The profitability or income-earning potential of a small business may depend on one person. Consequently, if that person suffers a serious illness or has an accident the profitability of the business may be seriously compromised.
It is possible to insure against such an eventuality by taking out a policy insuring against the loss of profits resulting from the death, critical illness, sickness, accident or injury of a director, an employee or another key person. This is known as key person insurance.
Premiums paid in respect of a key person insurance policy are deductible in computing the profits of the business if the premiums are incurred wholly and exclusively for the purposes of that business.
This test is met if the sole purpose in taking out the policy is to meet a loss of trading income arising from the loss of the services of the key person insured. The extent to which the sole purpose test is met is a question of fact which is determined by taking account of what the company directors or, in the case of an unincorporated business, the proprietor were aiming to achieve as a result of taking out the policy.
If the underlying purpose is not a trade purpose, the premiums cannot be deducted as a business expense. There are various scenarios in which a policy may be taken out for a purpose other than a trade purpose. This would be the case, for example, if a policy is taken out in respect of only those directors who are also major shareholders with a view to protecting the value of the shares and, in the event of the insured’s death, his or her estate.
Where the policy is a life insurance policy, the premiums are deductible only if the policy is a term insurance policy providing cover only against the eventuality of the insured dying within the term of the policy and no other benefits. The insurance term should not extend beyond the period of the insured’s usefulness to the company.
To qualify for a deduction in the computation of taxable profits, the premiums must be a revenue expense rather than capital expenditure. No deduction is given for a policy that provides against a capital loss. Further, no deduction is available for premiums to the extent that they contribute to a capital investment. This will be the case where a policy, whether a whole life, endowment, critical illness or accident policy, has an investment element.
Policies linked to long-term finance
The provision of long-term finance may be conditional on the taking out of an endowment policy on the life of a key person. HMRC do not regard the premiums on such as policy as being an `incidental cost’ of the loan finance and as such they are not deductible in the computation of business profits.
Insurance receipts – the other side of the coin
Where a key person insurance policy pays out, the treatment of the insurance money depends on whether the premiums were allowable or disallowable in the computation of business profits. In this way, there is symmetry between the treatment of the premiums and the treatment of the receipts.
As a general rule, if the premiums satisfy the conditions for deductibility, any receipts from the policy are similarly taxable. However, if the premiums are not deductible, for example because the policy was taken out for a non-trade purpose, any receipts are similarly non-taxable.
Practical Tip :
Where the business is heavily dependent on the contribution of one or more key individuals, it can be prudent to take out key person insurance. However, the policy must be taken out wholly and exclusively for the purposes of the trade for the premiums to be deductible.