must fit at least one category in 26 U.S.C. § 101(j)(2)(A):¹

An employee at any point during the 12 months before death.
A director of the company when the policy was issued.
A highly compensated employee under IRC § 414(q) when the policy was issued. The 2026 threshold is $160,000 in annual compensation.²
A highly compensated individual, meaning among the top 35 percent of employees by pay when the policy was issued.

Fitting a category is necessary but not sufficient. The notice and consent step described below must also be completed, or the exclusion is lost regardless of who the insured is.

Setting the Coverage Amount

There is no fixed formula for the face value, but underwriters focus on two things: how much revenue the person generates and how much it would cost to replace them. A common starting point is the employee’s salary plus their direct contribution to profit, multiplied by at least five. Specialized roles sometimes support a multiple as high as ten times total compensation.

A replacement-cost approach adds recruiting fees (often 20 to 30 percent of the new hire’s annual salary), the salary differential during the transition, lost productivity, and the ramp-up time before a successor is fully effective. Whichever method you use, the insurer will require financial documentation showing the requested coverage is proportional to the actual economic risk. Three years of audited balance sheets and income statements, along with a narrative explaining the employee’s role and revenue contribution, is standard.

Term or Permanent Coverage

The choice turns on how long the business expects to need coverage and whether it wants the policy to build cash value.

Term insurance covers a fixed period, typically 10, 20, or 30 years, and is significantly cheaper. It fits situations with a natural endpoint: protecting the company while a business loan is outstanding, covering a founder through the early growth phase, or insuring someone for the length of a specific contract. When the term ends, the coverage ends with no residual value.

Permanent insurance, whole life or universal life, costs several times more but lasts the insured’s lifetime and accumulates cash value on a tax-deferred basis. The company can borrow against that cash value, and the policy sits on the balance sheet as a financial asset. Permanent coverage tends to make sense for a long-term executive or co-owner, where the policy may also fund a buyout if the owner dies. The higher premium ties up cash flow a younger business may need elsewhere.

Notice and Consent Before the Policy Is Issued

This is the step businesses most often get wrong, and it’s the fastest way to lose the tax-free treatment. Under 26 U.S.C. § 101(j)(4), the employer must complete all of the following before the insurer issues the contract:³

Tell the employee in writing that the company intends to insure their life.
Disclose the maximum death benefit for which the employee could be insured when the policy is issued.
Inform the employee in writing that the company will be a beneficiary of any proceeds.
Obtain the employee’s signed consent to being insured, including acknowledgment that the coverage may continue after employment ends.

All four pieces must be documented and dated before issuance. Carriers typically provide a template, but the legal obligation sits with the employer. A consent form signed after the policy is already in force does not fix the problem.

How the Payout and Premiums Are Taxed

The Default Is That the Payout Is Partly Taxable

Most business owners have the rule backwards. The default under 26 U.S.C. § 101(j)(1) is that employer-owned life insurance death benefits are not fully tax-free. If the company doesn’t meet the statutory requirements, the exclusion is capped at the total premiums the company paid. Everything above that amount is included in gross income.¹ For a C corporation, that excess is taxed at the 21 percent corporate rate. For pass-through entities, it is taxed at the owner’s individual rate.

Full exclusion requires both conditions: the insured fits a qualifying category, and the notice and consent process was completed before issuance.¹ Miss either and the company could owe tax on the bulk of a seven-figure payout.

Premiums Are Never Deductible

Whether or not the death benefit qualifies for the exclusion, the premiums the company pays cannot be deducted. Under IRC § 264, no deduction is allowed for life insurance premiums when the taxpayer is directly or indirectly a beneficiary.⁴ The company pays with after-tax dollars, and the tax-free death benefit is the offsetting side of the bargain.

Form 8925 Every Year

Every business that owns one or more employer-owned life insurance contracts issued after August 17, 2006, must file IRS Form 8925 each year the policy is in force. The form reports the number of insured employees and the total amount of insurance in force at year end, and it attaches to the company’s income tax return.⁵⁶

Penalties for returns due in 2026 are tiered: $60 per return if filed within 30 days of the deadline, $130 if filed between 31 days late and August 1, and $340 if filed after August 1 or not at all. Intentional disregard raises the penalty to $680 per return with no cap, and the IRS charges monthly interest on unpaid amounts.⁷

Covering Disability as Well as Death

Death is not the only risk. A key employee who becomes permanently disabled creates the same financial hole without triggering a life insurance payout. Key person disability insurance pays the business a benefit while the employee cannot work.

The decisive detail in any disability policy is how total disability is defined. Most key person disability policies use an own-occupation standard: the employee is disabled if they cannot perform the core duties of their specific role. A stricter any-occupation definition only pays if the employee cannot work in any comparable position. Own-occupation protection costs more but is substantially broader.

Policies also include an elimination period, the waiting time between the onset of disability and the first benefit payment. Common ranges run from 30 to 365 days. A longer elimination period lowers premiums but forces the business to absorb losses in the gap. A 90- to 180-day period usually balances cost against the realistic time needed to confirm the disability is permanent enough to warrant a claim.

When the Insured Employee Leaves

Key employees eventually leave. The company still owns the policy and has four options.

Keep the policy and continue paying premiums. The full tax-free death benefit under § 101(j)(2)(A)(i) only applies if the insured was an employee within 12 months of death. Past that point, the company has to rely on a different exception, such as director or highly compensated status at issuance, to preserve the exclusion.¹
Surrender a permanent policy for its cash value. The surrender value equals the accumulated cash value minus surrender charges and outstanding loans. Surrender charges are highest in the first several years and decrease over time. Any gain above total premiums paid is taxable to the business.
Transfer the policy to the departing employee. Under the transfer-for-value rule in IRC § 101(a)(2), transferring a life insurance policy for valuable consideration generally makes future death benefits partially taxable, but a transfer directly to the insured is a statutory exception, so the death benefit stays fully tax-free for the employee’s beneficiaries.¹
Substitute a new key employee on the existing policy if the carrier allows it. Updated underwriting is usually required and the premium may change. Many companies simply let the old policy lapse and write a new one on the replacement hire.

Whichever path you choose, act promptly. Continuing to pay premiums on a policy for someone who no longer matters to the business is a quiet drain on cash flow that’s easy to overlook.

1
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
2
Internal Revenue Service. Notice 2025-67 – 2026 Amounts Relating to Retirement Plans and IRAs
3
Internal Revenue Service. Notice 2009-48 – Treatment of Certain Employer-Owned Life Insurance Contracts
4
Office of the Law Revision Counsel. 26 USC 264 – Certain Amounts Paid in Connection With Insurance Contracts
5
Internal Revenue Service. About Form 8925, Report of Employer-Owned Life Insurance Contracts
6
Internal Revenue Service. Form 8925 – Report of Employer-Owned Life Insurance Contracts
7
Internal Revenue Service. Information Return Penalties