Key Person Insurance taxation rules can be confusing. What are they and how are they applied? This guide from WIS Insurance tells you what you need to know.
At the beginning of 2021, there were 5.5 million businesses in the UK with 0-49 employees. This represents 99.2% of all UK businesses In fact, most businesses are very small, being either single-person businesses or businesses with just a handful of employees. These are often businesses that have been conceived, set up and developed by a single person with a strong idea about what they want to achieve. If this person dies or suffers a critical illness, this can have a devastating effect on their business. Key person insurance protects businesses from the loss of someone crucial to their operations, providing financial compensation that can help them adjust and rebuild.
How key person insurance can help
Key person insurance, sometimes known as key man insurance, can be used for a number of different purposes. This might include the costs of hiring new staff, providing necessary cover for any temporary losses, repaying any loans that are outstanding, bridging funding gaps and providing general financial support for the business as it adjusts to a new reality.
As with any funds coming into and out of your business, you need to be clear about the tax status of both premiums and payouts.
Is key person insurance taxable?
The HMRC approach to key person insurance is complicated, something they set out in their business income manual that is available online This approach is broadly based on the so-called ‘Anderson Rules’, a set of guidelines that were set out over 70 years ago.
A key factor in whether or not key person insurance premiums would be tax deductible is the ‘wholly and exclusively’ test. That means that if any payout from the policy would be used solely by the business, then your premiums towards the policy would be tax-deductible against the company’s Corporate Tax bill.
When the policy covers a shareholder
If a policy benefits a company shareholder it may not meet the wholly and exclusively test, meaning that premiums will not be eligible for Corporation Tax relief. Exceptions to this rule may apply in the case of minority shareholders who have less than a 5% stake in the company. This limit is a guideline only, rather than being statutory, and HMRC may be open to negotiations if someone owns slightly more than 5%.
When a policy that covers a company shareholder pays out this will usually be counted as a trading receipt. This means that HMRC will tax the payout accordingly. In effect, this means that both premiums and payouts could be liable to taxation.
When the policy covers a business loan
If a key person policy is taken out to provide protection against a business loan this will again mean that premiums will be taxable. The reason for this is that the policy is in effect being taken out to provide protection for the lender, so it’s not wholly and exclusively for the borrowing business.
However, any payouts taken out to cover a business loan will be used to rebalance the company capital account. This means it’s not usually counted as a trading receipt, and the payout won’t be taxable.
When the policy covers an employee
In most cases, when a business takes out a key person policy to cover an employee, this will usually pass the wholly and exclusive test set out by the HMRC. The policy is not being taken out to benefit the employee personally, but the overall financial health of the business. This means that premiums will be a tax-deductible business expense. They will be eligible for corporate tax relief.
However, when a payment is made the payout will be taxable. This means that any policy you take out to cover an employee should take account of the impact that taxation will have on its value. You should ensure that the amount insured is enough to meet the expected needs of the business should the insured employee die or become critically ill.
Can sole-traders or partnerships take out key person insurance?
Both sole traders and partnerships in England, Wales and Northern Ireland cannot take out a key person insurance policy. This is because they do not have a separate legal identity, therefore any policy would not be wholly and exclusively for the benefit of the business. However, it’s possible for one of the partners in the partnership to take out a relevant life plan on their own life and then place it in a trust for the benefit of the other partners.
Find out more about key person insurance
Key person insurance can give your business security putting it on a firm footing for the future. To find out more about Key Man Insurance from WIS contact our experienced team today.