Key Person Insurance Guide
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A vital part of any business is the people that work there. So it can have a major financial impact if an important member of staff dies unexpectedly or is unable to work due to serious illness. Small and medium sized businesses are particularly at risk but fortunately, you can take out insurance which will replace the lost profits caused by the loss of a key individual.
Short term or long term cover?
There are various types of insurance policy that can be used for this purpose. Often there is a short term need for cover during an important project. In this situation, a term assurance policy tends to be the most popular choice.
However, if a person is going to remain key to the business over the longer term or throughout his or her working life, such as the owner or founder of the business, whole of life assurance will be more appropriate.
All types of business can take out key person insurance, but the arrangements may differ. Companies and sole traders can effect policies on employees. But partnerships in England and Wales are not a separate legal entity, so where the key person cover is for an individual partner, the policy can either be taken out jointly by all the partners, in which case it becomes a partnership asset or, alternatively, the key partner could take out a policy and place it in trust for the other partners.
How much cover do I need?
The amount of insurance taken out has to be justifiable. Factors to be taken into account in estimating the cover needed will include the profits that will be lost, if the services of the key individual are no longer available, the expected cost of recruiting and training a new person and the length of time before that replacement is likely to be fully established.
Where a loan will be called in on the death of the key person, the amount of the loan and the effect this would have on the profitability of the business will need to be assessed.
To calculate the sum insured, it is generally acceptable to use the individual's earnings, including bonuses and company perks, multiplied by a factor of five to ten times earnings. Alternatively a multiple of profits may be used, which should not exceed two years' gross profits or five times annual net profit, divided by the number of key people being insured.
The tax implications of this type of insurance vary. Each case is treated individually so it is therefore highly recommended that a business liaises with the local taxman before taking out a policy, to find out how it will be treated for tax purposes.
Often the premiums for key person insurance will be allowed as a business expense for corporation tax purposes, but only if three conditions are met:
- that the sole relationship between the person taking out the cover and the person being covered must be that of employer and employee;
- that the plan should cover the loss of profits caused by the loss of the employee's services; and
- that the term of the insurance should be reasonable - typically five to 10 years at most.
Whole of life assurance would not therefore qualify, nor would the premiums for a policy covering a director with a significant shareholding (5 per or more) in a company, as it would be considered that the cover was primarily for his or her own benefit. In a partnership, it is also unlikely that tax relief would be given on the life of a partner.
Whether or not the proceeds of the policy are subject to tax will depend largely on how the premiums have been treated for tax purposes. Generally speaking, if tax relief has been allowed on the premiums, the proceeds will be taxed as a trading receipt, while if no tax relief has been received at the outset, the proceeds will not be taxed. But there are no hard and fast rules. Much will depend on the judgement of your local tax inspector.
Where the policy proceeds are taxable, the tax payable will be linked to the type of the underlying policy. Payments under a key person term assurance policy will be treated as a trading receipt and subject to corporation tax. Bearing in mind that the policy has been taken out to replace lost profits and those profits would have been liable to tax, this approach makes sense.
However, the payout from a whole of life policy is treated differently as it is considered a capital item. As these policies are deemed 'non-qualifying' for life assurance purposes, they will be taxed as the company's income. The taxable amount is the difference between the premiums paid and the surrender value of the policy immediately before the claim, and will be taxed as the company's income.
Due to these differences in tax treatment, clarifying the tax position in advance with the local tax office is vital so that an adequate sum assured can be calculated. If no account of tax is taken, the policy proceeds may fall short of the amount the business requires to compensate for any losses.
Taxation of Key Person Policies
There are strict rules about how the premiums and the benefits are treated for tax purposes.
1. Tax treatment of premiums The sole relationship of the key person and the business is that of employee and employer
The policy is intended to compensate for loss of profit
The policy term is five years or less
The policy premiums paid by the business firm may be treated as a deductible business expense and eligible for tax relief if all of the following conditions are met:
It is unlikely that tax relief on premiums will be allowed where the key person is a partner because the relationship is not purely that of employer and employee.
If the reason for the policy is not purely to compensate for loss of profit, then the premiums will not be a tax-deductible expense. This can arise where:
The policy has an investment element
The life assured owns more than five per cent of the company's shares
The policy is taken out to underwrite a business loan
The policy contains an option to convert it to another kind of policy (e.g. term assurance to whole of life) or to renew the cover.
2. Taxation of claims
If tax relief on premiums is allowed, then the policy proceeds will usually be taxable as a trading receipt.
Where tax relief on premiums is disallowed, the proceeds will usually be treated as a capital receipt taxed under Chapter ll Part Xlll of the 1988 Income and Corporation Taxes Act, whenever a "chargeable event" arises.
A chargeable event occurs on death but not on a critical illness claim. A tax liability arises if the policy generates a "chargeable gain" - calculated as the surrender value of the policy immediately before death less premiums paid to date. Any surplus is added to company or partnership profit and taxed accordingly.
3. Not claiming premium relief
The business may choose to forgo tax relief to try and avoid taxation of the proceeds. However, the decision on the tax treatment of the premiums rests with the local tax inspector who can rule premiums tax-deductible, even when no claim for premium tax relief is made.
In fact, it makes no difference to the premiums whether they are tax-deductible or not, provided that the policy is set up on the correct basis. For example,
A company is showing a £350,000 profit. If the key person assurance premiums are tax-deductible, an extra £100,000 trading receipt will be taxed at 32.75%. Therefore, to be left with £100,000 after corporation tax, the company would have to insure for £100,000/(0.6725) = £148,698.
If the premium for £100,000 cover is £25 p.m., the cost of £148,698 will be £37.17 p.m. However, after corporation tax relief it is £25 p.m.
If the premiums are not tax-deductible, then the policy proceeds should be treated as a capital receipt. As there is no surrender value on a term assurance contract, the policy proceeds should be tax-free at £100,000 for a gross premium of £25 p.m.
A problem only arises if the policy is set up on the understanding that the proceeds will be tax free and they later turn out to be taxed because, say, the tax inspector rules that the premiums should have been tax-deductible. For this reason, it is vital that the business liases with its local tax inspector to confirm the tax position of the premiums and the benefits before the policy is issued.
Last edited July 2007