Key Person Protection

The purpose of Key Person insurance must be to meet profits lost from the death or critical illness of the key person. The time to test the purpose is when the policy is being effected and it is important to keep records of the reasons why the policy was effected because it may be necessary to prove this to HMRC at the time of receipt of the proceeds. If the policy is taken out as security for a loan, the premium would be disallowed, because it is not to replace profits.

Income tax is the relevant tax paid by a partnership or sole trader in respect of Key Person insurance.

The sole relationship between the business and the life assured must be that of employer to employee. Working directors are employees for this purpose.

Any policy with a surrender value would not qualify, because a part of the premium goes towards investment. This would apply to whole life policies and unit-linked whole life policies taken out on a maximum cover basis.

Purpose of Key Person insurance

Wholly And Exclusively

The ‘wholly and exclusively’ test means that, to be treated as a business expense, the premiums must be ‘wholly and exclusively laid out or expended for the purposes of the trade’. If there is duality of purpose, this will result in non-deductibility.

  • If the life assured has a significant shareholding in the company, the test is failed because the policy is partly for the life assured’s own benefit.
  • There will be no tax relief where a parent company insures a key person in a subsidiary or associated company. In this scenario, there would probably also be difficulty in establishing insurable interest.

For Key Person Insurance premiums to be allowable for tax relief, the policy must be an annual or short-term assurance. These would not be eligible for tax relief:

  • Single premium policies, unless for one year only.
  • The maximum term should be how long the employer believes the employee will be useful to the company. That could be just a few years, up to the employee’s expected retirement age, but any term chosen may need to be justified.

Corporation Tax Relief

The main criteria that must be satisfied if premiums paid to a key person policy are to attract corporation tax relief are:

  • The key person’s relationship with the business is employee and employer (if the life assured has a significant shareholding in the company, relief is unlikely to be given).
  • The policy must be to replace loss of profits and not to cover a capital loss (such as a loan).
  • The policy is an annual or short term insurance.

Term Assurance

Term assurance may seem the automatic choice for Key Person protection, especially where the key person is working on a short-term project, or where the company is expanding rapidly. It may also be suitable for a new company, which may not be able to afford any other kind of life assurance. However, there are some significant disadvantages to term assurance in this respect:

  • Critical illness cover may have to be provided separately from the life cover and this is more expensive, although the amount of cover is greater because two claims could be made.
  • Some policies may not offer protection against inflation, so the value of the sum assured may decrease in real terms. In practice, a key person’s value to the company is likely to increase over the years.
  • Not all policies incorporate increase options and those that have are usually unable to cope with sudden large increases, e.g. on promotion.

Compared to Term Assurance, Flexible whole of life assurance may be more appropriate in these instances:

  • Where the key person is likely to be important to the business over a longer period.
  • Where the key person is expected to make a significant contribution during their working life.
  • Because it has more facilities for increasing cover on an annual basis or on other events compared with term assurance.