KEY PERSON PROTECTION
INTRODUCTION A company or partnership may have individuals who are crucial to their business. Their loss, whether through death or critical illness, could have a damaging effect in a number of ways, e.g. loss of profits and inability to raise any business capital. In a partnership the key people will usually be the partners themselves although occasionally employees of the partnership can also be key people. The lives of these people could be covered by an insurance policy. In the case of a company, the company would normally be the applicant/owner and the employee/director would be the life assured. In some cases an own life policy in trust for the other shareholders may be suitable. With a partnership how the policy is set up will depend on the type of partnership and whether the key person to be covered is a partner or an employee. Unless it s a Limited Liability Partnership, an English partnership is not a legal entity and therefore own life policies written under a suitable trust will usually need to be used if the key person is a partner. But where the key person is an employee, the partners would normally apply for the policy in their joint names with the employee as the life assured. In the case of a Limited Liability Partnership, which is a corporate entity with members rather than partners, the situation would be similar to that of a Scottish partnership. Where life of another policies are being set up, Scottish Widows will look carefully at whether the company or partnership has an insurable interest in the key person and if so, how much. Insurable interest means the reason that it s appropriate for a person to take out cover on someone else s life. This would generally be because they can show that they are likely to incur financial loss if that person died or became critically ill. An adviser can help calculate the correct level of cover, but it is also important to review it regularly to make sure that it is still appropriate for the current circumstances. Independent advice should be sought on the legal and tax implications of any such arrangement. For Scottish partnerships, as they are a legal entity, the partnership can effect the policy on a life of another basis and this is the way the policy would be set up if the key person is an employee. Where the key person is a partner, generally an own life policy in trust for the other partners would be effected. If the policy had been effected by the partnership then the partner himself (or his estate) would be entitled to a proportionate share of the policy proceeds. In most cases the purpose is to provide the surviving partners with funds to combat the loss of profits and/or to hire a replacement.
PAGE 2 WHO IS A KEY PERSON? PAGE 3 AN OUTLINE OF KEY PERSON PROTECTION PAGE 4 INVESTMENT PROTECTION PAGE 5 WHAT ABOUT FINANCIAL UNDERWRITING? PAGE 7 SPECIMEN KEY PERSON LETTER 1
WHO IS A KEY PERSON? A key person could be any of the following people: A leading salesman or someone with important contacts. A leading negotiator or specialist. Anyone running the business on a day-to-day basis. Anyone controlling a special project or who is crucial to some research. A director whose record ensures favourable treatment from lending institutions. A controlling director who has personally guaranteed loans. WHY TAKE OUT KEY PERSON PROTECTION? You can categorise the areas in which your business could face problems following the loss of a key person into four major categories: Loss of profit. Investment protection. Management buy-outs. Loan security. LOSS OF PROFIT Whether your business is established or growing, the loss of a key person through death or serious illness will result in a substantial loss of skills and ability. In the short term: You still need to pay both overheads and other salaries. You may suffer severe cashflow problems without the income generated by the key person. Projects may be cancelled or costs increased because specialist abilities or leadership are lost. Recruiting, relocating and training new staff could be expensive. In the longer-term you could lose the goodwill of some of your customers which may cost the business considerable investment in terms of time and resource. There may also be an impact on creditor confidence which can affect your ability to raise finance to help grow your business. 2
AN OUTLINE OF KEY PERSON PROTECTION What type of Business Limited Company Limited Liability Partnership (LLP) Scottish Partnership Partnership Sole Trader How do you set up a plan Limited Company LLP Scottish Partnership Life of another In Trust Sole Trader on Life of Employee Own life Who should be covered Employee and Director Partner or the Employee Partners Employee Own life Who owns the plan Limited Company LLP Scottish Partnership Remaining Partners Life Assured Sole Trader Sole Trader What needs to be completed Business Protection application form Business Protection application form Business Protection application form. Business Trust form. Business Protection application form Business Protection application form. Complete Your Flexible Trust form What Tax relief on plan premiums May be available subject to Anderson Principles being met. The business should check this with their local tax office. Employee Maybe Partner Income Tax and National Insurance relief None May be available None What tax on the business The policy proceeds will likely be liable to business tax where tax relief is allowed on premiums. The business should check this with their local tax office The policy proceeds will likely be liable to business tax where tax relief is allowed on premiums. The business should check this with their local tax office None None None What tax on the individual None None Periodic and exit charge could apply to the trust None None 3
INVESTMENT PROTECTION If your business is just starting up or expanding, it might be trying to raise capital to buy property and/ or machinery. Or your business might be doing a share flotation or additional share issues. In these cases, one person may have a high profile, being seen as crucial to the success of the venture. His or her loss may lead to a reduction in the amount of capital raised. MANAGEMENT BUY-OUTS If a management buy-out of an organisation is being negotiated, the new business will need to consider the impact of the loss of a key person when raising capital. (The expression management buy-outs is also intended to include other types of restructuring.) Management buy-outs tend to develop very quickly so life cover may be needed at very short notice. It s essential that the appropriate financial and medical evidence is readily available to enable our underwriters to assess the situation as quickly as possible. LOAN SECURITY Losing a key person can affect the ability of your business to repay outstanding loans. In some cases a lender may insist on you taking out cover on the lives who are recognised as being crucial to the repayment of the loan. TAX IMPLICATIONS Where the key person cover is set up on the life of a partner the premiums will be paid for out of the after-tax income of the partners. This means that