Key person insurance – protecting the business

Key person insurance – ‘income’ or ‘capital’ purpose?

Key Person Insurance

Key Person Insurance. Protect the business if a key person dies or gets sick.

Businesses without strong leadership and direction are ships sailing without the captain at the helm. Death, Trauma and Disability are the insidious ‘killers’ of business. Key person insurance protects the business.

  1. Who is a key person?

Businesses take out insurance to replace assets such as machinery, cars, and buildings. What about the human asset? Through your initiative, drive, skill, specialist knowledge and ingenuity, you turn capital and assets into profit.

A ‘key person’ is a person who provides the business with significant, direct and identifiable economic gain. The term ‘economic gain’ includes more than just profits. Economic gain includes cost savings, capital injections, goodwill, access to credit and credit lines and access to customers. An example of a ‘key person? An employee who is directly responsible for making all of the sales for a business is a ‘key person’. It is a person who holds the business’ technical expertise. Key persons include a:

  • Managing Director – whose expertise, ingenuity and ability enable the business to run smoothly, operate within budget and establish a strong market presence,
  • Sales Manager – whose unique contacts or business methods give the business a competitive edge,
  • Financial Controller – who has set up a new budgeting and reporting system which has already saved the business money, and will continue to do so as the system is developed further,
  • Computer Programmer – who has been contracted to write a software program that the business can on-sell, and which the business may later contract to maintain,
  • 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, and a
  • Silent Partner – who was brought in as a partner because of their reputation with financiers, with the result that the business can access more financing.

By overview, modern businesses are an amalgam of skills, some of which are – marketing, planning, technological and administrative. Key persons (whether business owners or employees) can be the persons solely, or primarily, responsible for innovative systems and systems implementation. In such instances, these key persons take responsibility for the day to day application of these systems or of their particular functioning. They are usually the ones that hold the knowledge, make the sales, run the division or train the staff.  Their importance is such that if they were lost to the business, the business would suffer significant financial burden or loss. A key person with those skills may also be a sole or joint guarantor of bank loans or overdraft facilities used in carrying on the business.

Specialisation is ever increasing.  In law, we see the development of specialist succession practices, specialist mergers and acquisitions practices, specialist intellectual property practices and even specialist superannuation practices.  In accounting, there are now specialist tax practices and within them, specialist cells for varied forms of direct and indirect taxes – and many more such examples. If these divisions are run by key persons there is a real prospect that the associated firm could suffer significant revenue or capital depreciation if the key person died. In your own business or practice, ask yourself this question. What is the impact on my business if I lose a key person?

Put simply – if a key person in your business or in one of your clients’ businesses died, would the business survive? You need key person insurance.

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  1. Why is key person insurance vital?

Losing any of these key people can reduce business profitability and can reduce the capital value of the business. If a business owner protects their business with key person insurance, and the key person is lost, insurance proceeds can be made available to the business to replace the lost profit or capital value that the key person would have generated. The funds can be used to stabilise the business until a suitable replacement person is employed with, or capable of being “trained up” to have the same key skills. Used in this way, key person insurance proceeds can bridge the gap and enable the business to operate efficiently through, and after, the ordeal.

Preventing a reduction of business profitability

The loss of a key person can result in an increase in business costs and to a reduction in business revenues. Key person insurance proceeds can be used to replace the revenue the key person would have generated or can be used to pay the extra costs the business incurs in finding a suitable replacement. In either case, the profitability of the business can be maintained, and the business stabilised when key person proceeds are available to the business.

Other areas of business profitability affected are:

Sales/Revenue – the loss of a key person directly responsible for sales can result in a fall in sales until a replacement is found and the replacement person starts to generate similar sales results.

Recruiting costs – the costs incurred by a business to locate, attract and recruit a suitable replacement can be considerable and will reduce business profit.

Training costs – the replacement key person may require expensive specialist training.

Destabilisation – a key person is an integral member of the business. The loss of a key person can also indirectly affect business revenue. Short-term internal re-organisation can cause remaining staff to take on extra duties. The extra pressure put on those people may prevent them from performing to their usual standard. In addition, the remaining staff may feel insecure about their future and the future of the business. Other businesses with which the business deals may also have the same misgivings. This type of destabilisation can have a profoundly negative effect on business revenue.

Workplace Policies

Preventing a reduction in the capital value of the business

The loss of a key person can also adversely affect the capital value of the business. Key person insurance proceeds can be used to maintain the capital value and stabilise the business if the key person suddenly dies.

