How to Protect Your Business From Losing its Most Important Assets: Key Person Insurance

No one ever plans on their business failing, but it happens more often than we care to think. A common cause of failure is the loss of one or more key people who can’t be replaced in time. Though you can’t use it to cover every possibility, key person insurance will help you insure your business against some forms of loss. In this post, we’ll look at the how and why of insuring against loss of key people for Australian businesses and how it helps protect the business.

If you’re a business owner, it’s important to think about what would happen if you or one of your key employees or business partners suddenly became critically ill or died.

Key person insurance can help protect your business in the event this occurs. In some situations, it may even have tax benefits.

Understanding key person cover

Just like any insurance cover you hold in your business, key person insurance (KPI) protects your business assets. It’s just in this case what you are protecting is your human assets.

Key person cover provides a lump sum if an essential employee or part-owner suffers a critical illness, is permanently disabled, or dies. You can then use the payout from the policy to cover any financial losses caused by the key person being unable to continue taking an active role in the business.

Most policies are structured as a life insurance benefit that pays out if the key person dies, while Total and Permanent Disablement (TPD) cover pays out if the insured person suffers a disability. Trauma cover is triggered if the insured person suffers a trauma condition – like a heart attack or stroke – listed in the policy.

Business advantages of KPI

To maximise the benefits from this cover, the business should own the policy, not the insured person. This ensures the business receives the payout if a claim is made.

With these policies, if the key person in your organisation becomes ill or dies, you can use the insurance payout for expenses like recruiting and training a replacement, guaranteeing a new business loan, settling debts, or making severance and liquidation payments if the business is forced to close.

You can also use the money to cover any capital value losses and help stabilise the business’ financial position. It can also be used to replace the revenue the key person would have generated if they were still working, which can help ensure your business continues to operate.

Who is a key person?

KPI policies generally define a key person as someone directly associated with the business who provides significant economic gain and whose loss would cause it financial difficulties or call its ongoing success into question. This is typically the managing director, sales director, IT specialist or financial controller.

Even less senior employees who have strong relationships with major clients, or specialist technical knowledge on which the business relies to continue operating, may be considered a key person.

Generally sole traders and one-person incorporated businesses can’t insure themselves as a key person. If you have employees, however, you may be able to buy cover for them.

Annual premiums for KPI are based on the amount of cover applied for, together with the insured’s age, health and occupation.

Premiums may be deductible

The ATO recognises the value of KPI to many businesses and in some situations the annual premiums your business pays are considered a legitimate tax deduction.

Unfortunately, the rules around deductibility are complicated and depend on whether the policy is held for revenue or capital purposes. Generally, if you use a KPI policy for revenue purposes such as replacing lost revenue, or for operating expenses such as rent, advertising and utilities, the premiums are deductible.

If the policy is used for capital purposes such as debt repayment, compensation for loss of goodwill, or as a lump sum payment to the deceased’s estate, premiums are not tax deductible.

This is a complex area and it’s vital to document carefully the purpose of a KPI policy to ensure the deductibility of annual premiums and that any future payout is not subject to capital gains tax (CGT). The purpose of the policy should be regularly reviewed and the documentation updated to avoid future tax problems.

For more information about the tax rules around key person insurance, contact us today.

This article is intended as an information source only and to provide general information only. The comments, examples, words and extracts from legislation and other sources in this publication do not constitute legal advice, financial or tax advice and should not be relied upon as such. All readers should seek advice from a professional adviser regarding the application of any of the comments in this article to their particular situation.