Under the Income Tax Act, 1961, a keyman insurance policy is taxed differently from ordinary life insurance: the business can deduct the premiums as an ordinary business expense under Section 37(1), but the entire payout — on death, maturity, or surrender — is treated as business income under Section 28(vi) and does not qualify for the Section 10(10D) exemption that shields most life insurance proceeds. This is the core of keyman insurance policy taxability under the Income Tax Act, and a 2013 amendment closed the older escape route of assigning the policy to the insured employee to convert the eventual payout into a tax-free receipt.
What Counts as a Keyman Policy
Explanation 1 to Section 10(10D) defines a keyman insurance policy as a life insurance policy taken by one person on the life of another who is or was an employee, or who is or was “connected in any manner whatsoever” with the policyholder’s business.1Income Tax Department. Income Tax Act Section 10 That last phrase pulls in relationships well beyond a standard employer-employee tie. A partnership firm insuring a partner, a company covering a lead consultant, and a family business insuring a non-employee promoter can all fall inside the definition.
The business pays the premium and is the beneficiary. The person insured is someone whose loss would cause the business real financial damage — typically a founder, a managing director, a top revenue generator, or a specialized technical expert.
Are the Premiums Deductible
Section 37(1) allows a deduction for any business expenditure that is not capital in nature and is laid out wholly and exclusively for the purposes of the business.2Income Tax Department. Income Tax Act Section 37 The Act itself does not carry a specific provision for keyman policy premiums, but CBDT Circular No. 762 dated 18 February 1998 confirmed that premiums on a keyman policy are deductible under Section 37(1), because the policy protects the business against financial loss from the death of a key person.
The deduction is available even where the insured is a director or shareholder. Courts have upheld deductions for policies taken on the lives of employee-directors, on the view that a director who actively drives revenue is precisely the type of person keyman cover is meant for.3BCAJ. Section 37(1) Premium Paid on Keyman Insurance Policy Allowable Expenditure
Partnerships are a grey area. The statutory language covers anyone “connected in any manner whatsoever” with the business, so a partner’s policy fits the definition. But some assessing officers have denied the deduction on the ground that a partner policy is a personal rather than business expense, and tribunal decisions have gone both ways. If your firm insures a partner, keep detailed records showing the policy protects business income rather than the individual partner’s personal interests.
Whatever the entity type, a board resolution or partnership deed entry recording why the insured person is critical to revenue is worth having on file. Assessing officers look for that link, and the deduction is exposed to disallowance without it.
How the Payout Is Taxed for the Business
Section 10(10D) exempts most life insurance receipts from tax, but clause (b) specifically excludes any sum received under a keyman insurance policy.1Income Tax Department. Income Tax Act Section 10 The exclusion applies whether the payment comes from a death claim, on maturity, or on surrender.
Section 28(vi) then places that receipt under the head “profits and gains of business or profession,” and expressly includes “any sum received under a Keyman insurance policy including the sum allocated by way of bonus on such policy.”4India Code. The Income-Tax Act 1961 The entire amount, bonuses included, becomes taxable business income.
The rate depends on the company’s structure and which regime it has opted into. For assessment year 2026-27, domestic company rates (before surcharge and cess) are:
- 22% for companies that have opted into Section 115BAA
- 25% for companies with turnover or gross receipts up to ₹400 crore in previous year 2020-21, or those under Section 115BA
- 30% for all other domestic companies
Surcharge and a 4% health and education cess apply on top.5Income Tax Department. Domestic Company for AY 2026-27 There is no concessional rate for insurance proceeds. A company receiving a ₹1 crore death benefit reports the full amount as business income and pays at whichever rate applies to it. Businesses that fail to plan for this often find themselves short of cash exactly when they most need liquidity.
When the Employee or Family Receives the Money
The payout doesn’t always land with the company. Where the insured person or their heirs collect the proceeds, the tax head depends on whether there was an employment relationship with the policyholder.
Current or former employees
Section 17(3) defines “profits in lieu of salary” to include any sum received under a keyman insurance policy, together with bonuses allocated on it.6Indian Kanoon. Section 17 in The Income Tax Act 1961 When an employee, a former employee, or their heirs receive the proceeds, the whole amount is taxed as salary income at the individual’s applicable slab rate. Slab rates for AY 2026-27 under the default new regime run from 5% on income above ₹4 lakh up to 30% on income above ₹24 lakh, plus surcharge and 4% cess.7Income Tax Department. Individual Having Income from Business or Profession for AY 2026-2027
Heirs receiving a death benefit inherit this same characterization. A ₹50 lakh death benefit paid to a deceased director’s spouse gets added to the spouse’s income for the year and taxed at the applicable slab rate.
