While it’s not the most pleasant aspect of business planning to think about, it can be important to consider how your business would cope if one of its key people were to suddenly pass away, be diagnosed with a terminal illness or become unable to fulfil their role in the business for a period of time. Would the business be able to keep operating? And would the surviving business owners or partners be able to cope financially? These are the kinds of uncertainties that key person insurance may help to address.
How does key person insurance work?
Key person insurance (also known as ‘key man insurance’) is designed to protect businesses in the event that a key person, such as a partner or director, dies or becomes unable to work.
The insurance is taken out by the business on the lives of named key persons, with premiums generally paid for by the company. Typically, policies can cover death, total and permanent disability (TPD), and trauma or critical illness. Some policies may also offer income protection cover. In the event of a claim, it’s normally the business that receives the insurance benefit. This is usually paid out as a lump sum, but some insurers offer monthly benefits to cover lost revenue. Unlike income protection or standard life insurance, key person insurance protects and is owned by the business rather than the individual and their family or other dependants.
The benefit can then be used by the business for revenue purposes or capital purposes. It’s important to distinguish between the two for tax reasons, but we’ll cover that later on. The funds can be used to make sure the business keeps running and to cover costs associated with losing the key person, such as the costs of recruiting and training a replacement or repaying outstanding debts. As pointed out by the Financial Planning Association of Australia’s Money & Life magazine, this purpose is distinct from funding the transfer of business ownership, which in some cases may need to be covered separately under a ‘buy/sell’ policy.
What is a key person?
A key person is someone whose knowledge, skills and experience are crucial to the success of your business. For example, for a small business this may be the founder of the business or partners in a partnership. These could be people who have personally guaranteed loans for the business.
For a larger business, a key person may be someone whose absence would reduce the profitability of the business, such as a sales manager or a highly-skilled employee.
What can key person insurance cover a business for?
Key person insurance benefits can be used for revenue purposes, capital purposes or both revenue and capital purposes. Depending on your insurer and particular circumstances, it may be helpful for your business to decide on and document the main purpose of your key person policy at the time you take it out and then review this annually.
If the business is highly reliant on a key person for generating income, then insurance for revenue purposes may be appropriate. This can be used to protect the business against any loss in revenue or increased costs that crop up as a result of losing the key person, such as the costs of recruiting and training a replacement for your key person.
On the other hand, if the key person makes a significant contribution towards the value of the business and its assets, then insurance for capital purposes may be more suitable. According to Citibank, this purpose would usually be limited to covering business owners, since they are typically the ones responsible for business liabilities. Capital purposes could be things such as paying off loans the key person guaranteed or offsetting loss of goodwill (that is, the business’ intangible assets).
If the business needs cover for both revenue and capital purposes, Money & Life says it could consider taking out a separate policy for each purpose or having one policy to cover both needs. A single policy may allow for greater flexibility if revenue and capital needs fluctuate. However, as you’ll need to document which portion of the premium relates to which purpose for tax reasons, a single policy may be cumbersome, Money & Life says.
How much does key person insurance cost?
The cost of a policy will depend on a number of factors. For example, insurers may take into account:
- Level and type of cover
- The age, health and occupation of the key person
- Policy term
- Waiting period
Is key person insurance tax deductible?
Distinguishing between revenue purposes and capital purposes can become important when working out whether your insurance premiums will be tax deductible. According to the Australian Taxation Office (ATO), insurance premiums for revenue purposes are tax deductible. However, in the event of a claim, the ATO says the proceeds will be assessed as income and taxable. In contrast, the ATO says key person insurance premiums for capital purposes are not tax deductible and the proceeds will not be treated as assessable income. However, according to Money & Life, Capital Gains Tax may apply.
How much cover should a business get?
When deciding how much key person insurance to get, it might be worth considering factors such as:
- Remuneration of the key person
- Contribution of the key person to the profitability of the business
- Cost of recruiting and training a replacement
- Business debts, including any outstanding loans the key person may be a guarantor for
Additionally, some insurers may cover multiple key persons on the one policy. How much cover you decide to take out will ultimately depend on the circumstances of your business and the nature of each key person’s contributions.
If your business is considering key person insurance, it’s worth weighing up the costs and potential benefits of any potential policies before deciding if it’s suitable for you.
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