Financial protection

In this chapter we consider the planning process and specific protection needs of businesses and their owners, p...

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...areas. This presentation will be of most benefit to those learning about this area for the first time:

 

Businesses routinely insure their material assets such as premises, plant and machinery and computer hardware/software. However, many businesses fail to protect one of their most valuable assets - their workforce.

Key person insurance is not a type of policy but an area of financial planning which deals specifically with this issue.

The success of many businesses often depends largely on a number of key people, for example, a product designer, a salesperson or a marketing manager. However, a key person does not have to be someone who is paid a very high salary or has a senior position. An individual is a key person if their absence from work would have a serious impact on the business continuing to function smoothly and profitably.

Of course, the problems of losing a key person will be different for each business, but common issues are likely to include:

Lost or reduced profits

Loss of confidence of creditors; loan and credi...

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...

In small to medium-sized businesses, the directors are also often the shareholders and are likely to be the individuals whose loss would have the most significant financial impact. However, any employee who contributes to the profitability of the company and without whom the company would face financial loss is considered a key person.

The smaller the business the more likely it is that its success will depend on a small number of individuals. Where these are shareholding directors, they will also depend on the business continuing as they may rely on it as their only source of income and may have personal assets tied up in the business. Therefore, if the business fails or is less productive as the result of the loss of a key person, the shareholding directors could also face personal financial implications.

What are the two main financial costs to a business on the death or serious illness of a key person?

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Putting a financial cost on the loss of a key person is difficult as it is impossible to predict the exact circumstances and time when somebody will die or become ill. Some information can be taken from the company accounts and financial statements, but some assumptions will also have to be made. Useful information would be:

The cash position of the company

Looking at the pattern of previous profits and the projections for at least the next 12 months

Estimated recruitment costs

Any special projects or developments that may be affected

Recruitment costs

Training costs and the length of time it would take for a replacement to become effective

Any loans that could be re-assessed on the loss of the key person

How profits would be a...

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...

Financial underwriting

Whichever formula or method is used to calculate the sum assured, there must be robust financial information available to support the application. The maximum sum assured available may be restricted depending on the quality of the financial information provided. The provider’s financial underwriter may require some or all of the following:

Company accounts

Business plans and management accounts

Loan agreements

They may also ask for a supplementary financial questionnaire to be completed by an independently qualified professional, usually the company’s accountant

What are the two main methods used for calculating the cover required for key person insurance?

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The taxation position of premiums paid and benefits received in respect of a key person policy are complex as there is no direct legislation in place that relates to key person insurance.

Tax relief on premiums

Generally, premiums are an allowable trading expense if they meet the following conditions which are based on the ‘Anderson statement’ made by the then Chancellor of the Exchequer, Sir John Anderson in 1944:

The sole relationship between the company and the life assured must be that of employer and employee:

* If the life assured has a significant shareholding (more than 5%) in the business, tax relief may not be granted

The purpose of the insurance must be to meet lost profits arising from the death or critical illness of the key person:

* A policy as...

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... polices used for security of a debt owned by the company, to the extent of the loan amount

Inheritance Tax

The receipt of a cash sum into the business when a person dies could artificially inflate the value of the company and the cash holding may mean the partial loss of Business Relief, leading to a possible IHT charge on the deceased’s estate.

An own-life policy written under trust could be used to ensure that payment is made outside of the life assured's estate; however, the purpose of key person insurance is to compensate the business for financial loss and not the individual.

What are the three “Anderson Principles” used to assess whether tax relief would be granted on premiums paid for key person cover?

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Underwriting would be carried out as for any other type of life assurance. However, there are a number of issues that regularly arise with key person insurance:

The sums assured are usually high compa...

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...rall risk of the case and to make sure that the sum assured can be supported and is not excessive.

As this is a specialised area, most providers have dedicated large case underwriting teams.

 

Usually short-term protection policies are used for key person assurance if the company is keen to get tax relief on the premium. A short term is typically considered to be five years or less. Where this applies, and the other conditions mentioned previously (the Anderson statement) are met, the premiums will be an allowable expense for the company and tax relief will be granted on the premiums. In the event of a claim, any amount paid will be trea...

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... critical illness cover and renewable or convertible options

Inflexible, may not be able to accomadate large increases in sum assured (e.g. on promotion)

May not include an indexation option

Flexible whole of life

Can provide cover over a longer term

Sum assured can be changed

May have guaranteed insurability options

Cover available on a maximum or standard basis

Will not qualify for tax relief on the premiums

 

Death is not the only risk that could have an impact on the continuation and profitability of a business, as long-term illness or disability can also have serious financial implications.

Income protection

The benefits provided by a key person income protection plan are likely to be higher than those available from an individual plan, mainly on the basis that benefits are paid to the employee after deductions for tax and NICs. Key person income protection can be up to 80% of pre-disability income and this could include:

Salary

National insurance contributions

Pension contributions

Dividends

The term...

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...lassed as general insurance. The insurer can refuse to offer new terms or change the policy conditions based on their own claims experience.

There are many restrictions in relation to the cover provided by these types of plan. However, they could be useful if used in conjunction with income protection where the sickness and accident plan is used to protect short-term liabilities and the income protection has a longer deferred period to provide cover for longer-term disability.

What is the tax treatment of benefits paid to an employee from a key person income protection plan?

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It is common for policies to be tak...

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...ned on the premiums paid.

 

Shareholder protection is appropriate where all or most of the shareholders are also directors in the business. In companies with a small number of shareholders, a change in ownership can have profound effects on the business, especially where the change is sudden or unexpected such as in the event of death.

The first pl...

