What happens to your business if you or one of your Directors falls ill or dies? It’s not the most cheery topic, but if the answer is that your business couldn’t function, couldn’t service its debts and couldn’t pay salaries, including yours, then it’s worth taking the time to consider your options.
If you haven’t comprehensively protected your business, then you’re not alone. Recent research conducted by Legal & General has found that UK businesses currently have a £1.35 trillion shortfall in business protection needs, with the level of underinsurance rising by 18% in four years.
The research found there had been a reduction in Key Person Protection of just over £21 billion and a significant increase in the Shareholder Protection Gap of over £255 billion. The largest factor to account for the increase in the protection gap was the growth in the number of limited companies and partnerships without cover, which now stands at 1.3 million, up 100,000 from 2008.
The study also found that 31% of business owners surveyed take assessing and managing business risk very seriously to ensure that they have an appropriate level of insurance cover. Yet 50% say that whilst business risk is important, they don’t always feel the need to be insured for everything, with 30% of business owners saying they didn’t have any insurance cover in place in the event of a key person within the business dying or becoming terminally or critically ill. This was because they either hadn’t considered it, hadn’t got round to it or because they were too busy to even evaluate it.
Unfortunately, these statistics and the fact that thousands of businesses are in the same position as you is of little comfort if you find your business in the difficult and often highly emotive situation of losing a key person.
What will protect your business?
Key Person Protection (KPP) will help safeguard your business against the financial effects of death, terminal illness and critical illness of a key person. It is designed to provide a financial buffer in the event of a key person becoming permanently or temporarily unable to make their normal contribution to the business. Proceeds would typically be used to replace lost profits or to fund finding and hiring a replacement for the key person.
The sum assured under a key person cover policy should reflect the loss of profits that are expected to occur on the key person’s death. A simple method is to take the key person’s salary and multiply it by a factor of up to ten but this is likely to be imprecise. Other methods are based on multiples of business profits.
The purpose of key person cover is to ensure that funds are made available to a business on the death or serious illness of the key person. How this protection works will depend on the type of business structure you operate within:
If you have a Limited Company: For companies, it is the company itself who should be the applicant for the cover, on the life of the key employee or director. The company would own the policy and pay all premiums. A trust is not required. An authorised official of the company, such as the managing director or company secretary, would make the applicant’s declaration.
If you have a Limited Liability Partnership (LLP) or Scottish Partnership: These are legal entities in their own right and can therefore take out policies on the lives of key individuals in the same way as companies.
If you are part of a Partnership: Under English Law, Partnerships do not have a separate legal entity and cannot effect a life policy. If a Partnership has a key employee, who is not a partner, a Key Person Policy can be taken out jointly by all the partners or, where this is not feasible, by one or two partners authorised to act on behalf of the Partnership. The policy would need to be held under trust for all partners for the time being, to accommodate any future changes in the partnership.
If you’re a sole trader: Sole Traders may take out a policy on the life of a key employee.
Whatever type of organisation you are, the cost of Key Person Protection (KPP) is often an important consideration, so don’t forget to find out if you are eligible for tax relief on the premiums.
Do you qualify for tax relief on KPP premiums?
If certain criteria are met under the Anderson Rules, it is possible for a business to receive tax relief on premiums under a Key Person Policy.
The relief is obtained by treating the premiums as an allowable business expense, which means that they can be offset against business profits for corporation tax purposes.
The taxation treatment of any policy proceeds (i.e. payment of life cover or critical illness benefit) will often depend on whether the premiums were tax deductible. Usually, if tax relief has been allowed on the premiums then any proceeds received are treated as trading receipts and charged to corporation tax.
Conversely, if premiums are not tax deductible then any proceeds are typically free of tax. If a business is eligible for tax relief on premiums, it cannot elect to waive this right in order to receive tax-free benefits.
A business should always ask its local Inspector of Taxes to confirm the likely tax treatment of any proposed key person cover before proceeding, as The Anderson Rules are not actually ‘Rules’ at all, but a set of principles that formed part of a statement made in 1944 by Sir John Anderson, Chancellor of the Exchequer. The principles form the basis on which a local Inspector of Taxes will decide whether key person cover premiums qualify as an allowable business expense.
There are three conditions that have to be met:
1. The sole relationship between the business and the key person must be that of employer and employee. Relief will not be allowed if the key person has a significant stake in the business.
2. The life policy is intended to meet loss of profits resulting from the loss of the key person’s services.
3. The policy is a short-term assurance (although ‘short-term’ is not defined, most tax inspectors will allow relief for terms of up to five years).
Making a final decision
If you are struggling with the concept or cost of Key Person Protection, you may want to consider:
1. Your business is your livelihood, if you don’t protect it no-one else will and you could lose it.
2. It’s not just you that would be affected by any downturn in your company, it would be your employees, your family and your suppliers too.
3. What’s the real cost to you of having business protection? Evaluate it properly and do a cost:benefit analysis. Is it worth not having business protection?
4. There are professionals that can help you make the best decision for you and your company. Find a Chartered Financial Planner that you trust and stat there.
Key Person Protection shouldn’t be an emotional decision, it should be a pragmatic one. The risks to any business without it are clear.
