Keyperson cover for sole traders

Keyperson cover for the sole trader falls into two areas:

1. Cover to be taken by a sole trader on the life of a keyperson. 

2. The position of the sole trader as a keyperson.

 

1. COVER TAKEN BY A SOLE TRADER ON THE LIFE OF A KEYPERSON 

(i) Arranging the cover 

In this case the keyperson is an employee and the usual way to provide the cover would be for the sole trader (as the employer) to effect a policy on the life of the employee on a life of another basis. The employer/employee relationship, combined with a potential financial loss, should be sufficient to establish the necessary insurable interest at outset. 

(ii) Deductibility of premiums 

The deductibility of premiums for income tax purposes depends on the circumstances of each case. There is no specific legislation governing the tax treatment of premiums paid under keyperson policies, and the basic rules for determining eligibility for a tax deduction were explained by the then Chancellor of the Exchequer in 1944 in reply to a question raised in the House of Commons, as follows: 

"Treatment for taxation purposes would depend on 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 policy as trading receipts, if 

1. the sole relationship is that of employer and employee, 

2. the insurance is intended to meet loss of profits resulting from the loss of services of the employee, and 

3. it is an annual or short-term insurance. 

Cases of premiums paid by companies to insure the lives of directors are dealt with on similar lines.  I am advised that it may be taken as a general rule that if the premiums are not admissible deductions the policy moneys do not constitute taxable receipts.  For technical reasons, however, it is not possible to give an assurance which could cover every type of case."

Current HMRC practice would seem to permit a deduction for premiums paid under policies effected by employers on the lives of employees for the employer's benefit, ie. non-trust policies, where the following conditions are satisfied: 

1. The sole relationship is that of employer and employee. This would not be the case, for example, where a holding company insures the life of an employee of a subsidiary company. Of course, the situation as regards a subsidiary company will not be relevant for sole trader cases. 

2. The policy is meant to meet the loss of profits arising from the loss of services of the employee (as opposed to a capital loss such as goodwill or the need to repay a loan). 

3. The policy is a short-term assurance. Long-term assurances may be allowed if they expire before the employee’s expected retirement date. This therefore excludes whole of life policies and endowments which would also fail the test under 2 because of the fact they are capable of acquiring a surrender value and so could be considered as part of the cost of raising capital. Therefore, the premiums cannot be said to have been expenses incurred "wholly and exclusively" for the purposes of the trade (section 54(1)(a) Corporation Tax Act 2009). Convertible term assurances would seem to fail the test under 2 above because they are capable of conversion to a permanent contract.  Single premiums may be permitted for term assurance policies with terms of 5 years or less. 

4. The sum assured is reasonable. For example, the loss of profits should be related to the period within which the employee could be replaced or, alternatively, linked to a multiple of their earnings. 

HMRC will broadly apply the same principles with regard to the deductibility of premiums to critical/serious illness policies as they apply to life assurance policies. 

Where there is a single policy on the life of one employee it should be fairly easy to determine whether or not the premiums are likely to be deductible. 

(iii) Taxation of the policy proceeds 

If the premiums have been allowed as a deduction, the proceeds referable to the deductible premiums will generally be taxed as a trading receipt. However, in this respect it is necessary to consider HMRC’s Business Income Manual at section 45525 where it states: 

"However, whether particular receipts are part of trading income is a separate matter of law to the deductibility of expenditure. No assurance can be given that any future receipt will be excluded from Case I income even though the premiums are not allowable (Simpson v John Reynolds & Co [1975] 49TC693 and McGowan v Brown & Cousins [1977] 52TC8)." 

Where premiums have not been allowed as a deduction [ie. they are treated as being for a capital purpose - and the nature of the 'purpose' will be tested at the time the policy is effected, not at the time that the proceeds are actually used], the policy proceeds referable to the disallowed premiums will usually be treated as a receipt on capital account with the capital gain potentially subject to corporation tax. However, no tax charge should arise. This is because capital gains tax is only payable in respect of gains made under a life assurance policy where there has at some time been a disposal of the rights or any interest in the rights under the policy for actual consideration – section 210 Taxation of Chargeable Gains Act 1992. 

