Key person insurance protects a business from the adverse economic effects of suddenly losing a key person through death, total and permanent disablement (TPD) or a traumatic illness.
Who is a key person?
Most businesses insure their machinery, cars and buildings. But, on their own, these assets can not produce profit. It is the human asset, which, through initiative, skill, expertise, knowledge and ingenuity, can turn capital and assets into profit.
A key person can broadly be defined as someone whose continued association with a business provides that business with economic gain. Economic gain does not just mean profits. Economic gain can also include cost savings, capital injection, goodwill, access to credit, access to customers, etc. The most common example is a key employee who is directly responsible for bringing in sales. The Following are also examples of key people:
- Managing Director – whose expertise, ingenuity and ability enable the company to run smoothly, and within budget;
- Financial Controller – who has set up a new budgeting and reporting system which has already saved the company money, and will continue to do so as it is developed further;
- Computer Programmer – who has been contracted to write a software program that the company can sell in the market;
- Specialist Engineer – whose specialist knowledge enables the company to win contracts;
- Working Director – who does the work of two employees, but only draws a moderate salary, so that more money can go back into the business;
- Silent Partner – who was brought in as a partner because of his/her reputation with financiers and the credit the business can access as a result.
Why is key person insurance needed?
Losing a key person can have an adverse effect on the profitability or capital value of the business. Protecting the business with key person insurance replaces the lost profit or capital value, stabilising the business until a suitable replacement is found and operating proficiently.
The loss of a key person can have an adverse effect on profit because of higher costs or lower revenue. Key person insurance proceeds are designed to replace the revenue that person would have generated, or to pay the extra costs incurred in finding a suitable replacement. Either way, the profitability of the business can be maintained, and the business stabilised. Some specific ways profitability can be affected are:
- Sales/Revenue – If the person was directly responsible for sales, the loss of that person might result in a fall in sales until a replacement is on board, eg. sales representatives.
- Recruiting costs – Extra costs incurred to attract and recruit a suitable replacement will mean lower profit.
- Training costs – If a new person needs special training before they can undertake the role proficiently, profit will be lower.
- Destabilisation – The loss of a key person can have an indirect effect on revenue because of the re-organisation that has to occur in the short term. Some people may have to take on extra duties and so can not perform to their usual standard. This is particularly the case if the key person is also an owner of the business. Business owners normally put much more effort into their functions than their salary reflects. In this situation, a business is not just losing one key person, it is losing an incredibly productive key person whose salary is not commensurate with their workload.
2. Capital Value
The loss of a key person can also have an adverse effect on the capital value of the business. Key person insurance proceeds are used to maintain the capital value to stabilise the business. The following are specific ways the capital value can be affected.
- Goodwill – As mentioned earlier, a person can bring a goodwill factor into the business by virtue of specialised knowledge, skills, business contacts and reputation. The loss of that person can affect this goodwill factor, eg. creative director of an advertising company.
- Credit standing – Some companies can secure credit lines more easily than others can because a director has sufficient personal assets to secure the credit. With the loss of the key person, access to credit may be much more difficult. Key person insurance proceeds give the company an alternative to the credit the key person could guarantee.
- Loan accounts – The loss of a key person who has loaned money to the business may mean that the loan will have to be repaid immediately.
- Other debts – If the business is destabilised and defaults on a loan, the financier could call in the loan. Capital purpose key person insurance aims to ensure that the business can repay debts, easing the financial burden of the business at a crucial point in time. This will give the remaining proprietors some breathing space to stabilise and maintain the capital value of the business.
Which policies should be used?
The policies that can be used really depend on the event being insured. Obviously the suddenness of death, traumatic illness and TPD will have the most impact on the business because there is no time to plan for the loss. Life insurance, trauma insurance and TPD cover are the obvious solution. For retirement and resignation, a policy, which builds up a cash value, could be used to offset the effects in part or full, when they happen.
The type of policy used can impact on the taxation treatment of the premiums and proceeds.
What are the taxation implications?
The tax treatment depends on the type of policy used.
Income Tax Ruling IT155 has been the governing ruling over key person insurance.
IT155 applies some basic rules which depend on whether ‘temporary’ (ie. Term) life insurance or ‘permanent’(ie. Whole of Life or cash value) policies are used.
If permanent insurance is used, the premiums paid by the business are not tax deductible and the claim proceeds will not be tax assessable.
If temporary insurance is used, then the tax treatment depends on whether the purpose of the insurance is “Revenue” or “Capital”. Revenue purpose insurance premiums are tax deductible to the business and the claim proceeds will be assessable.
Capital purpose insurance premiums are not tax deductible to the business and the claim proceeds will not be assessable.
TPD and Trauma Insurance
TPD and trauma insurance policies are also ‘temporary’ policies and some of the principles of IT155 can be applied. But, according to the Australian Tax Office (ATO), they are not life policies for capital gains tax purposes.
As with life insurance, revenue purpose insurance premiums for TPD and trauma policies are tax deductible to the business and the claim proceeds will be assessable.
But, while TPD and trauma policies for capital purpose insurance premiums are not tax deductible, the claim proceeds will be assessable as a capital gain.
Where one policy covers more than one of life, trauma and T&PD insurance, the tax treatment of the proceeds can be different depending on which event gives rise to the claim, as described above.
What does revenue and capital purpose mean?
In deciding on the tax treatment of a temporary key person insurance policy, the purpose, as specified under IT155, must first be determined.
Revenue purpose insurance is key person insurance taken out to protect the business from a fall in revenue or increased costs. Basically, any protection against an adverse effect on the revenue or profit and loss account is classified as revenue purpose.
Capital purpose insurance is protection against an adverse effect on the balance sheet.