The capital value of a business can be reduced by damage to:

Goodwill – the “attractive force” that brings clients to the business. A key person may be the sole person in the business with the specialised knowledge, the unique skills, the high-quality business contacts, or even a reputation for excellence. The loss of that person can adversely affect the goodwill associated with the business.

Credit standing – some businesses can more easily secure credit lines than other businesses because one director has sufficient personal assets to secure the debt. With the loss of that key person director, the business may find it more difficult to access or maintain lines of credit and overdraft facilities. Key person insurance proceeds give the business an alternative source of funds to the credit the key person guaranteed.

Loan accounts – the loss of a key person who has loaned money to the business may mean that the loan must be repaid to the key person (or their estate) immediately.

Other debts – if the business is destabilised and defaults on a loan, the financier could call in one or more of the loans made to the business.

Note that retirement or resignation cannot be funded by business insurance proceeds. However, if a key person retires or resigns, the business will still require cash to enable the remaining business owners to buy their business interests. Resignation or retirement issues are usually dealt with in the company, partnership or trust constituent documents. Generally, the constituent documents will include a first right of refusal, by which the outgoing business owner must offer his or her shares to the remaining business owners before offering them to anyone else. It can be difficult to fix prices for the outgoing business owner’s shares at some time in the future, so a formula is often used. What is often missing, however, is an agreement dealing with where the money comes from, how it is paid off and over what period of time.  This is a matter for expert legal advice from Legal Consolidated Barristers & Solicitors.

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How much should be insured, and what is being insured?

Highlighting the need, and helping the business owners estimate the amount of protection they need, is a specialist area. The analysis should be done in consideration of the business’ total insurance requirements.

Usually, the accountant estimates the capital value effect of the death of a key person.

Many assessment methods are used – most commonly:

  1. Loan repayment method – the value of loans made by a key person to the business;
  2. Turnover/Revenue method – how much of the business turnover was contributed by the key person in identifiable dollars or as a percentage of annual revenues;
  3. Estimate – the business owner and accountant agree on the amount by which the business revenues would be reduced if the key person were lost. It should be noted here that the insurer will likely require some justification of the figure, or that the same method be used to estimate in the future;
  4. Business Overheads Method – estimate and cover the business overheads for say 12 months until a suitable replacement person is found, trained and sufficiently proficient. This ensures that the business remains fully operational;
  5. Mathematical Formulae – other “rule of thumb” valuations use a mathematical formula to make a similar assessment. For example, for some news agencies in Australia, a multiple of between 3 and 3.5 times annual net profit, plus stock less debts is used. This is an indicator of the market value of the business. But this multiple may be inappropriate for other types of businesses.

In my experience, business owners prefer to receive recommendations using either the turnover/revenue method or the business overheads method. In any case, I recommend that any formula used should be comprehensively explained to the client and clearly documented.  This constitutes a full and frank disclosure and resolves a professional indemnity issue.

What type of policies should be used?

The sudden death, traumatic illness or TPD of a business owner has the most impact on the business if there is no written or agreed planning for the loss. Insurance proceeds can often be used to ease the burden. For retirement and resignation, there are some policies that build up a cash value over time, where the individual or firm may use the proceeds to offset the effects in part or full when they happen.  Or the client can simply save the money and pay for it out of their own, or their firm’s pocket.  Perhaps the business can be sold or allowed to collapse. Or the key person’s equity can be redeemed, surrendered or allowed to lapse. Each alternative has a taxation implication and brings with it a corresponding requirement to comply with ASIC and Corporations Law requirements, that are beyond the scope of this paper to explore.

What are the tax consequences?

The tax treatment of key person premiums and proceeds depends on the type of policy used and its purpose. The tax treatment of life, TPD, trauma and accident policy proceeds may, according to the test in Carapark Holdings Ltd v FCT (1966) 155CLR 653, be considered by the ATO to be assessable income to the taxpayer recipient under section 15-30 ITAA97.  This section brings to account as assessable income amounts that are not ordinary section 6-5 income.

The ATO’s power to make such a determination is found in section 15-30.  The ATO can so determine irrespective of whether the sum received from insurance proceeds is by way of:

  1. a lump sum; or
  2. by periodical payments; or
  3. whether the amounts received are for a “loss of earnings” or a “loss of earning capacity”.

