The success of a closely held business often depends on the personal services of key owner-employees and key non-owner-employees. The loss of a key employee�s services due to death or disability will probably result in a loss of income, at least temporarily, to the closely held business. In addition, the business could incur increased expenses if a replacement employee has to be recruited at a higher salary and requires extensive training. This key employee exposure should be considered to protect the income of the business.

The first step in handling this risk is to identify the key employees. Key employees have several characteristics distinguishing them from other employees, including the following:

Identifying the key employee might be more difficult than it seems. The owners of a closely held business are generally material participants in the business and can be classified as key employees. But beyond the owners the key employee risk is often overlooked. The business owners might uncover this risk by considering the damage to the business that would occur if a specific managerial employee was absent for longer than the normal vacation period.

Determining the key employee�s value to the closely held business is even more speculative than the valuation of the business itself. The actual valuation method depends on the characteristic of the employee that creates the key employee status. Determining the value of the key employee who attracts substantial business might be relatively easy. The net income resulting from the business he or she produces in excess of the amount of net income that could be expected from a similarly situated but less effective employee could be capitalized in some manner. Or if business goodwill is attributed to one key employee, the income level above the amount expected for a similar business can be attributed to that employee. This income attributed to goodwill can be capitalized to arrive at a current value for the employee.

The value of a key employee, particularly when more than one key employee is present, is usually more difficult to determine than in the example above. The firm may have to consider various subjective factors to arrive at a proxy for thekey employee�s value. For example, the firm should consider replacement salaries and the training required for a replacement employee to become effective. A simple approach might be to take the key employee and pick some multiple of current salary as a proxy for his or her value.

A business can purchase life insurance on the life of the key employee to cover the risk of an income loss and/or increase in expenses resulting from the key employee�s death. Term insurance can be purchased if the primary concern is the key employee�s dollar value to the business. Decreasing term might be appropriate because the key employee exposure decreases as the insured approaches retirement since the business can expect to have his or her services for a fewer number of years.

Key employee insurance, however, is usually coupled with some other purpose such as providing a retirement benefit for the key employee. Permanent life insurance is typically purchased to meet this objective. The life insurance death benefit will be received by the business as indemnification for the income

loss and/or increase in expenses resulting from the key employee�s death. If the insured survives to retirement, the corporation can use the cash surrender value to fund a deferred-compensation retirement benefit. Another approach is for the business to transfer the policy to the employee at retirement.

The business should be the owner and beneficiary of key employee life insurance. This should pose no insurable interest problems since the business will suffer a pecuniary loss at the death of the key employee. The premiums for key employee insurance will be nondeductible, while death benefits will be received tax free. An additional benefit of key employee insurance is that no accumulated-earnings tax problems should result since the accumulation of earnings to insure the key employee death risk will meet the reasonable-business-needs test. For incorporated businesses key employee life insurance may, however, increase exposure to the alternative minimum corporate tax discussed later.