Key person tax treatment unravelled
The tax treatment of keyman policy will differ depending on whether it is used for:
- Revenue purpose - the policyholder is entitled to a tax deduction.
- Capital Purpose - the key person insurance is not tax-deductible.
When a company takes out insurance for its employees one of the main concerns of a business owner, aside from the benefits and features, will be about costs and taxes.
Just like any other types of insurance policies, key person insurance has both tax-deductible and non tax-deductible components. Identifying which is which can prove to be quite overwhelming and confusing.
Whether the premiums of key man insurance are tax deductible or tax payable depends on how the ownership of the key man insurance is structured.
As per Section 51 of the Income Tax Assessment Act, the following practice is in place:
- treat the premiums as non-deductible under section 51 and the proceeds as non-assessable of a life policy is involved
- treat the premiums as deductible under section 51 and the proceeds as assessable income if an accident/sickness or term/whole of life policy is involved.
When it comes to paying tax on the benefits received by the beneficiary, the following ruling usually applies:
- the claim payment is not taxable if received by the original beneficial owner if a life insurance policy is involved
- the claim payment may be subject to capital gains tax (CGT) if the benefits are received by a company or trust for an accident/sickness/life policy
- the claim payment is usually not taxable if received by the life insured, spouse or relative for any policy involved.
Aside from the reason why the insurance is taken out, there may be a different approach taken by the ATO. If a policy is taken for capital purposes and the benefit is received by the original beneficiary, then the premium and the benefit are both not tax deductible. However, some of exceptions to this rule apply. If a policy is taken for revenue purposes, then the premium may be tax deductible and the benefit also subject to tax. If a company receives a sickness/disability benefit by way of the insurance policy, then CGT will apply. When considering the sums insured it is wise to factor in the possibility of CGT being taken from the benefit and increasing the sums insured accordingly.
Key Person Insurance Taxation Benefits: Revenue or Capital Purposes?
Most businesses either purchase the insurance for revenue, capital, or both.
Key Person Insurance for Revenue Purposes
Key person insurance is considered to be bought for revenue purposes if it has been bought for any of the following reasons:
- Finding a suitable replacement: If a key person is unable to work due to being injured seriously or because of an untimely death, then it may be necessary to find a permanent replacement for such a person. A business can end up incurring a considerable amount of expense in advertising for a suitable replacement and interviewing the various candidates for the position vacated by the key person. Training the shortlisted candidate may also incur significant costs, not to mention the salary that will have to be paid to the replacement. Therefore, if key person insurance is purchased to raise funds for these reasons, it is considered to be for revenue purposes. Even if the key person is temporarily available and will return to the business shortly, all expenses that are incurred in finding a temporary replacement too will be considered to be for revenue purposes.
- Replacing lost income: If losing a key person results in a loss of income for the company, or if the business profits have taken a hit due to the loss of the key person, than all such activities that are undertaken for replacing the lost income will come under the scope of revenue purposes.
Basically, any purpose that ensures continued revenue and profits for the business and any expense that has to be incurred for the successful running of day-to-day business activities that directly result in income are considered as revenue purposes. When key person insurance is purchased for such reasons, the premiums paid for the insurance will be tax deductible. However, any benefits received from the insurance will be assessable for Term Life, TPD and Trauma insurance.
Key Person Insurance for Capital Purposes
If key person insurance is purchased to back a loan of the company, or to enhance its goodwill after losing a key person, or to ensure that company debts are repaid then all such reasons are considered to be capital purposes. Essentially, if the funds from the key person insurance are not used for income generating activities but are instead used to strengthen the company after the loss of its key person, then they are considered to be for capital purposes. In such situations, the premiums paid for the insurance will not be tax deductible. However, benefits received from Term insurance will not be assessed as income, whereas benefits received directly by the business for TPD and Trauma insurance will be assessed for Capital Gains Tax.
Benefits of Key Person Insurance
Key person insurance protects both the company and the key person in your organisation. Aside from this protection, key person insurance may benefit you for by funding some issues that may arise as a result of their death or disability. Some of these benefits are as follows:
- Protects profits: A lump sum payment is paid to help minimise loss to revenue, sales, and profits until a replacement is found.
- Covers debt: It is a fact that companies have loans and outstanding debts they are repaying. This is not at all bad since it is necessary for the growth of the company. However, the death of a creditor or a guarantor can result in a mess without insurance. These situations could affect the company standing unfavourably. But with key man insurance, your business is protected against creditors.
- Covers liquidity: Most businesses have liquidity problems and can be aggravated by the loss of a cash flow producing key person.
Keyman Insurance Tax Frequently Asked Questions
In what situations are premiums for key-person insurance not tax deductible?
- Not deductible and not assessable if life insurance policy is covered
- Are deductible and can be treated as assessable if an accident/sickness or term life policy is covered.
Are the proceeds of key man insurance taxable?
|Cover type and use||Are benefits assessable?||Are insurance benefits subject to capital gains tax?|
|Life insurance for revenue purpose||Yes benefits assessable at applicable tax rate||No, unless the recipient acquired the interest for consideration and was not the original beneficial owner|
|Life insurance for capital purpose||No||No|
|TPD and critical illness insurance for revenue purpose||Yes benefits assessable at applicable tax rate||Yes, provided the recipient is not the insured or a relevant of the insured|
|TPD and critical illness insurance for capital purpose||No||No|
Are buy sell life insurance premiums tax deductible?
Premiums are deductible to self-employed workers for cover that will provide an income during the period that they are unable to work.
If a policy provides a benefit payment for disability or death, the component of the policy covering death will not be tax deductible unless:
- The premium payment is provided for revenue purpose
- The policy has been taken out to prolong the business
- The employer owns the policy
- The employer is the recipient of the policy benefit.
Is key person disability income taxable to a business?
The premium payments for key person disability insurance are generally tax deductible. Benefit payment will be taxed as part of the employer’s assessable income.
What are the various types of keyman insurance?
Keyman insurance is not exactly a specific type of policy as it is used to loosely describe the different types of cover that employers might take out for their employees. Keyman insurance can be taken out as:
- Life cover: Benefit paid in the event that the insured worker dies.
- Trauma cover: Benefit paid in the event the insured worker suffers a trauma condition listed in the policy.
- Disability cover: Benefit paid in the event the insured suffers a disability.
A buy/sell agreement ensures that in the event that one business owner suffers an insured event i.e. death, trauma or disability, the respective obligations of the business are executed in an appropriate fashion.
What does it mean if you want life insurance for capital purposes?
Business owners must attribute their use of key-person insurance as either capital or revenue protection:
- Revenue purposes: Used for the replacement of lost income and lost profits
- Capital purposes: Used for compensation for loss of goodwill, repayment of outstanding debts, discharging security of the guarantor’s property.
Capital protection ensures that outstanding loans can be repaid without having to withdraw from the businesses cash reserves following the loss of a key worker.