Business protection - Partnership, LLPs and sole traders - Tax implications
One of the main reasons why more key person plans aren’t written is because of uncertainty over the tax treatment of premiums and benefits.
- A key person is someone whose death, critical illness or disability would have a serious effect on the future profits of the business.
- Taxation treatment depends on the facts of a particular case and the practice of the local inspector of taxes.
- The proceeds will generally be taxable and the premiums tax deductible where:
- the person covered is an employee
- the insurance is to meet a reduction in profits resulting from the loss of services of the key person
- it is annual or short term insurance
The only guidelines we have on the tax treatment were set out in 1944 by the then Chancellor of the Exchequer, Sir John Anderson, who said:
‘Treatment for taxation purposes would depend upon the facts of the particular case and it rests with the assessing authorities and the Commissioners on appeal if necessary to determine the liability by reference to these facts. I am, however, advised that the general practice in dealing with insurances by employers on the lives of employees is to treat the premiums as admissible deductions, and any sums received under a plan as trading receipts if:
- the sole relationship is that of employer and employee
- the insurance is intended to meet loss of profit resulting from the loss of services of the employee, and
- it’s an annual or short term insurance’.
What does this mean in practice?
For a business to qualify for tax relief on payment of key person plan premiums, all three of the following tests must be met.
1. Employer/employee relationship
The relationship must be that of employer/employee. If the person covered has a significant stake in the business, relief wouldn’t normally be allowed. The logic behind this test is that for expenses to be tax allowable they must be ‘wholly and exclusively for the purpose of trade...’. Where a plan is written on the life of a partner or member, there may be an element of self interest in taking out the plan (that is, preserving the value of their interest in the business) and therefore the wholly and exclusively test can be failed.
2. Loss of profits
The plan must be intended solely to meet loss of profits arising from the death of the key person. Any plan with a surrender value won’t qualify for relief on the grounds that it’s not wholly and exclusively for business purposes due to the investment element. The level of cover must also be reasonable and this is usually addressed at the financial underwriting stage.
3. Short term assurance
There’s no clear definition as to what constitutes short term assurance but it’s generally accepted this means five years. Five-year renewable insurance is usually allowable. Longer terms could be justified provided they don’t exceed the period of usefulness of the employee to the company.
Can these tests be relied on?
These rules are for guidance only. The application of these tests can depend on the facts of the case so we recommend that the business or their accountant will write to the local inspector of taxes when the plans are being set up to confirm the tax treatment.
What about any proceeds paid out under the plan?
The tax treatment of the premiums can also have a bearing on the tax treatment of the proceeds. If the premiums have qualified for tax relief as a business expense, the proceeds will usually be taxable as a trading receipt.
In practical terms, partnerships are only generally likely to suffer tax on the proceeds paid where the partnership itself (in Scotland, or an LLP) owns the plan or where partners have applied on behalf of the partnership and the person covered is solely a key employee and not a partner. In all other cases, generally the proceeds will be paid into a trust for the partners individually and then paid into the business as capital introduced by the partners or members without the proceeds being taxed.
If tax relief has been given on the premiums, the proceeds from the plan will be subject to income tax in the partnership accounts.
This means that the profit share of each partner will increase and the proceeds taxed on them accordingly at their highest rates of tax. In the past it may have been possible to reduce the impact of tax by arranging for cover to be paid in instalments over a number of years. However, under current generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) requirements it’s unlikely that this would be successful as the liability to tax will arise in full on claim.
Is the payment of the proceeds a chargeable event for tax purposes?
Any gain made on the plan will be subject to income tax under the normal chargeable event rules, (S484(1) ITTOIA 2005). If a gain arises, the tax will depend on how the plan has been set up.
If the key person or one of the partners has taken out the plan and written this under trust, as settlor of the trust they’ll be taxed on any gains at their marginal rate. The partners could reimburse them for their share of this tax. If the business takes out the plan, any gain will be split between the partners in the business.
However, in practice it’s extremely unlikely that a gain will arise as the surrender value before death (if there is one) would generally be less than the premiums paid.
What if critical illness is included?
Critical illness is not a chargeable event for tax purposes. In all other respects, the tax treatment in relation to premiums and proceeds will be the same as for life plans.
Should income protection be included?
Premiums paid on income protection are unlikely to be tax deductible for the partnership or LLP. If the person covered is a partner or member, by applying the three tests in the Anderson principles the plan would fail to get tax relief on the grounds that the relationship is not solely employer/employee.
Any benefits would normally be paid tax-free to the partners or members as drawings if paid directly to the business. The partners can agree to forego profits for periods of incapacity, but this could be reimbursed through income protection.
If the plan has been placed in a business trust, income protection is a retained benefit, which means it’s payable to the partner or settlor of the trust. It can be agreed that while the benefit is being paid to the partner to provide sick pay, the business doesn’t need to pay the partner profits.
However, if the person covered is a key employee, the plan is owned by the business and the benefits are to be used for profit protection, the proceeds are likely to be taxed as a trading receipt in the hands of the partners as the plan is not intended to secure a lump sum.
If the proceeds are then passed on to the key employee as sick pay, the payments will be subject to PAYE and National Insurance as normal. If it’s intended to use the payment as sick pay for the employee it could be better to have the key person take out the plan individually. The business could pay the premium on their behalf, which would be taxable as a benefit in kind. The proceeds would be paid out tax free to the individual on claim.
Are there any personal tax implications for the key partner or employee?
Unless the plan is taken out to cover sick pay, the answer is no. The benefit in kind rules don’t apply to partners.
Any premiums paid by the business on behalf of the partners will simply reduce their outstanding capital accounts, that is, they will be treated as drawings from the business.
For key employees, if the business or partners own the plan there will be no benefit in kind. There will normally be a benefit in kind for the individual where they have taken the plan out in their own name for their own benefit (as in the case of income protection).
Can the plan be assigned back to the key person personally if the business no longer needs it?
If the person covered is a partner, the plan can be assigned to them personally with no tax implications.
However, the position for an employee is different as the assignment could be treated as a benefit in kind for the key person and may give rise to capital gains tax if there’s a claim. We recommend seeking professional tax advice before any assignment.
Key person protection for sole traders
Who needs to be insured?
1. The sole trader
The sole trader is the business, so they need to protect the profits in the event of their death, critical illness or sickness. Given there’s no distinction between them and their business, cover for this purpose will be written as personal protection. If the cover is solely for death, they would simply place the plan in a gift trust for their family.
If critical illness is included, the plan could be written under a split trust with the family as beneficiaries of the Life Cover. If the sole trader dies, their family could meet the financial obligations of the business.
On critical illness, the plan can pay the benefits directly to the sole trader allowing them to safeguard the future of the business. They could take out Income Protection to compensate for lost profits or find a temporary replacement.
2. An employee
The sole trader may also want to insure the life of one or more of their key members of staff. Such a plan would normally be established on a life-of-another basis, with the sole trader being the owner and the person covered being the key employee. The benefits would then be paid to the sole trader in the event of a claim, to allow them to reorganise or find a replacement.
Tax relief won’t be due where the person covered is the sole trader, as there’s clearly a personal benefit to them or their family. If the business pays the premiums on such a plan, it would normally be treated as drawings from the business.
If the person covered is a key employee, the same tests as outlined above, in 'What does it mean in practice?', will apply in determining whether the premiums are allowable and the proceeds taxable.
If the cover is designed to be used for sick pay, it will usually be better for the employee to take the cover out themselves. This will be a benefit in kind for the employee if the business pays the premiums on their behalf, but the proceeds would be paid to them free of tax.
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.