Recipients without an employment relationship
If the recipient was never employed by the policyholder — say, an outside consultant or a business associate — Section 56(2)(iv) directs the payment to “income from other sources.” The amount is still fully taxable at the individual’s slab rate; only the head of income changes, along with the deductions that may be available against it.
Assigning the Policy to the Insured Person
Businesses sometimes assign a keyman policy to the insured employee as a retention benefit or on retirement. Before 2014, this was also a widely used planning device: once assigned, the policy shed its keyman label and any eventual maturity proceeds in the employee’s hands could claim the Section 10(10D) exemption. The Finance Act, 2013 largely shut that door.
The 2013 amendment
The amendment expanded Explanation 1 to Section 10(10D) so that a policy that was originally a keyman policy but is later assigned to any person continues to be treated as a keyman insurance policy. It took effect from 1 April 2014.1Income Tax Department. Income Tax Act Section 10 For any policy assigned on or after that date, the keyman character carries through the assignment. Maturity proceeds or death benefits stay outside the Section 10(10D) exemption in the employee’s hands.
The Mumbai Tax Tribunal has held that this amendment is prospective, so policies assigned before 1 April 2014 may still qualify for exemption under the earlier rules. For any assignment after that cut-off, however, personal ownership doesn’t rescue the payout from tax.
Tax at the point of assignment
On transfer, the surrender value of the policy on the date of assignment is treated as a perquisite under Section 17(2) and taxed as salary in the employee’s hands for that year. A surrender value of ₹20 lakh at transfer means ₹20 lakh added to salary income at the applicable slab rate. Some tribunal decisions have taken a different view and held that no taxable event arises at the moment of assignment, with tax deferred until the policy matures or is surrendered. Given the split in authority, an employee taking over an assigned keyman policy should budget conservatively for tax on the surrender value in the year of assignment.
After the transfer, the employee pays future premiums from post-tax income, and the business loses the premium deduction for those payments. Because of the 2013 amendment, the eventual maturity proceeds remain taxable in the employee’s hands, either as salary under Section 17(3) or as income from other sources under Section 56(2)(iv), depending on employment status when the payout occurs.
TDS on the Payout
Insurers deduct tax at source under Section 194DA before releasing the proceeds. The TDS rate on life insurance payouts is 2% of the income component, reduced from 5% with effect from October 2024. Without a valid PAN, the rate rises to 20%. The insurer issues a TDS certificate, and the recipient claims credit against final liability when filing the return. This applies whether the business or an individual collects the money, and any shortfall between the TDS and the actual tax has to be paid as advance tax or self-assessment tax.
Planning Around the Tax Hit
The most common mistake is treating the eventual payout as clean money and forgetting the tax that comes with it. A company in the 22% bracket under Section 115BAA that collects a ₹2 crore death benefit owes roughly ₹48-50 lakh in tax on that amount alone, once surcharge and cess are added. A few precautions keep the structure workable:
- Record the business purpose at the outset. A board resolution or partnership deed entry explaining why the insured person is critical to revenue protects the premium deduction if it is later questioned.
- Reserve funds against the future tax liability. Some businesses buy slightly larger cover to absorb the tax drag on proceeds.
- Think through assignment before making it. Since the 2013 amendment, transferring the policy to the employee does not convert it into tax-free personal insurance; it moves both the premium burden and the tax on eventual proceeds onto the employee.
- Check that TDS deducted under Section 194DA is reflected in Form 26AS so the credit flows through on the return.
- Factor in GST on premiums. It adds to the cost of cover, and whether input tax credit is available turns on the business’s own facts and is worth checking with a tax adviser.
Keyman insurance still gives a business immediate liquidity after losing its most important person, and the Section 37(1) deduction offsets some of the running cost. The trade-off is that Section 28(vi) claims the full payout as taxable business income when it lands. Setting the structure up correctly at the start, and knowing what the 2013 amendment did to the assignment route, is what separates a policy that does its job from one that becomes an expensive tax problem.