Many businesses rely heavily on the knowledge, experience and relationships of a small number of key people. These could be directors, senior employees or other individuals whose contribution is central to the success of the business.
If one of these people were unable to work because of an accident, illness or injury, or were sadly to pass away, the financial effect on the business could be significant. Revenue may fall, important relationships could be disrupted and the cost of recruiting or training a replacement could place further pressure on the company.
Key person insurance can help protect a business against these risks. However, the tax treatment of both the insurance premiums and any eventual payout will depend on the purpose and structure of the policy.
What is key person insurance?
Key person insurance is a policy taken out by a business on the life or health of an individual who is particularly important to its operations.
The business pays the premiums and is normally the beneficiary of the policy. If the insured person dies or suffers a qualifying illness or injury, the business may receive a payout to help manage the resulting financial impact.
This money could help the business cover a loss of trading income, recruit a replacement or meet other costs arising from the individual’s absence.
Are key person insurance premiums tax deductible?
For premiums to be deductible when calculating the business’s taxable trading profits, HMRC generally requires the following conditions to be met:
• The sole purpose of the policy must be to protect the business against a loss of trading income resulting from the loss of the key person’s services.
• If the policy provides life insurance, it must be a term insurance policy with no additional benefits. The term should not extend beyond the period during which the individual is expected to remain useful to the business.
The circumstances and intentions behind taking out the policy are important. If the policy also has a personal, investment or other non trading purpose, the premiums may not be fully deductible.
This may be particularly relevant where the insured person is both a director and a major shareholder, as the policy could also help protect the value of their shares.
How is a key person insurance payout taxed?
Where the policy meets the conditions for the premiums to be deductible, any money received following a successful claim will normally be treated as taxable trading income.
A business cannot necessarily avoid tax on a payout simply by choosing not to claim a deduction for premiums that would otherwise qualify. The tax treatment is based on the nature and purpose of the policy rather than how the premiums were reported.
Where the premiums are not allowable for tax purposes, a payout will generally not be treated as trading income. However, this should not be assumed automatically, as the tax treatment of an insurance payout is considered separately from the deductibility of the premiums.
When might premiums not be tax deductible?
Key person insurance premiums may not qualify for tax relief where the policy is intended to provide a capital or investment benefit rather than compensate the business for a loss of trading income.
Examples may include:
• Whole life insurance policies
• Endowment policies taken out on the life of a key person
• Policies connected with securing or repaying long term business finance
• Critical illness or accident policies that include an investment element or contribute towards a capital investment
• Policies that also serve a personal or non trading purpose
The exact treatment will depend on the wording of the policy and the reasons why it was taken out.
Check the position before taking out cover
Key person insurance can provide valuable financial protection, but its tax treatment is not always straightforward.
Before taking out or changing a policy, it is sensible to review the terms carefully and consider what the policy is intended to protect. This can help establish whether the premiums are likely to be deductible and how any future payout could be taxed.
If you need help understanding the potential tax treatment of a key person insurance policy, please get in touch with our team. We’re always here to help.
This article provides general information only and should not be treated as advice tailored to your individual circumstances.