Key Person and Buy-Sell Life Insurance for Small Business Owners

Key person and buy-sell life insurance are the two policies that keep a small business alive after an owner or a critical employee dies. Key person insurance pays the business to replace the income, expertise, and stability it loses. Buy-sell life insurance gives the surviving owners the cash to buy out a deceased partner’s share, so the family gets paid fairly and control of the company stays where it belongs.

If you own a business with partners, or you rely on one or two people the company cannot run without, you likely need both. Here’s how each policy works, how to size it, what the IRS allows, and the one Supreme Court decision that can hand your family a surprise estate tax bill if your agreement is written the wrong way.

What key person life insurance actually protects

Key person insurance is a life insurance policy the business owns and pays for on someone the company depends on — usually an owner, a top salesperson, a lead engineer, or a partner who holds the client relationships. The business is the owner and the beneficiary. If that person dies, the death benefit goes to the company, not the family.

The money buys time. It covers lost revenue while you replace the person, pays down debt a lender might otherwise call, funds recruiting and training, and reassures banks, vendors, and other partners that the business will survive. For a lot of small companies, one person leaving unexpectedly is the difference between a rough year and a closed door.

Some lenders require it. Many small business owners first run into key person coverage when applying for an SBA loan, because the lender wants an assignment of a policy on the owner as collateral.

How to size key person coverage

There’s no single formula, but here’s how I walk owners through it during a consultation:

1. Replacement cost. What would it cost to recruit, hire, and train a replacement, plus lost productivity during the gap? For a rainmaker, that can be one to two years of the revenue they personally drive.
2. Lost profit. Estimate the profit tied directly to that person, and multiply by the number of years it would take the business to recover.
3. Debt and obligations. Add any business loans, lines of credit, or lease guarantees that would come due or be at risk.
4. A multiple-of-salary shortcut. Many carriers will approve roughly 5 to 10 times the person’s compensation without heavy justification. Larger amounts need financial documentation.

Term life is the usual choice for key person coverage because it’s affordable and matches a defined risk window. If the need is permanent — or you want the policy to build cash value the business can borrow against — permanent insurance can make sense. Not sure how much your own family needs on the personal side? Our guide on how much life insurance you actually need uses the same logic.

What a buy-sell agreement does — and why it needs funding

A buy-sell agreement is a contract among co-owners that spells out what happens to an owner’s share if they die, become disabled, or leave. It sets the price, names who can buy, and locks in the terms ahead of time so nobody is negotiating with a grieving spouse during a crisis.

The agreement is only half the plan. The other half is the money to honor it. That’s where life insurance comes in: policies are put in place so that when an owner dies, the death benefit provides the cash to buy the shares at the agreed price. Without funding, a buy-sell is just a promise nobody can afford to keep — and the deceased owner’s family can end up as unwanted business partners.

Cross-purchase vs. entity redemption: two ways to structure it

There are two common ways to fund a buy-sell with life insurance, and the choice matters more than most owners realize.

In a cross-purchase, each owner personally buys a policy on every other owner. When one dies, the survivors collect the death benefit directly and use it to buy the shares from the estate. In an entity redemption (also called a stock redemption), the business itself owns the policies and redeems the deceased owner’s shares.

Feature	Cross-purchase	Entity redemption
Who owns the policies	Each owner, on the others	The business
Who buys the shares	Surviving owners	The company
Policies needed (3 owners)	6	3
Cost basis for buyers	Survivors get a stepped-up basis	No basis step-up for survivors
Estate-tax value impact	Proceeds stay outside the company	Proceeds can raise the company’s value
Admin complexity	Higher with many owners	Simpler paperwork

Entity redemption is simpler to administer — one policy per owner instead of a policy for every pairing. But that simplicity now carries a real tax risk, which is where the Connelly case comes in.

The Connelly trap every business owner should check

In June 2024, the U.S. Supreme Court decided Connelly v. United States. Two brothers owned a supply company and set up an entity-redemption buy-sell funded with company-owned life insurance. When one brother died, the company received about $3 million in death benefit and used it to redeem his shares.

The estate argued the company’s value should be reduced by its obligation to buy back the shares, so the insurance was a wash. The Court disagreed — unanimously. It held that the life insurance proceeds were a corporate asset that increased the company’s value for estate tax purposes, and the redemption obligation did not offset it. The result was a much higher business value and a larger estate tax bill.

