As an entrepreneur, which of your business assets require greater protection? In the event of any problems, your first response may be to prioritise your tangible assets, to reduce the risk of profit loss and business disruption.
However, insuring against the loss of your most valuable assets – specifically, your key employees or yourself if you are a sole trader – is arguably of greater importance.
In this insight, we look at why protecting your key people is of critical importance, and their tax position in such scenarios.
Identifying your key people
The identification of a key individual who should be insured varies for each business, and it is essential to consider potential issues that could have an impact, including:
- How readily could the business find a replacement for their expertise?
- Would it lead to a decline in goodwill or stricter credit terms from suppliers?
- Would their absence hinder business growth initiatives or current projects?
- Are there any loans or overdrafts that rely on the key individual?
- Could the business risk losing customer orders?
- Would the business be deprived of their administrative or managerial input?
Key person insurance presents numerous advantages for entrepreneurs and their businesses, particularly those that depend significantly on specific individuals.
Here are some principal benefits:
Financial Stability
- Offers a financial buffer to assist the business in recovering from the loss of a crucial individual.
- Assists in covering costs such as recruiting and training a replacement, settling debts, or compensating for lost income.
Business Continuity
- Provides peace of mind that the business can maintain operations seamlessly without significant interruptions.
- Help maintain confidence among employees, clients, and investors during these uncertain difficult periods.
Credit Protection
- Improves the business’s credit profile by demonstrating to lenders and investors that a strategy is in place to manage the loss of a key person.
- Can be utilised to secure loans or lines of credit.
Tax-Free Process
- The death benefit received by the business is typically tax-free, enabling the entire amount to be allocated for business requirements without additional tax implications.
Independent Financial Adviser
MHA
What is the tax position of a key person policy?
Surprisingly, the only guidelines on the tax treatment of a key person policy were set out back in 1944 by then-Chancellor of the Exchequer, Sir John Anderson, who stated: ‘Treatment for taxation purposes would depend upon the facts of the particular case, and it rests with the assessing authorities and the Commissioners on appeal if necessary to determine the liability by reference to these facts. I am, however, advised that the general practice in dealing with insurances by employers on the lives of employees is to treat the premiums as admissible deductions, and any sums received under a plan as trading receipts if:
- The sole relationship is that of employer and employee –
- The insurance is intended to meet loss of profit resulting from the loss of services of the employee, and
- It’s an annual or short-term insurance’
To explain those points further – in the first instance, if the individual in question holds a substantial interest in the business, tax relief is typically not permitted. Any ownership exceeding 5% may be regarded as significant in respect to key person protection.
The rationale behind this criterion is that for expenses to qualify for tax relief, they must be ‘wholly and exclusively for the purpose of trade’. Tax relief will not be accessible if the individual is a sole trader, as there is evidently a personal advantage for them or their family. Should the business cover the premiums on such a policy, it would generally be classified as drawings from the business.
Regarding the second point, the plan must be designed exclusively to address profit loss resulting from the death of the key individual. Any plan that includes a surrender value will not be eligible for tax relief because it does not meet the criterion of being wholly and exclusively for business purposes due to its investment component. The amount of coverage must also be deemed reasonable, which is typically evaluated during the financial underwriting process.
And thirdly, while there is no precise definition for short-term assurance, it is commonly understood to refer to a duration of five years, or potentially up to ten years at most. Five-year renewable insurance is generally considered acceptable, as it allows for continuation of the cover at the end of the term without any medical evaluation, making it a frequently recommended option by financial advisers.
What about any proceeds paid out under the plan?
The tax treatment of the premiums can influence the tax chargeable on the proceeds. If the premiums qualify for tax relief as a business expense, the proceeds are typically taxable as a trading receipt. The tax situation becomes somewhat more intricate and complex if you are in a partnership, and it is advisable to consult your tax accountant regarding this matter.
Our financial planners understand that when you are running a business, there are multiple issues competing for your attention at any given time, which is why robust financial planning is key to protecting yourself and your business.
For guidance with any of the topics raised in this article, contact our wealth and financial planning team at the website here.
MHA Wealth is the trading name of MHA Wealth Ltd, a company registered in England (1916615) with registered office at The Pinnacle, 150 Midsummer Boulevard, Milton Keynes, MK9 1LZ.
MHA Wealth is authorised and regulated by the Financial Conduct Authority (FCA) with registered number 143715 and is a member of the London Stock Exchange.
MHA Wealth is a member of the MHA group. Further information on the MHA group can be found at www.mha.co.uk/details-of-mha-uk-entities.
This communication is for general information only, is a marketing communication, and is not intended to be individual investment advice, a recommendation, tax, or legal advice. The views expressed in this article are those of MHA Wealth or its staff and should not be considered as advice or a recommendation to buy, sell or hold a particular investment or product. In particular, the information provided will not address your personal circumstances, objectives, and attitude towards risk.
The application of these principles will vary based on the specifics of your objectives and personal circumstances, we therefore suggest that the business or their accountant contact the local tax inspector when establishing the plans to verify your tax treatment.
This information represents our understanding at the time of publication of current law and HM Revenue & Customs practice. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. You are therefore recommended to seek professional regulated advice before taking any action.
Key Risks: Capital at risk. Past performance is not a guide to future performance. The value of an investment and the income generated from it can go down as well as up, and is not guaranteed, therefore you may not get back the amount originally invested.
Investment markets and conditions can change rapidly. Investments should always be considered long-term.
