Key Person Insurance
What is it?
Key Person Insurance is insurance purchased by a business on the life of an owner or employee, whose services contribute substantially to the success of the business. The Company is the owner and pays the premiums and therefore is the beneficiary of the policy.
Key Person Insurance has many uses but there are three main purposes:
The Protection of the Business
The cash received from an Insurance Policy on the death of the Key Person will assist the company in the preservation, stability and continuation of the business, protecting other employees from losing their employment and will also assist in recruiting an outsider comparable to the deceased employee.
A special advantage of Key Person Insurance is that it constitutes an emergency reserve, apart from all other assets, which is not subject to business fluctuations. It could also be used to stimulate confidence in creditors.
Provision for the Key Person or his dependants
Key Person Insurance may also be used to provide or supplement a retirement benefit for the Key Person or to finance a benefit in whole or in part to the widow or other dependants of the Key Person on his or her death.
How to effect Key Person Insurance
The employer takes out a policy on the employee’s life and pays the premium. If the Key Person Insurance is effected by a registered company, the company should pass a resolution to effect the insurance and such resolution should contain the necessary details regarding the insurance policy and the purpose for which the policy has been taken out.
The Types of cover
Three major Lump Sum covers should be considered
- Term Life Insurance
- Total & Permanent Disability Insurance
- Trauma Cover Insurance
Income Tax in relation to Key Person Insurance
As mentioned earlier every Key Person Insurance Policy will cover a purpose. It is the purpose that determines the tax implications.
In certain circumstances the tax payer can claim a deduction under section 51 (1) of the Income Tax Assessment Act. This section allows a tax payer to deduct from assessable income “losses and outgoings” to the extent that they are incurred in gaining or producing the assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income.
It is important for the employer to determine what the purpose of the benefit will be for. Before any determination can be made of the deductibility of the premium or the assessability of the policy proceeds for Key Person Insurance, it is necessary to determine whether the purpose for which the policy was effected was for a revenue or capital gain purpose.
The general ruling is, if the purpose is for revenue i.e. covering loss of profits, cost of replacing the Key Person, providing a gratuity to the employee’s dependant:
- Premiums paid are Tax Deductible
- Proceeds are Assessable Income
From this it necessarily follows that whatever is determined, as the amount of insurance required, consideration will have to be made as to the amount of Tax to be paid
e.g. If the policy is for $1,000,000; tax of $300,000 will be paid (Company Rate of Tax 30%)
If the policy is put into place for Capital Purposes i.e., capital protection, repayment of a loan, to replace lost goodwill, to offset or stabilise a liquidity problem:
- Premiums are not Tax Deductible
- Proceeds are not Assessable Income.
Valuation of Key Person
The most difficult evaluation of any Key Person case is just how much the company will lose in the event of the untimely death of a Key Person.
In an old established company where earnings usually depend on a large number of “Key Persons” one death may not mean a great loss.
But in a situation where a new company breaking new ground, especially in new technology, a Key Person’s early demise could affect future earnings by many millions of dollars.
When assessing the value of a Key Person it is now becoming more important to establish the reasons for insuring the Key Person. The following are some examples of reasons for Key Person Insurance:
- To offset the loss of a Key Person’s services.
- To offset the loss of any unfinished business incurred by his or her death.
- To offset the loss of clientele attracted to the firm by his or her personality and ability.
- To offset the loss of employee unity and working harmony which is held by his or her good management and understanding.
- To offset the loss of future expansion of the firm.
- The loss from other stabilising and profitable efforts on his or her part.
- The need to cover loss in credit standing of the corporation for example: repay corporate loans which have been extended because of the Key Person’s abilities.
- To cover the cost of seeking and training a Key Person replacement.
To insure the human life assets of the business, in order that there is continuity and the ability to repay debts in accordance with the law.