Key Person Insurance
Key person insurance, also commonly called keyman insurance and key man insurance, is an important form of business insurance. There is no legal definition for “key person insurance”. In general, it can be described as an insurance policy taken out by a business to compensate that business for financial losses that would arise from the death or extended incapacity of the member of the business specified on the policy. The policy’s term does not extend beyond the period of the key person’s usefulness to the business. The aim is to compensate the business for losses and facilitate business continuity. Key person insurance does not indemnify the actual losses incurred but compensates with a fixed monetary sum as specified on the insurance policy.
An employer may take out a key person insurance policy on the life or health of any employee whose knowledge, work, or overall contribution is considered uniquely valuable to the company. The employer does this to offset the costs (such as hiring temporary help or recruiting a successor) and losses (such as a decreased ability to transact business until successors are trained) which the employer is likely to suffer in the event of the loss of a key person.
There are four categories of loss for which key person insurance can provide compensation:
- Losses related to the extended period when a key person is unable to work, to provide temporary personnel and, if necessary to finance the recruitment and training of a replacement.
- Insurance to protect profits. For example, offsetting lost income from lost sales, losses resulting from the delay or cancellation of any business project that the key person was involved in, loss of opportunity to expand, loss of specialised skills or knowledge.
- Insurance to protect shareholders or partnership interests. Typically this is insurance to enable shareholdings or partnership interests to be purchased by existing shareholders or partners.
- Insurance for anyone involved in guaranteeing business loans or banking facilities. The value of insurance coverage is arranged to equal the value of the guarantee.
Who can be a Key Person?
A key person can be anyone directly associated with the business whose loss can cause financial strain to the business. For example, the person could be a director of the company, a partner, a key sales person, key project manager, or someone with specific skills or knowledge which is especially valuable to the company.
Potential Pitfalls of Keyman Insurance Taxation
If the policy proceeds are not payable to the company, but are payable to the key worker’s estate or family, then this is not a key man insurance policy and the premiums will constitute earnings on behalf of the key worker and PAYE liabilities will arise. If the payments are not declared then the back tax and NICs can be considerable when discovered by the Inland Revenue.
Assuming one is dealing with a true key man insurance policy, there are no PAYE or benefit in kind issues, as no benefit accrues to the key worker or his family. The company should be able to claim a corporation tax deduction, however, this might be denied if the key worker is also a substantial shareholder in the company.
If the policy was taken out to provide a financial “cushion” from the loss of the key worker, then the proceeds will be taxed as if they were a trading receipt. It is often mistakenly assumed that if tax relief on the premiums is not claimed, then any proceeds receivable will be tax-free. This is not correct as the Inland Revenue has win-win rules. The taxability of policy proceeds is dependent upon the nature of the policy, not on whether a tax deduction is allowed (or claimed) in respect of the premiums. If the premiums are allowable as trading payments, the proceeds will inevitably be taxable as a trading receipt – but the reverse is not necessarily true.