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TaxationWeb by Bob Fraser MBA MA FSFA

Bob Fraser, MBA, MA, FSFA, Associate Investment Director, Rensburg Investment Management Limited, outlines how ‘Key Person Insurance’ operates and considers the tax deductibility of payments for cover.Key person insurance is a vital requirement for many businesses, and it is often the case that loans will not be advanced unless such cover is in place.

However, this is also an area in which the quality of advice can be mixed and there are a number of issues to be aware of, both in terms of how to calculate the benefit and the taxation aspects of premiums and benefits.

Definition

The correct definition of Key person insurance is that it is cover that pays out to meet a financial loss in the event of either the death or disability of a key person in a company. Whilst most companies will insure the managing director and finance director, or the partners, it is also the case that an experienced salesman, designer, or any other individual with a key skill that cannot easily be replaced should also be considered.

Calculation of Benefit Required

Because the premiums may be eligible for tax relief, the Inland Revenue require that the amount of benefit covered can be justified. The benefit required is measured by reference to the individual’s contribution to the profits of the business. This is based of on the following information:-

• Past profits and projections for the future

• The effect that the loss of the individual would have on future profitability

• The anticipated cost of recruiting and/or training a replacement

• The expected recovery period, i.e., the length of time before a replacement is effective

• The amount of any loan(s) that would be called in on the death of the key person

Calculating the contribution to profits should be carried out using the most appropriate of the following methods:

Multiple of Remuneration

A multiple of the individual’s total remuneration, including any bonuses and benefits in kind, may be used to calculate the sum insured. The exact multiple chosen will depend on the potential loss, but a factor of 5 to 10 times remuneration may be considered reasonable.

This way is particularly helpful where the firm would wish to recruit a replacement. It is not appropriate if the individual being insured is a director of a developing business who may be accepting a modest income in the early stages which does not reflect their true worth to the business.

Multiple of Profits

Where a multiple of profits is used, this should not normally exceed 5 times the net profit or twice the gross profit averaged over the last 3 years. Where more than one individual is to be covered, the result must be appropriately adjusted. A formula for this is (average net profit for last 3 years) x 5 divided by the number of individuals covered.

The advice of the accountant must be taken before basing the calculation on a net profit figure since some businesses aim to produce a low net profit figure for tax purposes. Also using a net profit figure will not make any allowance for the fixed costs of the business, which still have to be met.

Directors Loan Accounts

Where directors have made loans, these create known liabilities. The sum insured and the term should mirror as closely as possible the amount of loan(s) outstanding.

Taxation Aspects

Based on a set of principles laid down in 1944 by the then Chancellor of the Exchequer, Sir John Anderson, the premiums paid will be allowed as a business expense for corporation tax purposes provided that:

1. The only relationship between the proposer and the life assured is that of employer and employee (except in the case of shareholding directors).

2. The plan is designed to cover loss of profits only.

3. The term of the insurance is reasonable - a 5 year term is normally acceptable but some local Inspectors will allow up to 10 years.

4. The employee does not hold a significant shareholding (less than 5% is probably insignificant).

If the premium is a permitted allowable expense, then the policy proceeds would normally be subject to taxation. However, there are no hard and fast rules regarding the tax treatment of premiums and benefits, and each case should be referred to the local Inspector of Taxes for approval before the policy is implemented.

It is not the case that if the business decides not to apply for tax relief on the premiums, any proceeds will necessarily be tax-free. The taxation decisions rest with the Inland Revenue, and there are reported cases of where the Revenue has taxed benefits on which the premiums did not obtain tax relief. However, such policy proceeds should usually escape tax, unless the proceeds are payable in instalments. As above, each case should be referred to the local Inspector of Taxes for approval before the policy is implemented.

It is therefore very important that the effects of taxation should be considered when setting the sum assured on key person cases.

Trusts

Since the object of the policy is to pay a lump sum to the business on the death or incapacity of a key person, it follows that the policy should not be written in trust.

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April 2005

Bob Fraser, MBA, MA, FSFA
Associate Investment Director
Rensburg Investment Management Limited

Bob Fraser is an associate investment director and has achieved the highest level of professional advisory qualifications in the financial services industry. He is a Fellow by examination of Personal Finance Society, which is a specialist faculty of the Chartered Insurance Institute. He also holds a Masters of Business Administration degree.

Rensburg Investment Management is the largest company in the Rensburg group and a subsidiary of Rensburg plc, a public company whose shares are quoted on the London Stock Exchange. Its core business is investment management and it currently looks after around £3.0bn of funds for private investors, trustees, charities and pension funds. It provides independent financial planning advice and investment management services to both individuals and businesses in order to meet their financial objectives. Financial planning is the process by which resources and risks are firstly identified and then used or provided for in a way which best achieves financial goals and lifestyle. It provides detailed advice to clients across the whole range of financial planning issues from the provision of straightforward life assurance, to savings and retirement planning, to complex inheritance tax planning arrangements.

Rensburg is authorised and regulated by the Financial Services Authority (FSA) whose function is to provide investor protection through the regulation of financial product providers in securities and derivatives business.