DE-RISKING YOUR BUSINESS OUR GUIDE TO KEY PERSON INSURANCE

Most business owners insure the things they can see. The premises, the stock, the vans, the professional indemnity that a client contract insisted on. Ask the same owner what happens if the person who holds half the client relationships in their head is off for eight months, and the plan tends to get vague.

WHAT IT IS, AND WHAT IT IS NOT

Key person insurance is a policy the company takes out, on the life or health of an individual whose loss would damage the business, with the company as the beneficiary. The payout goes to the business, not the family.

The last point matters, because it is where key person cover gets confused with two other things:

• Personal life cover pays your family. It protects your household, not your company.

• Shareholder or share protection funds the purchase of a departing shareholder's stake so the remaining owners keep control. It protects ownership, not trading profit.

All of these can be sensible. They are different products, with different tax implications, and buying one while believing you have bought another is a common and expensive mistake. We will come to shareholder protection later in this series.

Key person cover exists to buy the business time and money: to cover the profit that walks out of the door with the person, to fund recruitment of a replacement, and to reassure lenders and clients while you do it.

WHO COUNTS AS A KEY PERSON

The instinctive answer is the founder. Often that is right, but it is worth being more rigorous than instinct.

A useful test: if this person disappeared on Monday, what would it cost us over the next twelve months, and how long would it take to put someone in their place? Run it across the whole business, not just the top of the org chart.

The answer frequently surfaces people who would not have been on the list. The developer who is the only person who understands the platform. The operations manager who holds every supplier relationship. The salesperson responsible for 40% of new business. In an owner-managed company, the answer is often two or three people, not one.

HOW MUCH COVER?

There is no formula HMRC prescribes, but the sum assured should be defensible. That is not just good business practice: as we come to below, proportionality is part of the tax test.

Common approaches include a multiple of the key person's contribution to gross profit, a multiple of their salary, or a figure built up from the actual costs of replacing them: recruitment fees, notice periods, a settling-in period at reduced productivity, and any revenue that is likely to leave with them.

The build-up method is more work but produces a number you can justify, both to an insurer and, if it ever comes to it, to HMRC. It also forces a conversation about how dependent the business really is on one person, which tends to be the more valuable output.

THE TAX TREATMENT: WHERE IT GETS INTERESTING

This is the part we get asked about most, and the part where answers on the internet can get it wrong, because it isn't straight forward and why we always recommend getting expert advice.

HMRC's position rests on guidance that dates to a 1944 parliamentary statement by the then Chancellor, Sir John Anderson. The Anderson rules are still the basis of HMRC's approach today, set out at BIM45525 and BIM45530 in the Business Income Manual. Yes it’s a mouthful. 

Premiums are generally deductible where all of the following hold:

1. The sole relationship between the parties is employer and employee.

2. The sole purpose of the policy is the trade purpose of meeting a loss of trading income resulting from the loss of that person's services, and not a capital loss.

3. It is term insurance only: cover against death within the term, with no other benefits and no investment content.

4. The term does not extend beyond the period of the person's usefulness to the company.

Then comes the part people often miss. Where the premiums are deductible, the payout is a taxable trading receipt. Where they are not deductible, the payout is generally not taxed. 

Purpose of policy	Premiums	Payout
Protecting trading profit, employee with no significant shareholding	Usually deductible	Usually taxable as trading income
Repaying a loan or overdraft	Not deductible	Usually not taxable
Cover on a director who is a major shareholder	Usually not deductible	Usually not taxable
Whole of life, endowment, or any policy with investment content	Not deductible (capital)	Usually not taxable

Two cautions on that table. First, HMRC is explicit that no assurance can be given that a receipt will be excluded from trading income even where the premiums were not allowable. In Greycon Ltd v Klaenstschi (2003), HMRC pursued a £586,000 receipt for corporation tax despite no relief having been claimed on the premiums. The company won, but only on the evidence of what the policy had been taken out to do.

Second, HMRC does not define "major shareholder". Where a director's death would meaningfully affect the value of their shares, HMRC's view is that one purpose of the policy may be protecting the value of their estate, which is not a trade purpose. For most owner-managed companies where the key person is also the owner, this is the point at which the deduction usually falls away.

THE GROSSING-UP TRAP

If your premiums are deductible and the payout will be taxed as trading income, then a £500,000 policy does not deliver £500,000 of usable cash. At a 25% corporation tax rate, it delivers £375,000.

If you have sized the cover on what the business will need, and the payout is taxable, the cover needs to be grossed up for that. Conversely, where the policy is protecting a loan and the payout will not be taxed, there is no need to gross up, which keeps the premium lower.

This is a straightforward calculation that is easy to get wrong at the point of application, and it is the single most useful thing to check before a policy is put in place rather than after.

THREE THINGS THAT COMMONLY GO WRONG

The purpose is never documented. The sole purpose test is a question of fact, decided on evidence of what the directors were seeking to achieve. Board minutes recording why the cover was taken out, at the time it was taken out, cost nothing and are worth a great deal if the position is ever queried.

Everything is lumped into one insurance figure. Key person premiums get bundled with the general insurance line in the accounts and claimed in full, without anyone asking whether they qualify. If the policy does not meet the Anderson conditions, that deduction is not available.

The policy is never revisited. The term is meant to reflect the period of the person's usefulness to the business. Cover taken out when a company was turning over £400,000 rarely still fits at £2m, and the key person at one stage of a business is not always the key person at the next.

WHERE SADLER ADVISORY FITS IN

We are Chartered Accountants, not insurance brokers, and we are not FCA authorised to advise on or arrange cover. What we can do is the part that sits on either side of the policy: helping you work out who the business is really dependent on, sizing the exposure on your actual numbers, and getting the tax treatment right so that the cover you pay for delivers what you expect it to.

If you are putting key person cover in place, or you have had a policy running for years that nobody has looked at, the tax position is worth checking before the next renewal. Get in touch.

This article is for general information and is based on our understanding of the rules at the time of writing. It is not advice and should not be relied upon as such. Figures are illustrative and your own position will depend on your circumstances. Please speak to us before acting.