Why should I consider key person insurance if I'm in a business partnership?
There are some people that are simply crucial to the ongoing success of a business. For a company run in a partnership, both partners play hugely important roles in keeping the business going.
If one of those partners is lost to the business, for example, if they suffer a serious illness or pass away, this can have a huge impact on the profitability of that company. There can also be additional financial implications e.g. the ownership stake of the lost partner going to his/her beneficiary (and not someone who is actively involved with the business) .
Key person insurance is designed to offer critical financial protection against:
- The loss of revenue associated with the loss of a key partner,
- Cost of finding and training a suitable replacement
- Cost of ownership transfer
Keep reading for closer look at how key person insurance works and how it can benefit business partnerships.
In the context of business partnerships, keyman insurance can payout if a business partner
- Passes away
- Develops a serious medical condition
- Is disabled due to an injury or illness
Key man insurance is simple, but the exact benefits can be complex. Taking out a policy means deciding who your business simply could not do without and then getting them insured. The proceeds of the policy can be paid directly to the business, or to an individual. In some cases two executives might personally take out key man policies on each other, or the entire board of a company might insure each other in the business’ name. In particular, key man insurance helps facilitate several difficult situations that emerge following the loss of a critical individual.
Two common ways that business partnerships take advantage of keyman cover
- Succession planning. The shares held by the key person are usually transferred to their family or other beneficiaries if they pass away. Key man insurance can provide the funds needed to buy them back and smoothly transfer ownership. If there are buy/sell agreements in place, where stakeholders have entered into written instructions on what to do with their shares on death, then the key man insurance payout can facilitate these plans.
- Business debts. What if the key man puts his or her name on business loans before passing away, or personally guaranteed loans made to the company? Key person insurance can be used to pay off the debts of a business partner in order to maintain the company’s reputation and credit rating.
Surviving a key loss
Richard and Bradley’s financial services company had been in operation for just over a year, and they were taking Australia by storm. By working together on sales pitches, double-teaming investors and generally being an extra-dynamic duo, they’d grown rapidly and become very profitable. Rich handled most of the numbers and behind-the-scenes work, while Brad maintained client relationships and focused on sales.
It wasn’t long before they realised that without the other, their entire company would fail. Both Brad and Rich were essentially key men. With the help of their insurance broker they found a good key person policy, and each took one out on the other, nominating the company as the beneficiary and earmarking the policies for capital purposes to avoid tax on benefits paid, but also making premiums non-tax-deductible.
In a tragic misfortune, Brad was involved in a fatal car crash, colliding with both another car and a billboard. He died instantly, and Brad’s wife inherited his half of the company.
It was now Rich’s job to reacquire company ownership. Using the lump sum awarded by key man insurance he made Brad’s wife a solid offer, which she accepted. Having required full ownership, Rich paid off debts and rekindling goodwill. He sent gift baskets to Brad’s old clients as part of the transition to new point of contact. Because the entire benefit was used for these capital purposes, none of it was taxed.
Using the rest of the funds awarded by the key person policy, Rich recruited and trained a replacement, and bolstered further growth.
Disaster was averted.
What if there was no key person insurance in place?
Without key person insurance there would have been some key implications:
- Brad’s wife would have had the stock in the company. Stock that she might have wanted to sell.
- Rich may want to buy stock back. However, Rich may not have had the cash to pay for Brad’s portion of the company.
- Lose-lose situation. Without the adequate funds to buy out Brad’s wife’s ownership, Richard may have low-balled her. Alternatively, Brad’s wife could have sold to another buyer, to the detriment of Rich.
The purpose of keyman insurance is to cover two main types of losses:
- Revenue losses. Lost revenue and operating cost resulting from the absence of a key person
- Capital loses. Capital value lost without the presence of a key person.
|Purpose of cover||Revenue||Capital|
|Tax rules||Premiums are tax-deductible and benefits are taxed like income.||Premiums are not tax deductible and benefits paid out are not taxed.|
Why are losses categorised into revenue and capital purposes?
When you take out a key person insurance policy you should document whether a payout will be used for revenue purposes or capital purposes – this affects tax deductibility of premiums and the taxes applied to any benefits paid. The payout can be used for either purpose, even if intended for the other, but the tax conditions will be adjusted accordingly. All key person policies offer life cover which pays out in the event of death, but just like life insurance, there are also options for permanent disability and critical illness payouts. Some policies may include these as standard, while others class them as extras.
What is the difference between revenue purpose and capital purpose?
You should record, with meeting minutes, the decision to earmark key person insurance policy benefits for either revenue purposes or capital purposes. You do not have to use the entire payout for either one or the other, and can spend the benefits on almost any business purpose.
Premiums paid for revenue purposes are tax deductible, but the benefits are also taxable. Premiums paid for capital purposes are not tax deductible, but the benefits are also not taxable. This only applies to business taxes and if the company is the policyholder. If you nominate yourself rather than the company as a beneficiary, then the benefits may be subject to capital gains tax.
- Revenue purposes is used to replace lost revenue, such as from lost sales or poor productivity following the loss of a key person. This includes, but is not limited to, recruitment, training and directly offsetting lost revenue.
- Capital purposes is used to secure the company with provision of capital. This includes, but is not limited to, paying off shareholder loans or debts in the key person’s name, replacing lost goodwill, protecting the business credit rating and purchasing ownership from the key person’s beneficiaries.