there will be no income tax deduction. The policy proceeds will not normally be subject to income tax as a trading receipt. In certain circumstances, tax relief may not be available on the premiums. The general criteria for tax relief are as follows: The relationship between the business and the life assured must be employer/employee. The purpose of the policy must be to cover the potential loss of profits on the death of a key employee. Where, for example, the policy has been effected as security for a loan, the premiums may not be allowed as an expense of the business. However, the proceeds should not then be taxable. The policy must be a regular short term assurance. The question of what is short term may depend on the company s Inspector of Taxes. As a general rule policies with a term in excess of five years may not qualify for tax relief. Again the proceeds in that case should not be taxable. The value of any tax advantages will depend on your personal circumstances which may change. Remember tax rules can also change. The local Inspector of Taxes must be consulted in every case individually. They will not give a general ruling on whether a premium is allowable for tax relief or the proceeds taxable. A specimen letter that you may want to use is on page 5. Please note you should not use this letter without seeking professional advice. Any HM Revenue & Customs response cannot be relied on if incorrect information is provided. Where the key person cover is set up on the life of a shareholding director, the premiums paid for by the company will not be tax deductible but the proceeds of the policy will not normally be subject to tax as a trading receipt. Where key person cover is effected on an employee (other than a shareholding director) there are no simple rules for deciding whether the premiums will be allowable as a tax deductible expense of the business and/or whether the policy proceeds will be taxable. 4
WHAT ABOUT FINANCIAL UNDERWRITING? Scottish Widows needs to be sure that: There is insurable interest. The level of cover is reasonable. The period of cover is reasonable. Scottish Widows may require: Three years reports and accounts if three years are not available, two years accounts will suffice plus where relevant a copy of the business plans/ projections. If the latest available accounts are over 30 months old, the last two years accounts that can be obtained. Draft accounts (if available). An explanation of why up-to-date accounts are not available. An explanation of cause of loss. A description of the key person s duties and importance. Scottish Widows may require further financial evidence when the sum assured exceeds 1,000,000 for life cover only or 500,000 for critical illness cover. If cover is required in respect of a loan, then sometimes a copy of the loan agreement document will be required by our underwriters. Please note: Scottish Widows policies have no cash-in value at any time. If you don t pay your premiums on time your cover will stop, your benefit will end and you ll get nothing back. If the benefit amount has not been paid out by the end of the selected term, the policy will end and you ll get nothing back. HOW MUCH COVER CAN BE PROVIDED? Normally a company or partnership should try to place a value on a key person and estimate the financial loss that would be incurred through death or critical illness. That could include the cost of recruiting, loss in credit standing, increased project running costs etc. All of these can be difficult to judge, especially when future expectations of profits need to be taken into account too. There are three main ways acceptable to Scottish Widows to estimate a key person s value, where Loss of Profit Protection is being considered and these are: (a) Multiple of salary (known as the Salary Formula) This is often the basis used when the purpose is to buy in a replacement. A multiple of gross salary, including benefits in kind can give a useful guide to the amount needed to recruit a replacement. Between 7 and 10 x gross salary is a useful guide for nonshareholding employees, but you should to take care with shareholders who may be taking a reduced salary to build the business or taking dividends for tax reasons. (b) Multiple of profits (known as the Profits Formula) A multiple of either gross or net profit is taken. The normal multiples would be as follows: 2 x gross profit or 5 x net profit These would be the upper limits on the business as a whole. So where there s more than one key person, you would need to apportion cover according to each person s contribution. (c) Turnover Formula Key Person s remuneration is first expressed as a fraction of the overall remuneration costs of the business. The result is then multiplied by the annual turnover of the business, and then multiplied by the number of years it is estimated that it will take the business to recover. 5
EXAMPLE Gross profit Total salaries pa 5 million 2.5 million Employee s salary pa 60,000 Recovery time Cover required = 3 years (say) 5,000,000 x 60,000 x 3 2,500,000 = 360,000 (a) and (c) above may not be appropriate when deciding on the cover required where the key person is one of the partners. Private company shareholding directors set their own salary levels and may choose to take dividends plus a smaller salary in such a case, salary basis will also not be appropriate. Partners, of course, are not remunerated by salaries and it is generally considered that measurement of financial loss by reference to drawings is likely to be misleading. The multiple of profits formula is likely to be more appropriate in these circumstances. However, there is no better way than to calculate your level of cover by identifying your particular protection need. Your adviser can help you with this. 6
SPECIMEN KEY PERSON LETTER (TO BE ISSUED TO YOUR LOCAL TAX INSPECTOR) To: HM Inspector of Taxes Dear Sirs, Re: ABC Partnership/Ltd Business Tax Reference... The above Company/Partnership wishes to effect a Key Person Policy on the life of...for the sum assured of... The life assured is a Key Person and the policy is intended to compensate our Company/Partnership for the [loss of profits] which, in our opinion, will arise on his/her* death/becoming seriously ill. The proposed policy details are as follows: Type of Policy:... Sum Assured:... Term of Policy:... Premium:... The life assured holds the title of.... within the Company/Partnership and [is an employee with no share in the Company/Partnership.] [is not a shareholder/holds x per cent of the shares in the above company.]* Our understanding is that the premiums for this plan will/will not* be an allowable deduction for Income Tax purposes and that the sum assured paid on death will be [treated as a taxable trading receipt]/[non taxable]*. Please confirm in writing that our understanding is correct. Yours faithfully For ABC Partnership/Ltd * Delete as appropriate 7
Scottish Widows Limited. Registered in England and Wales No. 3196171. Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Telephone: 0131 655 6000. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number 181655. SW57764 12/15