Here’s why this matters for you: if your buy-sell is an entity redemption funded with company-owned insurance, the death benefit meant to rescue your family could inflate the taxable value of your estate. Many agreements written before 2024 still have this exposure. A cross-purchase structure — where individual owners, not the company, hold the policies — generally keeps the proceeds outside the business and sidesteps the problem. For businesses with several owners, an insurance LLC can hold the policies and fund a cross-purchase without the headache of dozens of cross-owned contracts. This is worth a review with your attorney and CPA, not a DIY fix.

Are the premiums tax-deductible? What the IRS allows

This is the most common misconception I hear. No — premiums for key person or buy-sell life insurance generally are not tax-deductible. Under IRC Section 264, a business cannot deduct premiums on a policy where it is directly or indirectly the beneficiary. Trying to write them off is a classic audit trigger.

The trade-off is on the back end. The death benefit is usually received income-tax-free under IRC Section 101(a). But for business-owned policies, there’s a catch created by IRC Section 101(j): to keep that tax-free treatment, you must meet the notice-and-consent rules before the policy is issued. In writing, the insured employee has to be told the business intends to insure them and the maximum amount, consent to the coverage, and acknowledge the business will be the beneficiary.

Miss that step and the death benefit above the premiums paid can become taxable to the business — a costly, avoidable mistake. The business also files IRS Form 8925 each year to report its employer-owned policies. Get the paperwork right up front and the coverage does what you intended.

Common mistakes I see business owners make

A few patterns come up again and again:

• No funding behind the agreement. The buy-sell exists on paper, but there’s no life insurance to pay for the buyout. When the day comes, nobody has the cash.
• Stale valuations. The agreement names a price set years ago. The business has doubled since, and the coverage no longer matches the real buyout number. Revisit both every few years.
• Skipping the 101(j) consent. The policy is bought without the written notice and consent, quietly putting the death benefit’s tax-free status at risk.
• One captive quote. An agent who represents a single carrier can only offer that carrier’s price and underwriting. Business coverage often needs bigger face amounts and financial justification, and offers vary widely between companies.

Owners also tend to protect the business but forget their own income. If you’re self-employed or a partner, personal disability insurance protects your paycheck if you’re too sick or hurt to work — a risk far more likely than death during your working years. Real protection covers both the business and the people who run it.

Key person and buy-sell life insurance FAQ

What is the difference between key person and buy-sell life insurance?

Key person insurance pays the business to survive the loss of a critical person, covering lost revenue, debt, and hiring costs. Buy-sell insurance funds the purchase of a deceased owner’s shares, so the family is paid and ownership stays with the surviving partners. Many businesses need both.

Is key person or buy-sell life insurance tax-deductible?

Generally no. Because the business is the beneficiary, IRC Section 264 blocks a deduction for the premiums. The upside is that the death benefit is usually received income-tax-free under Section 101(a), as long as the business met the notice-and-consent rules before the policy was issued.

How much key person coverage does a small business need?

It depends on the person’s role. Start with the cost to replace them, the profit tied to their work, and any business debt at risk. Many carriers approve roughly 5 to 10 times the person’s compensation without extensive documentation; larger amounts need financial records.

Should I use a cross-purchase or entity redemption buy-sell?

Cross-purchase gives surviving owners a stepped-up cost basis and keeps insurance proceeds outside the company, which avoids the Connelly valuation problem. Entity redemption is simpler to administer but can raise the business’s estate-tax value. With several owners, an insurance LLC can fund a cross-purchase cleanly. Confirm the choice with your attorney and CPA.

How does the Connelly ruling affect my buy-sell agreement?

The 2024 Supreme Court decision held that company-owned life insurance used to redeem a deceased owner’s shares increases the business’s value for estate tax and is not offset by the buyout obligation. If your agreement uses entity redemption funded with company-owned insurance, have it reviewed — a cross-purchase structure often removes the exposure.

What type of life insurance is best for a buy-sell agreement?

Term life is common and cost-effective when the risk window is defined. Permanent insurance can fit when the need is lifelong or you want cash value the business can access. The right answer depends on the owners’ ages, the business plan, and budget, so compare both across carriers.

Can one policy cover both key person and buy-sell needs?

It’s usually cleaner to keep them separate, because they have different owners, beneficiaries, and purposes. Key person coverage is owned by and paid to the business. Buy-sell funding follows the structure you choose. Mixing them can create tax and ownership confusion, so most owners hold distinct policies.