A guide to business protection
What is business protection and how can it be used to protect a business from the effects of a key person being diagnosed with a critical illness or dying?
- Business protection is an insurance contract that helps protect a business from the financial effects of key people being diagnosed with a critical illness or dying.
- Business protection is available for partnerships (including limited liability partnerships), shareholders, sole traders and key employees.
- How the arrangement is set up will depend on the type of business and its particular needs.
What is business protection?
The importance of business protection is often overlooked. It helps business owners plan for the unexpected by providing cover to ensure the business can continue with minimal disruption following the loss of one of their key employees or one of the business owners through death, critical illness or temporary disablement.
What are the different types of business protection available?
Business protection is available for partnerships (including limited liability partnerships), shareholders, sole traders and key employees. It can also be used to ensure repayment of a business loan in the event of death or critical illness of a partner, key person or sole trader. How the arrangement is set up will depend on the type of business and its particular needs. Below is a summary of the most common types of business protection arrangement.
Key person protection
There are two solutions for key person protection for companies:
- Life of another
- Own life in trust
Under the life of another solution, the company takes out a plan on the life of the key person. If the key person suffers a critical illness or dies, the plan benefits will be paid directly to the company. The funds can be used to meet the company’s financial needs while it re-organises or recruits a replacement. In the case of a critical illness claim, it's possible the key person will return to work, so the funds can be used to pay for a temporary replacement or replace lost profits.
Alternatively, if, for example, the key person is a shareholding director, they can take out a plan on their own life and write it under trust. The potential beneficiaries of the trust would be the other shareholders. In the event of the key person suffering a critical illness or dying, the other shareholders will receive the proceeds of the plan from the trustees and can inject additional capital into the business if it’s needed.
Limited liability partnerships
A limited liability partnership is similar to a limited company in that it has a separate legal persona. Accordingly, it is possible for a limited liability partnership to take out a plan on the life of a key person in the same way as a company.
There are two different solutions for partnerships depending on whether the key person is a partner or an employee.
Partner - Where the key person is a partner, they can take out a plan on their own life and write it under trust for the benefit of the other partners in the firm. Usually, the other partners in the firm will enter into reciprocal arrangements. In the event of death or diagnosis of a critical illness of one of the partners, the proceeds of the plan can be paid to the remaining partners.
Employee - Partnerships in England, Wales and Northern Ireland aren’t separate legal entities. Accordingly, if the key person is an employee, the partnership cannot take out a plan on a life of another basis. In this situation, one of the partners can take out a plan on the life of the key person and write the plan under trust for the benefit of the partners in the firm. If the key person suffers a critical illness or dies, the partners can receive the plan proceeds from the trust. Partnerships in Scotland are separate legal entities. This means that in Scotland if the key person is an employee, the partnership can take out a plan on a life of another basis.
A sole trader may need protection for both them and a key employee. The sole trader could take out a plan on their own life and write the plan in a discretionary split trust for the benefit of their family. This will ensure that in the event of death, their family will have funds available to settle any business liabilities like, for example, a business loan. The split trust contains a carve-out provision so that in the event of the settlor of the trust (in this case the sole trader) surviving diagnosis of a critical illness by 30 days, the proceeds of the plan will be held for the settlor. In this case, the sole trader can then meet the financial responsibilities of the business.
Clearly, the sole trader will be a key person in the business. However, it is possible they may employ someone who is also key to the success of the business. In this situation, the sole trader can take out a plan on the life of that other key person so there are funds available to meet the financial responsibilities of the business in the event of the key person’s death or critical illness.
The loss of a partner, member or shareholder can have a major impact on the success of a business in terms of ensuring continued control for the remaining owners.
Individual purchase - Companies, Limited Liability Partnerships and Partnerships
Under an individual purchase arrangement, each business owner takes out a protection plan on their own life for the value of their share of the business. The plans are written under trusts for the benefit of the other co-shareholder, members or partners. In the event of the death or critical illness of one of the business owners, the others will receive the proceeds of the plan from the trust to enable them to fund the purchase the shares of the deceased or critically ill business owner.
Alternatively, if there are only two or three owners it is possible for each owner to take out plans on each other’s lives so that in the event of one of the owners dying or suffering a critical illness, the proceeds of the plan will be payable to the surviving business owners.
In both cases it is recommended that a cross-option agreement is made between the business owners in order to regulate the sale and purchase of the share of the business. The cross option agreement provides that on death or critical illness, the deceased’s personal representatives have the option to sell the deceased business owner’s share of the business and the surviving business owners have the option to buy it. The cross-option agreement usually provides that the options must by exercised within 3 months of the date of death or critical illness and once either party to the agreement exercises an option, the agreement becomes binding on the other party. For critical illness it is also possible for the agreement to give the person suffering a critical illness the option to sell immediately. The option for the other owners would be to defer for a period, typically 12 months, and could only be exercised if the ill person does not return to work within that period.
