Key Man Insurance Tax Treatment
The tax treatment of a key man policy is often a concern for a lot of our customers. The main question; is key man insurance tax efficient? Well, it can be. To put a long story short. However, if you’re not taking out the policy solely for the benefit of the business, then it’s not tax deductible. Each policy is treated different, so it’s important to establish where you sit on the scale.
When it comes to anything regarding tax and your life insurance policy it’s always best to check with your local tax office. But for those that want a quick overview, here’s a rough guide to the basics of key man insurance tax to make things a little clearer before you get your quote.
What is key person insurance?
Essentially, key person or employee insurance is an insurance policy taken out by the company on the life of a key individual. The business owns the policy and will be paid the financial sum to cover businesses expenses associated with the loss of the employee in the event of their death. A keyman insurance policy is designed to protect the business against the loss of a key member of the team. It can also help cover when an employee is terminally ill. This type of protection insurance is particularly useful for small businesses. It can help to protect against loan repayments as well as the cost of replacement. A business insuring an individual on key employee insurance will be paying the premiums out of the business account. When a claim is made, the insurance provider will pay out a lump sum that goes back into the business.
Who is a key employee?
The key people in your team can be any individual within the company whose skills, knowledge or experience are integral to the businesses success. For example, a key employee could be a director, sales manager, head of marketing, software developer or systems programmer that would cause a detrimental effect to the business should they pass away or become critically or terminally ill.
Is my policy tax-deductible?
If you’re looking for a simple answer – then yes, you can run the policy through the business as an allowable expense. However, like most businesses expenses subject to tax there are conditions attached. For example, if the policy is ‘not solely for business purposes’ then it’s not subject to tax relief. We’ll look into what that means in a minute.
There are a few reasons why key man insurance tax is treated differently by HM Revenue and Customers. This is due to the complexity of businesses. Each business is not necessarily the same as any other business. It also depends on the key person and their precise involvement in the business. Specifically, if they have an interest invested in the business in the form of shares.
What does for the purposes of the business mean exactly?
There have been a few definitions that state what ‘the purposes of the business’ means over time. Ultimately, it’s best to check with your tax office, but getting an understanding can be useful when setting up your policy.
‘The Anderson Rules’
In 1944, the Chancellor of Exchequer, John Anderson responded to a question regarding key man insurance tax treatment stating that the ‘treatment for taxation purposes would depend upon the facts of that particular case and it rests with the assessing authorities and commissions on appeal.’ During his reply, he stated that three ‘rules’ that businesses need to conform to in order to be eligible for tax relief;
I) The sole relationship needs to be between employer and employee
II) The insurance needs to be intended to meet loss of profit resulting from the loss of services of the employee
III) The insurance needs to be annual or short-term
In simpler terms, a shareholder cannot benefit from the key man insurance tax advantages. Neither are those with a whole of life policy. Despite ‘The Anderson Rules’ being widely used to determine the taxation of policies, it was never actually passed as a law. Therefore, it is still, as Anderson quoted himself, based on the assessment of the local authority i.e. your local tax inspector.
HMRC’s view on the taxation of a key man policy
HMRC’s view on the matter strongly connects the tax-efficiency of the policy to the specific business purposes. For example, if the company is taking out a policy to protect the business from loss of profits resulting from the loss of the employee, then tax relief is allowed on the premium.
However, this is not permitted if the key employee owns a substantial number of shares and is a ‘major shareholder’. This is because if they have invested in the business, the money paid back is likely to increase their share. This is then likely to be paid back to their estate and their family. With this in mind, the insurance no longer a business expense. The policy can be seen as an interest to them, rather than the business. Particularly, if critical illness cover is added.
It’s not that key person insurance isn’t available for major shareholders, or even sole traders. But it’s the key man insurance tax advantages that make it an attractive policy. This is lost when an owner of shares takes out a policy. In this instance, the payment may be used to cover any loss of goodwill or a loan written in the key person’s name. Whilst the premiums are not an allowable business expense, the payout is usually tax-free. So, there are still benefits to obtaining a key policy for business owners and sole traders.
Who is a major shareholder?
A major shareholder and definitions of such aren’t always as clear-cut when it comes to matters relating to key man insurance. The Interpretation Act 1978, states that control is where each party holds at least 40% of the company. Therefore, for owners such as sole traders and majority shareholders, their life insurance policy isn’t usually tax-efficient. However, if they can demonstrate how the payout will be paid back into the business for ‘trade’ purposes, then the premiums may qualify for tax relief.
The rules to follow
Despite these restrictions, a key employee insurance policy can still be eligible for tax-efficiency if they follow specific rules. If the terms within the policy are laid out so that the money paid back into the business is solely for business use (i.e. to cover any profits lost based on the work of the individual), then the premiums could be eligible for tax relief. Strictly speaking, the premiums must be a revenue expense rather than capital expenditure. Therefore, business owners and directors can still get tax relief.
To get the key man insurance tax advantages, the policy should also be taken out as term insurance to be eligible. The cover is only provided during the term set in place and whilst the employee is working for the business. The term insurance should not go beyond the period of the key employee’s usefulness to the company either.
Is the payout of a key man policy taxed?
In most instances, if the key man policy isn’t exempt from paying tax then the payout is unlikely to be taxed. However, if the policy doesn’t get tax relief, then HMRC will decide how to tax any money spent out of the policy money, like any other business expense. In general, they won’t tax it as a trading receipt, but each case is treated differently.
Whilst our advisors at Business Cover Expert can provide you with a brief overview of the policy options, it’s always best to get the latest information regarding key man insurance tax from the HMRC themselves or from your local tax office. For advice on life insurance policies, our advisors are on hand to help clarify if this type of policy is right for you and your business.
What other options are there?
If you are a director of a business, you can still take out key person insurance, even if you are a majority shareholder. However, tax relief is less likely. Particularly, if you take out a critical illness policy. It’s always best to check this before taking out a policy first and to write up the terms to make yourself eligible.
If you’re an owner looking for a whole of life policy, then shareholder protection is probably your best bet. However, as this is a more permanent option, it is unlikely to get tax relief. A shareholder protection policy works by taking out a policy on the life of a shareholder or owner. The money then goes to the remaining shareholders in the event of the insured’s death. If you would like the money to go to your family rather than the business, Relevant Life Cover is a great tax-efficient option. This is exempt from corporation tax, income tax and national insurance contributions for both the business and the employer.
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