Business protection - Partnerships, LLPs and sole traders - Key person protection

When business owners are asked what business or partnership assets they insure, they always list their premises, plant and machinery, vehicles, computer equipment and so on. They know they need cover for the cost of replacement, potential loss of profits and ultimately to minimise any business disruption.

However, what could happen to the business if a key employee, partner, member or owner, in the case of a sole trader, were to die or become critically ill? The cost to the business could be devastating. Consider for example the sudden death of the head engineer when a business is in the process of tendering for a major project. Their death could result in the loss of that contract which may be essential to secure the future of the business.

Who is a key person?

A key person is someone whose death, critical illness or disability would have a serious effect on the future profits of the business. In any given business a number of people could be regarded as ‘key’ including the partners, members, senior employees or the owner.

There will always be at least one key person in any given business. However, clients should also consider the impact of losing someone who may not have any financial stake in the business but nevertheless plays a fundamental role in its success.

You can find out who the key people are by asking:

• How easily could the business replace their expertise?
• Would their absence affect business expansion plans or ongoing projects?
• Would the business be in danger of losing customer orders?
• Would it result in a loss of goodwill or hardening of suppliers’ credit terms?
• Would the business miss their administration or management contribution?
• Are there any loans or overdrafts that depend on the key person?

Calculating the cover

Once you’ve identified the key people, the next step is to establish the level of cover needed. There are no hard and fast rules when assessing the financial value of a key person. But there are several ways you can assess a reasonable amount of cover:

Multiple of profits

This is the main way of calculating a key person’s worth. As key person cover is concerned with protecting the profitability of the business, considering profit is a sensible first step. The normal multiple is:

• 5 x net profit

The profit may need to be split where there’s more than one key person. Higher multiples may be justified for a rapidly expanding business.

Multiple of salary

Where the key person is an employee rather than a partner or member, a multiple of gross salary, including benefits in kind (P11D benefits), can give a useful indication of the amount needed to bring in a replacement. This might be up to 10 times gross salary for life cover and up to 5 times gross salary for critical illness cover.

Proportion of salary roll

An alternative for employees is to calculate the key person’s contribution to turnover as shown in the formula below. It will usually take at least a year to train and recruit a replacement, but in some cases it could take three or even four years.

Special circumstances - business start-up

The working capital at risk must be calculated, together with the key person’s proportion of this risk.

Other considerations

If the business owners have provided security personally, this may also need to be covered to protect their dependants.

Which type of cover?

Key person protection is intended to cover future loss of profits so the cost of finding a replacement, training them and the business lost may only become apparent after a number of years. This suggests that term assurance to the key person’s normal retirement date may be a good option. The business can choose to have the cover payable as a lump sum or possibly by instalments. However, depending on who the key person is, their involvement with the business may not last until retirement. So perhaps shorter term cover would be better.

Another option is whole of life. Although this isn’t the obvious choice for key person protection, it can have advantages for a founding or managing partner who has no intention of retiring in the short to medium term. Even if the key person leaves, it may be a good idea to assign the plan to them.

The tax implications of doing so are covered our tax implications article. The most appropriate type of cover to choose can often depend on the comparative costs of the premiums and the tax implications.

Writing the plan

Whatever type of cover is chosen, it’s important to remember that the plan should be set up for the business to ultimately receive the proceeds.

Partnerships

For partnerships, there’s a potential problem with ownership. In England, Wales and Northern Ireland, a partnership is not a separate legal entity in its own right. So it can’t take out a key person plan. However, the key person could insure their own life and place the plan under trust for the benefit of all the partners in the business. Providers often offer a specimen business trust for this purpose.

For this set-up the plan should be written in trust from inception.

A Scottish partnership is a separate legal entity. So the plan can be set up as life of another with the business as both owner and beneficiary.

Limited liability partnerships

A limited liability partnership (LLP) is halfway between a limited company and a partnership. It’s a
legal entity in its own right, completely separate from its members and is registered with the Registrar of Companies. The liability of the members is limited to the amount subscribed for the LLP and
any personal guarantees given.

However, for taxation purposes, the individual members are treated as if they’re self-employed individuals, just as if the LLP was a partnership with individual members paying tax on any income and/or gains. If an LLP wishes to take out a key person plan, this would normally be written on a
life-of-another basis with the LLP owning the plan.

Note

The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.

All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.