Key Person Insurance / Key Man Insurance

Alena Miles looks at the importance of key person insurance in a business and how it protects the business if there is a key person death, disability, or a serious illness.

Many business owners insure against damage to physical business assets and have workers compensation and professional indemnity/public liability insurance. However, for many businesses the most important asset, the key people in the business, is unprotected.

A client's fact find may reveal a risk to the business revenue and/or capital value due to reliance on key employees, such as the business owner(s) or key sales people, technicians, managers, etc. The death or disability of this person could:

• Result in financial loss for the business;
• Jeopardise its continuation; or
• Have a potentially significant adverse impact on the achievement of the business owners' financial goals.

What is the purpose of key person insurance?

Insurance cover on death, disability or a serious illness of a key person is often used to protect the business from any potential financial loss associated with the occurrence of such an event. The insurance proceeds can be used to fund one or more of the following:

• The loss of revenue the key person would have otherwise generated;
• The additional costs associated with the recruitment and training of a replacement;
• Repayment of debts outstanding at the time of the key person's departure (particularly debts that are personally guaranteed); and/or
• Replacement of lost goodwill due to the key person's departure.

The purpose of key person insurance is to ensure that the business continues to operate despite the insured event happening to the key individual.

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The purpose is not to provide funding for the business owners to buy and sell each other's shares in the business (that need is covered by buy/sell insurance arrangements).

Tax considerations

From a tax perspective, when structuring key person insurance, it is critical to be clear on the purpose of the cover as it will affect:

• The tax deductibility of the premiums; and
• The tax treatment of the insurance proceeds.

Key person insurance can be taken out for:

• Revenue purpose;
• Capital purpose; and
• Both revenue and capital purpose.

The table below provides examples of purposes which are either revenue or capital in nature.

Revenue purpose

Insurance premiums where the cover is for a revenue purpose are tax deductible. However, in the event of a claim, proceeds will be assessable.

According to the Australian Taxation Office (ATO) Tax Ruling IT 2434, for revenue purposes "an employee may be accepted as a key person where the loss of that employee would result in a significant loss of profits being derived by the employer during the continuation of business operations subsequent to that loss".

However, the ruling goes on to clarify that a key person revenue purpose does not exist "where the loss of an employee, such as the owner/manager of a one person incorporated business, could be expected to result in the termination of the business".

Capital purpose

Insurance premiums for key person insurance with a capital purpose are not tax deductible and the proceeds do not attract income tax.

However, the proceeds of insurance with a capital purpose may, in certain circumstances, be subject to Capital Gains Tax (CGT).

Dual purpose

If a business needs key person cover for both revenue and capital purposes, the client can consider:

• Obtaining a separate policy for each purpose; or
• Having one policy to cover both needs.

While one policy can be used for both purposes, apportioning of the insurance cover and the premium between the two needs should be documented each year. This may be impractical in some circumstances.

The table below summarises the deductibility of premiums and the tax treatment of the insurance proceeds with respect to the different types of cover available.

As the purpose of key person cover can change over time as the business changes, the owners should review the purpose of this insurance annually and document it in the business minutes/papers.

Note that when confirming the purpose of the cover, the ATO will look at both the deductions that have been claimed for the premiums and how the proceeds are actually used.

Key person policy ownership

When deciding who should own the policy, careful consideration must be given to the purpose of the policy and who needs to receive the proceeds.

Key person revenue insurance must be owned by the business.

In most circumstances, the entity operating the business should also be the owner of key person — capital cover. This is because, in the event of a claim, the business needs to receive the proceeds to pay expenses and/or repay loans.

However, unlike the revenue purpose, there may be more flexibility as to how ownership of the insurance cover needs to be structured when key person capital is being taken out.

For example, when a company takes out key person cover for a capital purpose, CGT will be payable on total and permanent disability (TPD) and trauma proceeds. In these circumstances, it may be appropriate to consider having the key person hold the insurance in their own name and to subsequently inject the claim proceeds into the structure by way of loans or additional capital.

However in doing this, one needs to ensure that the purpose of affecting the policy can still be achieved.

That is, it needs to be ensured that the required funds are still ultimately received by the entity.

Other legal, tax, or cash flow issues may also need to be considered with input from the client's other advisers.

Note: Key person insurance should not be held within superannuation as this ownership structure creates concerns. First is the potential breach of the sole purpose test. The potential breach relates to the employer or business benefiting from the superannuation benefits (including the insurance cover), rather than the member (life insured) of the super fund or the member's dependents. Another risk is that the super benefits may end up with someone other than the business (e.g. the member's dependents). This may result in the insurance cover failing to fulfill its purpose.

Example — taxation of key person capital insurance proceeds

Peter and Tim are brothers and operate a farm in a partnership. They wish to pay out the total business debts of $500,000, with joint and several liability, if either partner dies or becomes permanently disabled.

Peter and Tim each take out key person life and TPD insurance cover on each other. Each is the owner of a life and TPD policy of $500,000, with their brother as the life insured.

As the purpose of the key person insurance is capital in nature, the insurance premiums are not tax deductible. Any insurance proceeds paid due to death or TPD do not attract income tax.

In this case, if one of the brothers dies, there will be no CGT on the life insurance proceeds received by the surviving brother (the policy owner) as the surviving brother being the owner of the policy, was the original owner.

In the event of TPD of one of the brothers, there will be no CGT either as the proceeds will be received by a relative of the ill/injured individual, in this case, the brother.

However, if Peter and Tim were not related, there would be CGT payable on the TPD proceeds, as the recipient of these proceeds is not a relative. In this case, their financial adviser would consider:

• Grossing-up the sum insured to take this tax into account; or
• Having each partner own their own policy.

Specific tax and legal advice needs to be sought to ensure that the funds end up with the remaining partner without any adverse legal or tax consequences.

Alena Miles is the technical services manager at AMP TapIn.