Life Insurance

Income Tax Ruling IT155 governs key person insurance.  IT155 applies some basic rules that depend on whether ‘temporary’ (i.e. Term) life insurance or ‘permanent’ (i.e. Whole of Life or cash value) policies are used.

If Whole of Life insurance is used, the premiums paid by the business are not tax deductible and the claim proceeds are not taxable in the hands of the policy owner.

If Term insurance is used, then the tax treatment depends on whether the purpose of the insurance is for “Revenue” or “Capital”. Revenue purpose insurance premiums are tax deductible to the business and the claim proceeds are assessable in the hands of the recipient. Capital purpose insurance premiums are not tax deductible to the business and the claim proceeds are not assessable.

TPD and Trauma Insurance

TPD and trauma insurance policies may also be considered to be Term policies and some of the principles of IT155 can be applied.  However, the ATO has advised that 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 are assessable.

While TPD and trauma policies for capital purpose insurance premiums are not tax deductible, the claim proceeds are assessable as a capital gain.

Where a single policy covers life and trauma or TPD insurance, the tax treatment of the proceeds depends on which of the two events triggers the claim.

What do we mean by the terms “revenue purpose” and “capital purpose”?

IT 155 requires that, in deciding the tax treatment of a Term key person insurance policy, the purpose of taking out the insurance, and the intended application of the proceeds, must first be determined.

1. Revenue purpose insurance is key person insurance taken out to protect the business from a fall in revenue or increased costs and includes any protection against an adverse effect on the revenue or profit and loss account (“P&L”).

2. Capital purpose insurance is protection against an adverse effect on the balance sheet.

A non-exhaustive list of examples of such purposes is:

            Examples of revenue purpose        Examples of capital purpose
·         Costs to locate, recruit and train a full-time replacement ·         Repaying the estate of a deceased key person for loans made by the deceased key person to the business
·         Cost of a temporary replacement until a full-time replacement can be recruited ·         Repaying other debts called in because of the loss of the key person
·         Compensation for fall in revenue/ sales/ profit ·         Replacing the value of goodwill lost because the key person is no longer there
·         Compensation for bad debts resulting from the loss of a key person ·         Replacing lines of credit guaranteed by the key person

How is the purpose established?

The taxation impact of the firm receiving such proceeds depends on whether the key person policy had, or has a capital or revenue purpose. When the policy is first purchased, the purpose of the insurance could be recorded through minutes or book entries. In the case of a sole trader, the purpose could be recorded by a file note or in a letter to the insurance company.  However, IT155 says these notes or letters:

“…would be of some value, but should not necessarily be regarded as conclusive” [evidence of the purpose of the insurance].

 IT155 states further that:

“…all the surrounding circumstances may properly be taken into account in seeking to determine the purpose for which a policy was effected.  The purpose for which the proceeds are used is relevant not because this governs the issue directly, but because it provides some indication of what the purpose of taking out the policy is likely to have been”.

Therefore, just because the minutes show that the policy was taken out for revenue purpose, it does not mean that a tax deduction can always be claimed on all premiums paid for all time.  At best, company minutes show little more than the intent of the business at the time the policy was taken out, and the intent of the business at each documented policy renewal.  If the proceeds are actually used to pay out debts, then the business may have claimed deductions to which it wasn’t entitled because the ATO could determine that the purpose had “changed”.

A policy minuted for capital purposes and on which no tax deduction is claimed may have the claim proceeds assessed if the proceeds are used for revenue purposes.

In the same way, if a business does not claim the premiums as a tax deduction it does not necessarily mean that the proceeds are tax-free.  It is important that the purpose of the insurance is reviewed regularly, and any change documented.  The ATO will base their investigations on the purpose at the time the last premium was paid.  If the purpose at that time was genuinely for a revenue purpose and the premium was claimed as a tax deduction, and then the need in some way changes to being for a capital purpose, the business should still be able to claim a tax deduction for the premiums paid, in the year to that point, if the person dies in that year.  From there on, any further premiums paid must not be claimed as a tax deduction.  This will hold true until the need changes again at a later date.

What about permanent policies with a life insurance component?

Because some business owners may have existing Whole of Life policies, it is useful to be aware of the tax treatments surrounding them.  IT155 states clearly that the premiums on Whole of Life policies are not deductible unless the cost of the insurance component can be readily divisible.

