Maintaining Capital Value through Key Person Insurance

What Benefits can Key Person Insurance Provide to All Businesses?

All businesses have one or more key people who are vital to the success of the business. Whether it is the owner of the business who is responsible for driving maximum business profits, or it is an executive who has the technical knowledge required to run the business, or even if it is a senior employee who is responsible for enhancing the goodwill of the business and helping the owners to acquire necessary capital - any of these people can be a key person for a business.

Since key persons are those who are vital for the success of a business, losing them could result in significant fall in profits and may even lead to financial ruin depending on how important they were to the business. Whether the loss has been brought about by the death of a key person or due to a critical illness or permanent disability, the continued success of any business could be jeopardised by such a loss. It is thus important to try and put various strategies in place that can protect a business from the loss of a key person. An effective way to do this is through Key Person Insurance.

Understanding Key Person Capital Insurance

Key person insurance provides a business with financial compensation that can be used to keep the business going even after losing the key person to various reasons. The benefits received through key person insurance are usually used in the following two ways:

  • To increase business profits: The profits of a business may be compromised due to the absence of a key person. Hence, the proceeds from the key person insurance can be used to hire another expert in place of the key person, which in turn could help to restore the business profits or even enhance them. Other activities too that result in revenue can be carried out with the money received from the key person insurance.
  • Maintaining the capital value of a business: Certain key persons are such who may not be responsible for driving day-to-day revenue for the business, but could be critical to the capital appreciation of a business. The loss of such persons could result in capital depletion for the business. In order to prevent that from happening, key person insurance can be purchased for such persons. This type of key person insurance that is used to maintain the capital value of a business is known as Key Person Capital Insurance.

How to Maintain Capital Value with Key Person Insurance

Here is a look at some of the ways in which key person insurance can be used to maintain the capital value of a business:

  • Alternative source of credit: The ability of a business to obtain required funds through credit lines, loans, and overdraft accounts is essential to maintaining its capital and ensuring business success. However, if a key person who was responsible for obtaining lines of credit for the business dies or becomes disabled; that business could face capital depletion. In such situations, proceeds from the key person insurance policy can be used as an alternate source of funds to maintain the capital value of the business
  • Repaying business debts: Often, business loans are obtained after providing personal guarantees, which are usually given by key persons. The loss of such key persons could thus compromise the ability of the business to repay the business debts. Even if the business can continue to repay the debts, creditors may call in their loans if the loss of the key person makes them believe that the business is unstable and will not be able to repay their loans. Therefore, with key person insurance in place, the business can have access to proceeds that can be used to pay off business debts. Many a time, the proceeds may not be required to pay off business debts, but the fact that they are available can go a long way towards projecting a stable business and maintain its capital value
  • Repaying loans taken from the key person: If the key person is a partner or co-owner of the business, then it is likely that they may have given some loans to the business as an owner. Hence, when such a key person leaves the business for any reason, they may call in their loans immediately. It is also possible that the estate of the key person calls in such loans on the death of the key person. Therefore, in order to ensure that such loans can be paid off in full (if the situation arises) so that the capital value of the business can be maintained, the proceeds from the key person insurance can be extremely handy
  • Maintaining business' goodwill: While goodwill is an extremely intangible aspect of a business' success, it can be a very important one. The loss of a key person could reduce the goodwill, and standing of a business, which in turn could lower its capital value. However, the benefits from the key person insurance can be used to hire others to build business contacts and enhance business reputation, which helps to maintain its capital value significantly.

Key Person Insurance FAQs

Who is a key person?

A key person is someone who is crucial to the ability of a business to be profitable. If they were to die or become incapacitated, it would have an adverse economic impact on the business. Key people may include company owners, directors, management, financial controllers, sales managers and IT staff.

What is the purpose of key person insurance?

A key person insurance policy protects a business financially if a key person dies, becomes totally and permanently disabled or suffers a critical illness. It does this by providing a lump sum payment.

How much cover do I need?

The only way to determine this is to calculate what the financial impact would be on your business if a key person were no longer able to work. How much would you have to pay out to their estate? Would you lose any particular clients or contracts? How much would it cost to find, hire and train a replacement? Answering these questions and more will help you figure out the sum you need to insure.

I need help finding a policy. What can I do?

Your best bet is to speak to a qualified insurance broker. A broker will take the time to understand how your business works, who the key people are and what your insurance needs are. He or she will then be able to offer you a range of policy options and help you find one that best meets your requirements.

Tax Implications of Key Person Insurance

The exact tax treatment of a key person insurance policy will depend on whether the policy benefit will be used for revenue protection or capital protection purposes. As the name suggests, revenue protection involves safeguarding your business against a loss of revenue that results from a key person’s departure. Capital protection, meanwhile, is when you use the insurance payout to help many cash flow issues that arise following the loss of a key person.

If your key person insurance policy will be used for revenue protection purposes, your premiums will generally be tax deductible. In addition, any benefit you receive from your policy will be assessable come tax time.

However, if you use your policy for capital protection purposes, for example to repay debts, the premium will probably not be tax deductible. Nor will it be deductible if you use your benefit payment for a combination of revenue protection and capital protection.

Remember to be upfront and honest when stating the purpose of your insurance cover, as the ATO will check up on how you used your benefit payment if your business is ever audited.

Why Take out Key Person Insurance

The loss of a key employee can have dire financial consequences for a business, so taking out key person insurance cover often makes sound financial sense. With this cover in place, your business’ financial position will be protected if a key person dies, is totally and permanently disabled or suffers a critical illness.

You have plenty of options available when it comes to key person insurance cover, so feel free to seek advice from an insurance adviser. He or she will be able to assess the insurance needs of your business and find a policy that matches your requirements.

Purpose and conditionsAre premiums tax deductible?Are the insurance benefits taxed?Will capital gains tax affect the insurance benefits?
Revenue Purposes
  • Yes
  • Yes
  • No
Capital purposes
  • No
  • No
  • No
  • Business taxes only
  • Business taxes only
  • Benefits are subject to capital gains tax if the recipient is not business, and is not a relative of the key person

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Provides a lump sum payment if you become totally and permanently disabled and are unable to return to work.
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William Eve

Will is a personal finance writer for specialising in content on insurance. While he cannot give personal advice to clients, Will enjoys explaining the intricacies of different types of protective cover to help individuals and businesses find affordable cover that won't leave them underinsured.

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