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.
Critical illness cover
In addition to life assurance, it is wise to consider taking out critical illness cover. The same problems can arise for the business if the key person is unable to work due to serious illness such as cancer, heart attack or stroke as would be the case if that person died. Critical illness cover can be combined with life assurance and the policy will pay out a lump sum whichever event happens first. Alternatively, stand-alone critical illness insurance is also available.
The type of key people for whom insurance could be taken out includes both directors and employees. If an owner director dies or is unable to return to work due to ill health, there could be succession costs to pay, or he or she may have personally guaranteed loans made to the company. Key employees might include project managers working on a new product or a sales director whose absence would result in lost sales and goodwill.
Partnerships
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.
Tax position
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.
Last edited July 2007
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