Understanding Key Person Insurance

When looking to protect the financial stability of a business upon the death or disability of an important employee or owner, key person insurance can be a valuable tool.

The term “Key person” refers to an employee or some other individual whose contribution to the success of the business is significant.  In the absence of such an individual, the business profitability would be seriously affected. In short, the purpose of key person cover is to make sure that the business is not unduly financially affected by the unforeseen death or disability of a key person in the business.

Ascertaining the purpose

The tax treatment of the proceeds arising from a key person insurance policy depends on whether the proceeds are for a capital, or revenue purpose.  Therefore, the purpose of the key person insurance should be fully documented to ensure there is no confusion as to the purpose of the insurance.

Revenue Purpose

If the death of disability of the key person may results in a decrease to the business profitability then it would be considered “revenue purpose”.

Capital Purpose

If the impact on the business performance (through loss of the key person) is such that a third party such as an investor or financier may lose or risk the loss of capital, then this would be considered “capital purpose”.

Valuing the key person

Once it is established that someone is a key person (on either a capital or revenue basis) the challenge is then quantifying the loss and establish the level of insurable interest (amount of cover).

It is often more difficult quantifying key person cover on a revenue basis, as opposed to a capital basis. This is because the loss on a capital basis is usually linked to a fixed amount of investment or debt.

Taxation

From an income tax perspective, there are two key considerations in respect of the key persons planning strategy:

  • Tax deductibility of premiums
  • Taxation of claim proceeds

The treatment of premiums and claims of a key person policy depends on the:

  • Purpose of the policy when it was initially effected
  • Purpose of the policy during the term
  • Actual use to which the proceeds are put

A summary of deductibility and assessment of proceeds is summarised in the table below:

Purpose Premium Policy Proceeds
Revenue Deductible Assessable*
Capital Non-Deductible Non-Assessable (CGT may apply)

*Policy proceeds used to pay business operating expenses are deductible.

How can a financial adviser help?

For information on how to best structure a key person policy for your business and its resultant taxation implications, it is highly recommended you speak with your accountant and your Risk Insurance Specialist at ALEA Insurance.

 


Disclaimer

The information contained on this website is for general information only and should not be relied upon unless you first discuss your circumstances with a Licenced Financial Planner.

The Authorised Representative of Alea Insurance Pty Ltd ACN 107 647 192 is Steve Wilson (AFSL No: 331367) who is licensed by ClearView Financial Advice Pty Ltd ACN 133 593 012.