Depending on the insurer and the policy, conditions may apply as to who can be qualified as a key person. That person may be required to directly contribute to a certain proportion of company income, or otherwise have a defined critical role.
When deciding how much key person insurance to take out, there are several factors to consider.
- Finding and training a replacement is not cheap, particularly for a very specific or highly trained job. Searching for the right candidates, assessing them and then finally making an offer and paying their salary can be expensive. If you need to hire a temporary replacement until you find the right permanent one, this will cost even more. Know all about your hiring processes so you can accurately judge how much it will cost.
- Offsetting the revenue lost depends on what the key person did. If they were a sales leader, or crucial to your manufacturing process, this could be a huge amount. You can get a rough idea of this cost by looking at your business’ annual revenue and then determining what proportion of that would not be possible without the key person.
- Covering debts is extremely important. Failure to pay them off can adversely affect your business for years to come, and interest rates can rise – meaning the sooner the debts are dealt with the better. Unfortunately, without that key person your company might not have the revenue to pay them off. Lump sum key man payments should be used to pay off relevant loans. Depending on your business, this might be a critical factor to consider when working out how much insurance you need to take out.
- Transferring ownership of the company is vital to its continuity. Many key man policies will let you set up special automatic procedures in the event of decisionmakers not being around anymore, or you can use the payout to do it yourself. Typically this will involve buying the key person’s share of the company from their beneficiaries. Depending on how much your company is worth, and how ownership of shares will be transferred upon death, the cost of this can vary enormously.
- Losing clients, contacts and goodwill can be an unpredictable expense, but not an impossible one to calculate. Think about which clients will definitely disappear without your key person, and which ones might stick around. Consider the value of the key person’s industry contacts and what will no longer be possible without them. You should have a good idea of the intangibles your partner is bringing to the table and can work out how much it might cost to buy a replacement for them.
The tax treatment of key person insurance for business partnerships depend on the purpose of the policy. The proceeds from key person insurance can be used by a business for revenue or capital purposes.
Following the payout of a key person insurance claim, the ATO will compare the stated purpose of the insurance policy in your company records with how you actually used the benefit amount to determine your tax liability.
|Are premiums tax deductible?||Are insurance benefits taxed?||Are the insurance benefits subject to capital gains tax?|
|Conditions||Only for business taxes||Only for business taxes||Benefits are subject to capital gains tax if the recipient is not a relative of the insured or a business|
Tax treatment of revenue purpose cover
If you take out key person insurance for a revenue purpose, such as replacing lost income and revenue, the premiums you pay will be tax-deductible. However, this also means that any proceeds you receive from the key person insurance policy will be assessable for tax, so you’ll need to consider the Capital Gains Tax (CGT) implications when you take out cover. While term life insurance benefits are not subject to CGT, trauma and TPD benefits do attract CGT.
Tax treatment of capital purpose cover
If you take out key person insurance for a capital purpose, such as repaying business debts or compensating for lost goodwill, your insurance premiums will generally not be tax-deductible. However, this means that any proceeds you receive from your key person insurance policy will usually not be tax-assessable.
How is tax treated when cover is for both revenue and capital purposes?
In cases where you use a portion of the key person insurance benefit for revenue purposes and the remaining portion for capital purposes, only the portion of the proceeds used for revenue purposes will be tax-assessable. Similarly, you will only be able to claim a similar portion of your premiums as a tax deduction.
Key person insurance can be purchased and held through superannuation, but only in a few specific circumstances.
Legislation requires that the benefits from a superannuation fund be paid to someone’s estate or dependents if they die, or them directly if they suffer permanent disability. This is at odds with key person insurance, which is paid out to the company or a business partner.
As such, the only situation where you can get key person insurance through superannuation is if you are part of a family business where the beneficiaries are both part of the family and part of the company, such as a husband and wife team running a company. If you are able to do this, then premiums paid will typically be tax deductible and benefits paid will typically not be taxable.
If you are considering taking out key man insurance through superannuation it is a good idea to speak with a tax and/or insurance adviser first. Certain circumstances, such as paying off a family business loan with proceeds from the key person’s estate rather than company benefits, can have tax consequences.
There is no direct alternative to key person insurance, but there are other options which might be preferable for your business in the event of the loss of a key person, and the loss of revenue or capital which results from it.
- Take out a loan. This is obviously another way to access funds at a crucial time, and because it is done after the loss of your key person, not before, you can more accurately judge the amount needed. The downside is that lenders may be hesitant to offer money to a company that’s just lost a key person, or might offer poorer rates.
- Cover the loss with company profits. Accumulate a reserve or recover the situation with the current year profits. Naturally this is only an option if your business is sufficiently profitable, and might not be best for the bottom line. Having the money readily available usually means lower risk, lower return corporate investments, while covering the loss with the current year’s revenue will mean less profit for the business as a whole.
- Sell off assets. This can help you raise money fast, but you generally won’t get your money’s worth. Businesses generally don’t hold unnecessary assets, so you will likely be selling off useful equipment. Also, due to the circumstances of the sale you cannot necessarily expect a fair price.
Key person insurance is fairly cost-effective compared to the alternatives, with an annual cost that typically ranges from 0.5% to 5% of the sum insured, depending on the type of cover taken out, the age and health of the key person, and the business.