IT155 goes on to state that:

 “Life policies are sometimes issued with a term, accident and/or sickness rider.  In such cases, the premiums are to be treated as being wholly for life assurance unless they are readily divisible as being applicable to (a) life assurance and (b) term, accident or sickness benefits.  Where a premium is so divisible, the amount applicable to life cover should be treated as non-deductible and the question whether the balance is allowable should be determined according to the purpose for which the term, accident or sickness cover was taken out.”

So, if a Whole of Life policy is used for revenue purpose, the premiums will not be deductible because the sum insured and cash value components are interlocked.

Split dollar key person arrangements have a different tax treatment.  Unlike the treatment for Whole of Life policies, for the more modern “unbundled policies” that can have separate “cash value” and “sum insured” components, it is consistent with IT155 that they can be used for revenue purpose and that part of the premium which pays for the life insurance can be claimed as a tax deduction.  The life insurance proceeds will be assessed for tax, but the cash value on a separate policy will not be assessed for tax.

Tax determination TD 94/40 specifically says that:

No part of any premiums paid by an employer under a “split purpose” insurance arrangement is an allowable deduction to the employer” so it is therefore not possible for an employer to use one policy for both revenue and capital purposes.

A split purpose arrangement is defined as:

“…where one party owns all or part of both the investment and risk components of a life assurance policy and states that each component is held for separate and distinct purposes.  For example, an employer may claim he or she holds the risk component for a revenue purpose and the investment component for a capital purpose.”

Where you discover a client who has, or who continues to use, such policies (prevalent about 6 years ago), review and advise on the taxation treatment of the premiums and proceeds of the individual policy. Also, determine if the client wishes to continue with such a policy.  In the alternative, suggest that the client obtains written advice from the insurer to update them as to the taxation impacts for those policies. Legal Consolidated Barristers & Solicitors can assist.


What is the tax treatment for sole traders?

Sole traders and one-person incorporated businesses can not insure themselves as key persons and get the tax deduction for revenue purpose premiums. But they can insure their employees.

Income tax ruling IT2434 defines a “key person” and states that the business must suffer a loss of profits during the continuation of the business. It further states that if the business must automatically cease when the person is lost, then the business is clearly not “in continuation”. The result is that the business cannot insure that person as a key person for tax purposes.


Temporary Cover

Since a temporary key person insurance policy has no cash value, it will generally not be recorded on the balance sheet as a business asset. It is, however, often referred to in the notes accompanying the accounts. Therefore, whenever temporary key person insurance coverage is used, the transaction appears on the profit and loss statement of the business (“P&L”).

The annual policy premiums are reflected on the P&L as an expense item.

Whether or not the expense is tax deductible depends on whether the purpose for which the key person insurance cover was proposed was of a capital or revenue nature.

In the event of a successful claim under the relevant policy, the proceeds are recorded as an extraordinary item on the P&L. The taxation treatment of the proceeds would then depend on the ATO’s interpretation of the documented proposed purpose of the policy and the use to which the proceeds are put.

Permanent Cover

The total premiums paid for permanent key person insurance cover in each year, via cash payments, are recorded as an expense in the P&L of the relevant year.

As soon as the policy acquires a cash surrender value, a journal entry is made to bring the asset onto the balance sheet. In effect, the journal entry reflects the cash surrender value of the policy as at the balance date.

When the business receives the policy proceeds, whether, through a death, surrender or maturity, a cash receipt is recorded and accounted for on the P&L. A further journal entry is needed on the balance sheet to reverse the earlier asset account entry against the asset revaluation reserve that records the receipt of the policy proceeds.

The policy proceeds of the key person insurance are recorded in a capital reserve on the balance sheet of the business.

Key Person Insurance vs Business Succession Plan

You need separate agreements for each of these situations:

1. A Shareholders Agreement is a contract between the company and the shareholders. It overrides a company Constitution. It details how the company is managed. (It is similar to a Unit Holders Agreement.)

2. A Business Succession Plan is an agreement to get rid of the disabled or dead owner with some money. The outgoing owner gets some money and the remaining owners get his interest in the business. A BSP does nothing to help the business itself. The business may well fold after the person leaves, but at least his wife gets some money and the remaining owners get the business. A BSP is usually funded by life, TPD and trauma insurance.

3. Key person insurance agreement is insurance paid to the business if a key person is disabled or dies. This does not deal with how to get the shares off the outgoing owner. Key person insurance just helps the business. Key person insurance is usually to repay debt (often secured by the outgoing owners’ home) or cover the cost of training up a new person.

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