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Key Person Cover – The tax differences between loss of profit and loan repayment

key person cover

In any company, the loss of key personnel can often have quite a large impact on the business financially. That impact can be detrimental to the future of the business. In particular, for smaller companies with one or two directors or fewer employees. Key person cover can help to protect the business by providing the funds necessary to keep the business running.

What is key person cover?

Key person cover, also known as key employee or key man insurance, is a life insurance policy that is taken out on a vital employee in the business. This is usually a company director, but can also be a sales manager, software developer or head of marketing. Key employees are people who are crucial to the success of the business; without them, the business would suffer financially or potentially fold.

How it works

With key person cover, the company owns the policy and therefore pays for the premiums each month. The policy is written so that if the person insured were to pass away or become terminally ill, the business can make a claim to receive the payout from the life insurance policy.

The effect of losing a key employee

Losing a key member of a company can cause a dramatic breakdown in management and systems. The sudden loss of an integral part of the team can lead to the failure of a business, particularly for SME’s and sole traders as well as a number of immediate financial pressures.

This can include;

  • Business loans in the key person’s name can be called in by lenders
  • Loss of business clients
  • Loss of reputation and therefore faith from suppliers, customers and employees
  • An interruption to business activities causing delays and cancellations
  • The recruitment, training and replacement of the key person

business meeting

Saving on tax

One of the most attractive qualities of key person cover is that it can be a tax-efficient policy. However, the tax benefits associated with this type of policy depends on what the policy is used for.

 The premiums

Generally speaking, the premiums of a key man insurance policy are not eligible for corporation tax. However, the HMRC will consider a policy for corporation tax if it meets the following conditions:

  • There is an employer-employee relationship between the policyholder and the individual.
  • The individual does not hold a substantial interest in the business.
  • The purpose of the policy is to pay for any loss of profit resulting from the loss of services from the employee
  • A short-term policy

If the policy is taken out for the purpose of repaying loans or other debts are not allowable as a business expense. HMRC states that the ‘sole purpose’ must be to meet ‘a loss of trading income that may result from loss of services’ in order to be an allowable expense.

The payout

When it comes to the taxation of the payout of a life insurance policy, it depends on the purpose for which the plan is taken out. This can be split between a ‘revenue’ or a ‘capital’ loss to the business.

When the business would like to protect against the repayment of business loans or outstanding debts, then HMRC is likely to treat the payout as a capital receipt. As a result, the benefit is not taxed on the payout. However, if the policy is to protect against ‘loss of profit’ for example recruitment and replacement then the payout will be subject to corporation tax.

The decision made by HMRC is determined by the evidence presented by the directors demonstrating what they are seeking to achieve.

Revenue purposes

  • Finding a replacement: When you lose a key employee, the money can be used to find someone to replace their skills and expertise within the business. If a person is that valuable to the business, it can often be hard to replace and cause be a costly expense to the business. Costs involved could include advertising for the role, interviewing candidates, training and the new employee’s salary.
  • Loss of profits: Losing a key person can also lead to a direct loss of income to the business. This could be due to errors or delays inefficiency or a loss of sales. The payout can then be used to cover the business until they can get back to normal.

Capital purposes 

  • Paying back a loan or debts: If a key member has a loan or debts written in their name they can be called back from the lender in the event of a death. Key person cover can then be used to pay back the loan. This prevents it from coming out of company profits.
  • Strengthen the goodwill of the company: With some insurance policies, the established reputation of the business is regarded as a quantifiable asset. If goodwill is reduced the payout can be paid back into the business to increase the company value.
** This article contains general advice and does take into consideration your individual circumstances. The article is written in mind for insurance purposes rather than for tax advice. You should always obtain professional advice when it comes to the tax treatment of your life insurance policy.**

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