WHAT IS KEY PERSON INSURANCE
Key person insurance is the provision of protection to a business against the death and / or disability of a key employee. What makes a key employee is a subjective matter. Clearly, a salesperson who is responsible for the bulk of a company’s income would be defined as a key employee, likewise a design or research individual who is working on key new product areas would again qualify. There are, however, many other fields in which an employee may be defined as being of special worth to the business.
THE NEED FOR KEY PERSON INSURANCE
Clearly, the need for key person insurance is the protection of the business against unforeseen circumstances. No business would carry on without ensuring that their property ( computers, software, etc.) were protected by insurance. Statistically, it is just as likely that the staff who generate the income for the business will suffer an illness or injury that could be far more damaging to the health of the firm than the destruction of inanimate objects.
- The death or disablement of a key person can lead to:
- Interruption or loss of existing and potential product sales.
- Loss of confidence from existing or new suppliers.
- Loss of competitive edge afforded by innovation or design expertise.
- Special projects delayed or not completed.
- Additional strain on remaining staff who have to cover for the missing key person.
- Lowering of staff moral.
- Large recruitment costs and head hunting fees to find a replacement.
All these factors make it imperative that well run businesses insure their key staff, as well as their other assets.
TYPES OF KEY PERSON INSURANCE
There are many different ways to insure the key person.
Personal Accident Insurance
If a key person is going abroad, or it is felt by the employer that they undertake hazardous pursuits, then it is possible to insure the key person against death and permanent disablement by way of an accident.
Life assurance is the most common form of key person insurance. When the individual dies, the agreed sum assured is paid out.
Life cover can be undertaken in two main ways:
The life cover is taken out for an agreed period of time (for example, five years). If the key person dies within the term of the policy then the proceeds are paid to the company.
Whole of Life
A whole of life insurance provides the potential for continued cover of the key person for the remainder of their life. There are many types of whole of life plans; however, normally key person insurances are taken out on a “maximum sum assured” basis. This is an eight or ten year term of premium payments followed by a review where the premiums are reassessed according to the new age of the insured.
Critical Illness Cover (CIC)
A critical illness insurance pays out the benefits upon the confirmed diagnosis of an illness/condition which is listed in a range of life threatening illnesses. The main benefit to a business would be in the circumstances of perhaps a heart attack where the key person was unable to work, but likely to survive for a considerable period.
Permanent Health Insurance (PHI)
PHI benefits to a company are usually paid after the key person has been ill for a waiting period of three to six months. The benefit is usually paid for no more than three to five years.
TAX TREATMENT OF KEY PERSON INSURANCE
It is made clear within the guidelines that the tax treatment of a key person insurance will be subject to the agreement of the local inspector of taxes. Having said this, as a general rule, if the local inspector agrees to grant tax relief on the premiums, then the proceeds are usually taxed as a trading receipt. Conversely, if the inspector has disallowed the premiums as a trading expense, then the proceeds of any claim should be received tax free.
Please note it does not matter whether a business has been claiming tax relief on premiums and getting away with it. Until the local inspector agrees to the tax treatment of the premiums and benefits, then no certainty of tax treatment is achieved.
The following are further requirements which have to be met if the premiums for the key person insurance are to be agreed by the local inspector as an acceptable trading expense.
The Sole Relationship is that of the Employer and Employee
It is generally felt that where the key person has more than a 5% stake in the business, then tax relief on the premiums will be disallowed. This is because the premiums are not being paid exclusively for the purposes of the trade. On the key person’s death/disablement his estate will benefit due to the proceeds of the insurance possibly increasing the value of the business.
The Insurance is Intended to Meet a Loss of Profit Resulting From the Loss of the Employee’s Services
This requirement affects the following types of plans:
Life Contracts Which Acquire a Surrender Value
Whole of life and endowment plans usually generate surrender values which mean that their sole purpose is not to protect against a loss of profit. The premiums would normally not be an allowable business expense.
Life Contracts With Conversion Options
If the conversion options allow for the plan to be converted to a form of insurance which could acquire a surrender value, then the premiums would be unlikely to obtain tax relief.
Life Insurance Solely Designed to Protect Loans
Where a key person insurance is taken out to protect a loan, business relief on the premiums would not usually be granted, as a loan is a capital liability not a loss of profits. Typical examples of this would be where the lender insists on assigned life cover and the insurance, therefore, is a security for the loan and hence cannot be argued as being a protection against loss of profits.
The Contract is Annual of Short Term Insurance
This element of the requirements is very subjective. As a general guideline, local inspectors will usually approve straight term assurance plans up to ten years, however, term plans with options to extend beyond this period will not have their premiums agreed as a tax deductible business expense.
Tax Treatment of Benefits
Once the premium treatment has been agreed by the local inspector, you can usually expect the proceeds to be treated as follows:
Term Assurances Where Tax Relief Has Been Given on the Premiums
The proceeds would be taxable as a trading receipt. In these circumstances, it is sometimes possible to arrange for the proceeds to be paid out over a number of trading years to reduce the tax burden.
Term Assurances Where Tax Relief Has Not Been Given on the Premiums
Assuming that no surrender value is payable under the plan, the proceeds are usually paid tax free.
Whole Life and Endowment Assurances
Where a plan generates a surrender value, the tax on the proceeds is as follows:
- The surrender value prior to claim less any premiums paid. This is usually negative, hence no tax to pay.
- The surrender value less any premiums paid. This is usually negative, hence no tax to pay.
- The maturity value less any premiums paid.
Endowment Policies Undertaken to Repay Loans
Where the loans are to purchase land or buildings for the sole purpose of carrying out the firm’s trade, then tax arises only on the excess of proceeds over the loan the endowment is secured upon.