All businesses should consider the use of life insurance to compensate the business for any financial impact as a result of loss through death, disablement or critical illness of key persons or employees who are responsible for the ongoing success of the business. This type of insurance is called keyman insurance or key person insurance.
Who is a key person or keyman?
A key person or keyman is an individual whose continued association with a business provides that business with a significant and direct economic gain. Economic gain means more than just profits. It can also include inter alia, capital injections, cost efficiency, goodwill, access to credit and contacts with suppliers and customers. Business owners will also usually be key persons.
What is key person or keyman capital insurance?
Key person insurance or keyman insurance can compensate the business for the loss of a key person in two different ways: business profitability (revenue purpose); and the capital value of the business (capital purpose). Whilst both revenue & capital protection are important, this article will focus on the second area.
Reduction of the capital value of a business
Key person insurance or keyman insurance proceeds can be applied to maintain the capital value and stabilise the business. The capital value of a business following the loss of a key person could be reduced in the following ways:
- Credit standing: Some businesses can secure credit lines and overdraft facilities more easily than others due to the personal assets of a business owner. Key person capital cover provides the business with an alternative source of funds
- Goodwill: This intangible is what brings clients to the business, and this will likely suffer due to the loss of a key person’s specialised knowledge, business contacts and reputation
- Business debts: If a business is destabilised and defaults on a loan after the loss of a key person, financial institutions could call in one or more loans to the business
- Loan accounts: Loans by owners to their business may be called in immediately by an outgoing business owner or his/her estate
- Guarantor protection: Although this does not directly affect the capital value of a business, if directors, for instance, have signed personal guarantees, it means that they secured a loan for the business directly or indirectly using all or some of their personal assets. These guarantees are generally extinguished only when the loan is repaid in full.
Establishing the level of cover for keyman insurance
If you are looking for keyman insurance, you might like to ask how much of the business’s current capital value and annual capital appreciation, as a percentage, is attributable to the key person/s. The capital value of the business is often determined by profitability and may include a goodwill component. If profitability or goodwill would be reduced by a certain percentage, this would be one measure of the potential capital loss to the business.
Financiers most commonly secure business loans by having guarantees signed by principals. In addition, most financial institutions insist on the joint and several liability of business owners in relation to loans or overdraft facilities, meaning each guarantor is 100% liable for the debt, regardless of his or her share of the business or of individual assets offered as security. Therefore, the full repayment of business debt is attractive to many business owners.
Tax treatment of premiums for keyman insurance
The taxation treatment of keyman insurance depends on whether the key person policy is for a capital or revenue purpose. It is necessary to establish the intent when the policy was taken out (and any change of purpose during the life of the policy) and the purpose for which the policy proceeds are actually used. The purpose should be recorded via minutes or file notes.
Generally, capital protection insurance premiums are not tax deductible to the business and the death benefit proceeds are not taxable if received by the original beneficial owner. The proceeds of TPD and trauma insurance are subject to capital gains tax (CGT) if received by a company or trust and not taxable if received by the life insured, a spouse (including de facto) or a relative, as defined by section 118-37 of the Income Tax Assessment Act (ITAA) 1997.
Keyman insurance policy ownership
Since it is the business that is being protected against the loss of a key person, it makes sense for the entity (company, partnership, trust or individual) to own the policy and pay the premium. The drawback here is that TPD and trauma proceeds paid to a company or trust would attract CGT, so any TPD or trauma sum insured should be grossed up to cover this liability and provide the business with a net amount of proceeds.
As an alternative, you may like to consider self-ownership for debt reduction/guarantor protection, which would avoid CGT on the proceeds paid in the case of death, terminal illness, TPD or critical illness. Once the insurance proceeds are received, they are needed to discharge the debt to the financial institution. The previous industry understanding of this has been that Commercial Debt Forgiveness (CDF) which imposes an additional tax liability on the debtor (e.g. company) may arise if a guarantor pays the debt directly to the creditor (a bank or similar).
In addition, a right of contribution (a doctrine of both common and equity law) may arise when a person has paid, or has been called upon to pay, more than his or her proportion of a debt.
Case Study: Keyman policy ownership structures
Let’s take the situation of John and Mary, who are unrelated co-directors and equal shareholders in JM Pty Ltd and who have borrowed $600,000 for their business, providing personal guarantees with their family homes as security.
They are looking at insurance cover for the debt, and decide they would like to pay off the entire debt in the event of death or TPD and half the debt in the case of critical illness. The first option is to have a policy owned by JM Pty Ltd with John and Mary as lives insured. However, this would require $857,143 of TPD and $428,571 of trauma to cover CGT on the respective proceeds to discharge 100% and 50% of the debt respectively.
If they attached TPD to term life as a rider, they would also need to gross the life component as well.
Alternatively, John and Mary can own the cover personally, with no need to gross up the sum insured. In this scenario, they should implement a debt reduction agreement, whereby on the death, TPD or critical illness of either, the insurance proceeds would pay off the creditor. They should also contractually exclude a right of contribution for either party.
As regards the potential CDF liability, for the relevant provisions to apply, there must be forgiveness according to Australian law, as amongst other things, a commercial debt being ‘released, waived, or otherwise extinguished’. In common language, the debt is being extinguished via the insurance proceeds. However, the law also states that ‘extinguished, in relation to a debt, does not include the payment of the whole of the debt in cash’. Therefore, CDF would not apply.
Keyman insurance and tax treatment of proceeds
The purpose of key person insurance must still apply at the time of claim. If the purpose has changed or if the proceeds are used for a different purpose at time of claim, it may affect the deductibility of past premiums and the assessability of the insurance proceeds. The proceeds of a policy minuted for capital purpose (and therefore not deductible) might still be assessable at claim time, if the proceeds are applied for a revenue purpose. It is, therefore, important that there be new records of the purpose at the annual renewal of the policy, because the need may have changed over the previous 12-month period.
Key man insurance can be used to maintain the capital value of the business, including the reduction of debt. Keyman insurance is quite complex, so it may be best to speak to a specialist keyman insurance adviser to analyse your business and recommend the appropriate sums insured and relevant ownership structures.