Protection for partnerships, LLPs, and sole traders – a comprehensive guide.

The importance of key person protection

In small businesses, people are the most critical asset. The sudden loss of a key person— whether due to death, critical illness, or disability — can have a severe impact on business operations and profits. A key person is typically someone whose absence would significantly affect the business’s financial performance. This could include partners, members, senior employees, or even the business owners themselves.

Key person protection ensures the business can continue to operate with minimal disruption by providing financial cover. For example, the sudden death of a head engineer during a major project could jeopardise the business’s ability to complete the project and secure future contracts. Key person protection mitigates these risks by covering the costs associated with finding and training replacements, while also compensating for any lost profits.

For LLPs the existence of a membership agreement will be important. If there’s no agreement, the Limited Liability Partnership Act 2000 will dictate what happens. 

For sole traders, the business and personal finances are indistinguishable, making it crucial to protect profits in case of death, critical illness, or disability. Cover for these purposes is typically established as personal protection. Where the plan only covers the sole trader’s death it can be placed in a gift trust to benefit the family.

If critical illness cover is included, the plan might be structured under a split trust to address both business and personal needs. Benefits from such plans allow the family to meet financial obligations, on the sole trader’s death, or help the sole trader secure the business’s future during recovery.

Sole traders may also insure key employees, establishing life-of-another plans where benefits go directly to the business owner to fund reorganisation or replacement efforts. This ensures continuity and stability during unforeseen disruptions.

Identifying a key person

Determining who qualifies as a key person involves asking questions such as:

• How easily can the business replace their expertise?
• Would their absence affect ongoing projects or expansion plans?
• Could their loss result in lost customers or strained supplier relationships?
• Are there financial obligations, like loans, tied to their presence in the business?

In most businesses, there is at least one key person, and sometimes even employees without a financial stake can be considered key due to their indispensable role in the company's success.

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 net profit used needs to be directly related to the key person.

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 dependents.

Tax implications of key person protection

The tax treatment of premiums and benefits associated with key person protection varies depending on specific circumstances. Businesses need to understand these implications to ensure compliance and maximise financial efficiency.

Qualifying for tax relief

To qualify for tax relief on premiums, the following three tests, derived from the "Anderson principles" established in 1944, must be met:

1. Employer/employee relationship: The insured must be an employee rather than a business owner or partner/member as the benefit must be for the trade and not personal gain. 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 fail.
2. Loss of profits: The plan must solely address loss of profits due to the key person’s death or illness. Policies with a surrender value generally fail to meet this criterion. The level of cover must also be reasonable, and this is usually addressed at the financial underwriting stage.
3. Short-term assurance: The insurance must be for a relatively short term, typically five years, though longer terms may be acceptable if justified by the key person’s expected duration of usefulness to the business.

If these criteria are met, key person protection premiums may be tax-deductible, but the proceeds will generally be taxable as trading receipts. Conversely, if premiums do not qualify for tax relief, the proceeds are often tax-free. Businesses are advised to consult their tax adviser to confirm the tax treatment of their plans.

Specific considerations for partnerships and LLPs

In partnerships and LLPs, tax implications can become more complex. For example:

• If the plan is owned by the partnership and covers a key employee, proceeds are typically taxable as trading receipts.
• Proceeds distributed to partners individually are generally not taxed if the plan is placed in trust for their benefit.
• If tax relief is granted on premiums, the proceeds increase the partners' profit shares, which are then taxed at their individual rates.

Importantly, any benefits paid out for income protection purposes are usually treated as taxable income for the individual receiving them, particularly if the business pays the premiums.

And for sole traders

Tax relief is not granted when the covered individual is the sole trader, as the plan inherently benefits them or their family. Premiums for such plans, when paid by the business, are typically treated as drawings from it.

For key employees, eligibility for tax relief follows the same criteria outlined previously, determining whether premiums are allowable and proceeds taxable. If the coverage is intended for sick pay, it is preferable for the employee to hold the plan themselves. In cases where the business pays premiums on behalf of the employee, the premiums are considered a benefit in kind, but the payout remains tax-free.

Implementing key person protection

Setting up key person protection involves several steps, including determining the appropriate type of cover, calculating the level of cover, and structuring ownership to align with tax and legal considerations.

Types of cover

The type of protection chosen depends on the specific needs of the business:

• Term assurance: Ideal for covering the key person’s projected working life, offering financial support during their absence.
• Whole of life assurance: Suitable for founding or managing partners with long-term involvement in the business.

In some cases, the plan can be structured to pay out benefits either as a lump sum or in instalments, depending on the business’s financial requirements. 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.

Ownership structure

The ownership structure of the plan is crucial to ensure the proceeds are paid to the business. For example:

• Partnerships in England, Wales and Northern Ireland, are not separate legal entities in their 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.
• Scottish partnerships, as separate legal entities, can own the plan directly.
• LLPs, being legal entities, can similarly own plans written on a life-of-another basis.

Conclusion

Business protection, particularly key person protection, is an invaluable tool for safeguarding small businesses and partnerships from the financial fallout of losing a key individual. By understanding the tax implications and setting up appropriate cover, business owners can ensure continuity, protect profits, and provide long-term security for their enterprises. Consulting with tax and legal professionals during the planning stage is strongly recommended to tailor solutions to the unique needs of the business.