Company share purchase
The rules are strict, but it is possible for a company to purchase the shares of a deceased or critically ill shareholder. In this situation, the Company would take out a plan on the life of the shareholder so that in the event of their death or critical illness, the proceeds of the plan would be payable to the company enabling it to purchase the shares of the deceased or critically ill shareholder. A cross-option agreement should be made between the Company and the shareholder.
What are the pros and cons of the different types of business protection?
|The pros are:||The cons are:|
|Provides a financial safety net in the event of the death or critical illness of a key person.||For own life plans written in trust, it is recommended the premiums on each of the plans are equalised to ensure commerciality.|
|Provides funds to the remaining partners or shareholders so they can buy-out the critically ill partner or shareholder or purchase the deceased’s shares from his or her estate.||A charge to income tax under the Pre-Owned Asset Tax (POAT) legislation may arise where an own life plan is written under trust. This is because the settlor of the trust is usually also included as a discretionary beneficiary of the trust. Accordingly, where the plan pays out on critical illness or terminal illness and the funds continue to be held in trust, a charge to income tax could arise under POAT.|
|Provides funds to ensure repayment of a business loan in the event of death or critical illness.||The Companies Act 2006 sets out strict rules which must be complied with in relation to a company buying back its own shares.|
|Ensures business continuity by providing funds available to the remaining shareholders or partners to enable them to purchase the deceased or critically ill shareholder or partner’s share of the business.||Company buy back arrangements are generally not suitable for new companies since the shares must have been held by the seller for at least five years. Otherwise, the buyback may not be treated as a disposal for capital gains tax but rather a distribution which could result in a higher tax liability on the sale of the shares.|
Ensures the deceased’s family or the critically shareholder or partner receives a fair value for their share of the business.
|Life-of-another plans may not be suitable where there are more than two or three partners or shareholders in the business as this could result in multiple plans being written. For example, a four shareholder company could require twelve plans – shareholder A takes out plans on each of the lives of B, C, and D etc.|
How do I assess the business protection needs of my clients?
In assessing business protection needs, it is crucial that you and your client consider the impact the loss of a key person, partner or shareholder would have on the business. Royal London has a business protection calculator that can be used to assess your clients' needs
- Your client should take a moment and ask themself what would happen if their top sales person was to suffer a critical illness?
- What impact would that have on revenue?
- Would the business have enough funds to survive until a replacement is found?
- What would happen if one of the partners in the firm died?
- Would the remaining partners have enough funds to buy out the deceased’s partner’s share from their estate?
Should this type of plan be placed in a trust?
This depends on the type of business and its needs, as described in detail above.
What are the tax implications of business protection?
The tax implications of business protection depend on the type of arrangement.
- It is unlikely that the business will get tax relief on the premiums where the life assured is a significant owner of the business.
- Tax relief is possible if the life assured is an employee and the plan is for a short term (less than 5 years).
- Plan proceeds paid to a limited company or limited liability partnership are likely to be taxed as a trading receipt.
- If the plan has been taken out by a partner on the life of a key employee and written in trust, the plan proceeds will, generally be paid free of tax.
Premiums paid by a limited company for plans written under a trust will usually be regarded as a trading expense, however, they will be taxed as income on the shareholder.
- Premiums paid by a limited company under a company share buy-back arrangement will not get relief, but the shareholder will not be taxed.
- Premiums paid for partnership cover will not receive tax relief.
- If a partner or shareholder pays the premiums, this would be paid out of their pay after tax and would not attract tax relief.
- Generally, the proceeds of the plan would be paid free of tax.
- Premiums will not attract tax relief.
- Plan proceeds are generally received free of tax as a capital receipt.
- As mentioned above, a charge to income tax under the Pre-Owned Asset Tax (POAT) legislation may arise where an own life plan is written under trust. This is because the settlor of the trust is usually also included as a discretionary beneficiary of the trust. Accordingly, where the plan pays out on critical illness or terminal illness and the funds continue to be held in trust, a charge to income tax could arise under POAT.
- Periodic and exit charges. It is usually the case that where a plan is written under trust in a business protection arrangement, the trust will be a discretionary one. This means that it will fall within the relevant property regime. Although unusual in a business protection arrangement, in the event that the proceeds of the plan are left in the trust following the tenth anniversary of the creation of the trust, then any proceeds which exceed the nil rate band applying at the tenth anniversary, will be subject to IHT at a maximum of 6%. In addition, any capital distributed from the trust between tenth anniversaries will also be subject to an “exit” charge which is calculated with reference to the periodic charge.
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.