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... full market value of the shares; and

The remaining shareholders retain control of the company

This will consist of three distinct elements:

An agreement on how to transfer the shares

Insurance plans in place to provide the funds required to buy the shares

Appropriate planning to mitigate any tax

 

There are several different methods for arranging the transfer of shares and each one should be considered carefully in terms of the legal and taxation implications.

Buy and Sell agreement

The shareholders agree that if any of them were to die their shares will pass to their estate, but the estate will have to sell the shares and the remaining shareholders will have to buy them. The method for valuing the shares should be written into the agreement.

Each shareholder would take out a policy on their own life in trust for the benefit of the surviving shareholders. The sum assured should equate to their agreed share in the business.

On the death of the shareholder the sum assured is paid to the trustees who pay out the ...

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...eholders to make up the difference

One of the shareholders could change the terms of their will without informing the others. This could result in the shares and the life assurance proceeds all being left to the deceased’s beneficiaries

Equalisation

With any of these arrangements, if the shareholders ages or states of health vary then the costs of funding policies could also vary. Where premiums differ materially (not just in respect of the size of shareholding), there may be some financial adjustments between the shareholders to achieve an equitable distribution of cost (known as ‘equalisation’).

Which type of shareholder agreement would result in the loss of BPR?

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The life assurance plan will provide the funds which will allow the agreement to be implemented. This will either be by providing the shareholders with the funds to buy back the shares from the deceased’s estate or by providing financial compensation for the value of the business that has been left to the surviving shareholders.

The most suitable type of plan will depend on the circumstances of each case:

Term assurance is the cheapest way to provide cover. Options can be added to increase flexibility and indexation options can be included to make sure the sum assured is not eroded by inflation. However it may not be possible to alter the sum assured significantly in the future

A whole of life assurance is much more flexible and will last as long as cover is required and premiums are maintained. The policy could be used in the future for IHT planning if it is no longer required for shareholder protection. This could be where the shares have been sold and the assets no longer qualify for BPR

Calculating the sum assured

The main purpose of a shareholder protection arrangement is to ensure that the surviving shareholders have sufficient funds to buy out the deceased’s shares or that the shareholder’s beneficiaries receive sufficient compensation where the s...

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...made. With agreement the sale would usually be treated as a disposal for CGT purposes. As the deceased’s family will have received the shares at probate value this is likely to have little or no tax consequences. Where no agreement is received the sale is treated as a distribution and would be liable to income tax.

Taxation

These arrangements are complicated and great care is required to ensure that they are set up correctly to avoid any unexpected legal or financial implications. It will be necessary to liaise with other professional tax and legal advisers to ensure the validity of the information provided and to ensure that no actions taken are contrary to other planning that is already in place.

Normally shareholders would pay the premiums for share protection arrangements from their own taxed income

Where premiums are paid by the company on their behalf the amount paid would be treated as additional income and liable to income tax and NICs

Where the arrangement qualifies for BPR then no IHT would be payable on the proceeds of the arrangement or the premiums paid to the policy

Why would an own life policy written under trust be more appropriate where there are four shareholders as opposed to a life of another basis?

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Partners face similar problems to shareholders of limited companies, in that if a partner dies or is seriously ill, the remaining partners would have to make some payment to the estate or the partner involved. What happens on death of one of the partners is dictated by the Partnership Act 1890 or this can be overruled by a valid partnership agreement.

If an agreement is not put in place, the Partnership Act 1890 dictates that the partnership will automatically dissolve on death. This will mean that:

The partnership will have to cease trading

All the partners’ capital accounts and their share of the business would have to be repaid <...

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...tribution of profits so that all partners are equally affected.

Limited Liability Partnerships (LLPs) incorporate some of the features of both a limited company and a partnership. They have their own separate legal identity and are liable to the full extent of their assets. The LLP allows for members to organise their internal structure with the flexibility of a traditional partnership but with limited liability. The partnership protection arrangements discussed in the next section are equally effective for LLPs.

Which act of parliament applies where no partnership agreement is in place?

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The arrangements that can be used for Partnership protection are similar to those that would be used for shareholder protection.

Buy and sell agreement

The partners agree that for instance, if any of them were to die, the estate will have to sell the deceased partner’s share and the remaining partners will have to buy it. Each partner would take out a policy on their own life in trust for the benefit of the surviving partners. The sum assured should be equivalent to their agreed share in the business.

On the ...

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...result of the deceased’s share passing to the other partners.

With any of these arrangements, if the partners’ ages or states of health vary then the costs of funding policies could vary. Where premiums differ materially (not just in respect of the size of shareholding), there may be some financial adjustments between the partners to achieve an equitable distribution of cost (equalisation).

What are the three main arrangements that are used for partnership protection?

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Where a business borrows funds, it would need to consider what protection (if any) is required.

In the case of a sole trader, the risks of the loan not being repaid are considerable. Should long-term disability or death occur, life...

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...iod, after which the rolled-up interest is added on to the outstanding loan. In these situations, cover would need to be taken out with a sum assured that reflects this need, having greater cover after a certain period than is needed initially.

It is very important that any business protection is done purely for commercial purposes. In other words, you should not be recommending shareholder protection cover of £1million if the value of the shares is only worth £500,000, for example.

Factors which may affect commerciality

Are there beneficiaries under a trust who will receive the...

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... of the trust, which is usually the case with a business trust, this will create a gift with reservation should the arrangement be considered non-commercial by HMRC. If this occurs the policy proceeds will be treated as part of the deceased’s estate for IHT purposes

What is the effect of the loss of commerciality?

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This revision test (opens in a new...

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... test will be added to your CPD certificate.