For tax reasons, the purpose of key person insurance or keyman insurance needs to be clearly defined and documented from the outset and reviewed on a yearly basis to ensure that it hasn’t changed. For example, the purpose may change if the insurance was originally taken out to wipe out a personal guarantee but the loan has subsequently been discharged.
Broadly speaking, key person insurance or keyman insurance either needs to be attributed to Revenue or Capital Protection:
- Revenue Protection – e.g. replacing lost income, compensating for loss of profits etc.
- Business Loan / Capital Protection – e.g. repaying debts, discharging security over a guarantor’s property, compensating for the loss of goodwill etc.
Keyman insurance and tax
If your business is audited following a claim, the Australian Tax Office (ATO) will not only look at the stated purpose for the insurance in your company records but also the actual use to which the proceeds are put (ie revenue losses will be reflected in the company’s profit and loss statement, while capital losses will be directly reflected on its balance sheet).
If the main purpose for the key person insurance is revenue, the premium is generally tax deductible and the proceeds are assessable for Term, TPD and Trauma benefits. Whereas if the company takes out insurance for capital purposes, the premium is generally not tax-deductible.
While Term insurance benefits are not assessable, Capital Gains Tax (CGT) will apply to Trauma and TPD benefits paid directly to the company (as these proceeds do not receive the CGT concession afforded to life insurance proceeds when received by other than the insured or a defined relative).
That’s an important consideration in situations where small business owners have taken out keyman insurance through the company for business succession purposes. In this situation, grossing up the benefit to reflect the potential CGT liability on disposal of the interest in the business is an option.
If the keyman insurance policy is held for a split purpose (eg part revenue/part capital) generally no part of the premium is deductible.
Taxation information provided is as a guide only and may not be relevant to your circumstances please seek the advice of a qualified tax adviser before acting on any information provided in this article.
Keyman insurance review triggers
- Sizeable new loan
- Providing personal guarantee
- Employing new employees crucial to the business
- Change in business structure
- Leasing new equipment/premises
How much keyman insurance or layperson insurance is enough?
Calculating the cost of losing a key person is a specialist area. For example, while loans made to the business by key people can be used as an indicator to estimate the effect of their loss on capital value, it’s far more difficult to value intangible risk factors, like potential loss of goodwill and special client relationships.
Common methods for valuing a key person for insurance purposes include salary multiple, net revenue multiple (ie calculating the amount of turnover contributed by the key person and time frame before sales/cost efficiencies can be recovered), replacement cost (estimating the time it will take to find a suitable replacement and fully train them) and a combination of these.
The combination approach allows for capital needs to fund replacement as well as the income needed to recoup lost net revenue attributable to the key person over a set period.