Both the IRS and the courts have long recognized that the loss of an owner, manager, scientist, salesperson, director or other key individual will almost always have a serious effect on the earning power and sometimes on the very stability of a business. Although the principle applies in publicly held businesses, it is particularly true in a privately held company where profits are dependent on the ability, initiative, judgment or business connections of a single person or small group of owners/employees. The death or disability of a key person at the wrong time can have a dramatic impact on a smaller business.

There is no universally recognized and accepted formula for computing the economic effect of the loss of a key person. Some authorities feel that if the business will survive the death of the key employee and, in time, a competent successor can be found, a discount factor of from fifteen to twenty percent should be used. Where the business is likely to fail or be placed in serious jeopardy upon the death or disability of the key employee, a discount of from twenty to forty five percent is more appropriate. The exact discount factor should be arrived at through consultation with the officers of the company and the firm's accounting and legal advisers.

Some questions to ask in determining the factor or range of factors to be used include the following:

How long will it take for a new person to reach the efficiency of the key individual?

How much will it cost to locate and situate a replacement?

Will the new employee demand more salary?

What mistakes is a replacement likely to make during the break-in period and how much are those mistakes likely to cost the company?

What proportion of the firm's current net profit is attributable to the key employee?

Is the employee engaged in any projects that, if left unfinished at death or disability, would prove costly to the business? If so, how costly?

Would a potentially profitable project have to be abandoned or would a productive department have to be closed?

Would the employee's death result in the loss of clientele or personnel attracted to the business because of his or her personality, social contacts, unique skills, talents, or managerial ability?

What effect would the key employee's death have on the firm's credit standing?

What proportion of the firm's actual loss is it willing to self-insure, if any?