Understanding key person insurance and its CGT complications

John Ciacciarelli explains key person insurance and the capital gains tax issues it raises.

Now that the New Year is upon us, many business owners are reviewing their business operations and looking to put plans in place for 2010. This makes it a good time to also consider their business insurance needs.

One area of business insurance often overlooked is the need to insure a business from the financial loss that may occur as a result of the serious illness, injury or death of a key person within the business.

It is also quite common for key person and buy/sell insurance arrangements to be confused for one another, so it is important to understand the two different arrangements.

The objective of a key person arrangement is to sustain the business and enable it to continue operating despite the illness, disability or death of a key individual. Without such an insurance arrangement in place, it is possible the business would face severe financial difficulty, with the value of the business reduced accordingly.

In contrast, buy/sell arrangements are used by business owners who want to ensure upon their departure from the business (typically due to death, disability, or serious illness) that their business interest transfers smoothly to the surviving business owner(s) for an agreed value.

Key person insurance

For both commercial and tax reasons it is vital to identify the key person(s) within a business and work out both the nature and value of their contribution. This is generally based on the desired outcomes the business owner is seeking to achieve in effecting the insurance.

The receipt of insurance proceeds usually has the desired outcome of allowing the business to continue its operations by funding 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 for the key person;
• replacement of lost goodwill due to the key person’s departure; and/or
• repayment of debts outstanding at the time of the key person’s departure.

For tax purposes, the treatment applicable to the payment of insurance premiums and receipt of policy proceeds will be determined by the purpose of the insurance arrangement (ie, whether the need is revenue or capital in nature or both), as well as the structure within which the business operates (eg, partnership or company).

Taxation issues

Who is a key person?

In a business context, a key person is a person whose contribution to the business is so substantial that if the person were no longer available to provide their contribution, the business would suffer. Often the key person is an employee, but it could also include contractors, consultants and suppliers to the business.

Typically, a key person could be a director, partner, employee or any other person who contributes significantly towards the ongoing success of the business.

Purpose of the insurance

From a taxation perspective, when structuring key person insurance it is particularly important to be clear about the purpose of the cover as this will affect the tax deductibility of the premiums, as well as the tax treatment of the insurance proceeds.

Table 1 provides some examples of purposes that are either revenue or capital in nature.

Revenue purpose

Insurance premiums relating to a key person arrangement are only tax deductible to the extent that the arrangement has a revenue purpose.

Further, in the event of a claim, proceeds from a key person insurance arrangement with a revenue purpose will be treated as assessable income of the business.

Importantly, revenue-purpose key person arrangements are unlikely to apply in so-called one man companies. This is because the death or disablement of that person would normally lead to the closure of the business and is accordingly in the nature of a capital receipt.

Capital purpose

The insurance premiums for a key person insurance arrangement with a capital purpose will not be tax deductible, but the proceeds will not attract income tax.

However, the proceeds from an insurance policy under an arrangement with a capital purpose are potentially subject to the capital gains tax rules.

Capital gains tax on proceeds

Capital gains tax (CGT) will only apply to insurance proceeds if the policy has been held for a capital purpose and the proceeds are received as per Table 2.

Tip: If income or capital gains tax is expected to apply to insurance proceeds, it may be worth considering increasing the level of insurance required to cover the tax liability.

In the event of the TPD of one of the brothers, there will be no CGT as the proceeds will be received by a relative of the disabled individual. If Peter and Tim were not relatives (see Example 2), there would be CGT payable, as the recipient of the TPD proceeds would not be a relative.

Examples

Example 1: Key person insurance — revenue purpose

Donald, Ivana and Marla own a real estate business valued at $1.5 million. The business is incorporated through DIM Pty Ltd, the shares of which are held by Donald, Ivana and Marla in equal proportions.

Although Ivana and Marla do help in the business, Donald is the main driver. He negotiates all the large deals and hires and fires the agents as necessary.

Donald, Ivana and Marla are worried that if Donald were to become ill or die, the business may quickly lose revenue and profitability. They decide to take out an appropriate level of key person insurance on Donald’s life.

The purpose of the policy has been identified as a revenue purpose. That is, in the event of a claim, the proceeds will be used to hire a replacement manager and cover ongoing business expenses (eg, salaries, bills). The purpose of the insurance has been noted in the company minutes.

Therefore DIM Pty Ltd takes out a policy on Donald’s life. As the insurance is being held for revenue purposes DIM Pty Ltd will be able to claim a tax deduction for the cost of the premiums.

In the event of a claim, the company will be required to include the insurance proceeds in its assessable income for the year of income in which it is received. However, capital gains tax (CGT) will not apply.

Example 2: Key person insurance — capital purpose

Peter and Tim are brothers and operate a farm under a partnership arrangement. They decide to effect policies of life and total and permanent disability (TPD) insurance cover on each other, as they wish to pay out business debts if either partner dies or becomes permanently disabled.

As the key person arrangement is capital in nature, the insurance premiums will not be tax deductible. And, any insurance proceeds received due to death or TPD will not attract income tax.

But CGT also needs to be considered. In our example, if one of the brothers dies, there will be no CGT on the insurance proceeds received by the surviving brother (the policy owner), provided that:

• the surviving brother, being the owner of the policy, was the original owner; or
• the surviving brother acquired the policy for no consideration.

Summary table

Table 3 summarises the deductibility of premiums and the tax treatment of the proceeds with respect to the different types of insurance cover available.

Note: the tax treatment of whole of life and endowment policies is not covered in this table.

John Ciacciarelli is technical services manager at AMP.