For those seeking some certainty regarding the tax treatment of premiums paid (and assessability of the sum assured), confirmation of the deductibility or non-deductibility of the premiums could be sought from HMRC. If relief is denied on the premiums as having been paid for a capital purpose it is unlikely that the policy proceeds would then be taxed. However, in such circumstances, it would be prudent to go back to HMRC and seek confirmation in writing of the taxation of policy proceeds. 

It is important to remember that if, in any case, a premium satisfies the test for deductibility but tax relief is not claimed, this will not prevent the sum assured from being taxable. 

As well as considering the tax treatment of the policy proceeds it is necessary to determine whether any tax liability arises on any gains made under the policy.  For a policy which provides life cover and which is a non-qualifying policy, the payment of benefits will give rise to a chargeable event. Any chargeable event gain would be potentially liable to income tax with any tax falling on the sole trader, as the policyholder. In most cases, though, because the policy will not acquire a surrender value, no chargeable event gain will arise. The payment of benefits on critical/serious illness does not give rise to a chargeable event.

(iv) Inheritance tax 

As no trust is involved there are no implications on the payment of premiums or benefits. However, the policy will be an asset of the sole trader if it is in force at death although its value will be fixed at its market value which is likely to be nil or very small. If benefits become payable to the sole trader during their lifetime then to the extent the benefit amount has not been spent it will form part of their estate on death.

 

2. THE SOLE TRADER AS A KEYPERSON

Arguably, a sole trader is the most 'key' of keypersons in that their death or critical/serious illness is likely to cause serious financial damage to the financial wellbeing of themselves and their family. 

Indeed, in a number of cases, the death of the sole trader could signal the end of the business. This may help to explain why the sole trader need for keyperson cover is perhaps too often overlooked.  Essentially, the objective will be to put funds in the hands of the family or dependants on the death of the sole trader, or in the hands of the sole trader on critical/serious illness. The need is very much financial protection for the sole trader and their family.

(i) Arranging the cover 

In the majority of cases the financial compensation solution required for sole traders looking to protect themselves and their family against the financial risk resulting from death or critical/serious illness will be a personal protection-based solution. Any life assurance policy would usually be held in trust for the sole trader’s family and/or dependants. 

The required sum assured should be arrived at by determining the income/capital needs of the family and dependants. The trust should, of course, not be a 'business' trust but a 'personal' trust – most probably a discretionary trust but possibly a bare trust if the sole trader knows for sure who they wish to benefit and are happy that no change of beneficiary can be made. 

If the policy is subject to a discretionary trust and the sum assured is significant there could be a perceived risk that there may be future IHT periodic or exit charges. This might be because the policy had a value as the life assured was in serious ill health at the valuation point, or the sum assured had been paid to the trustees but not distributed to beneficiaries so that the available nil rate band could be exceeded. To help eliminate this risk, the sole trader could consider splitting the policy into a number of smaller policies with the sum assured under each one being less than the nil rate band. Each policy would be effected on a different day and held under a genuine separate trust to which no property would be added at a later date. This way each policy trust would be entitled to its own nil rate band. This is based on the so-called “Rysaffe” principle.

For stand-alone critical/serious illness policies, no trust would be needed although should death follow soon after a critical/serious illness any unspent benefits would then be included in the taxable estate of the sole trader as the policyholder. 

Where a policy delivers benefits on the sole trader’s critical/serious illness or death whichever occurs first, then a 'split' trust could be the answer. Under such a trust the full sum assured would be paid, via the trustees: 

•            to the life assured if the occasion of payment is critical/serious illness 

•            to the beneficiaries if the occasion of payment is death. 

To avoid any gift with reservation of benefit problems the settlor’s interest should be properly carved out. Furthermore, to avoid a problem under para 7 Schedule 20 Finance Act 1986, on the happening of the first event the full sum assured should be paid and the policy terminated. 

(ii) Deductibility of premiums 

As the sole trader will be effecting a policy on their own life under trust, or a policy for their own benefit, the premiums will be paid out of after-tax income meaning that there will be no income tax deduction available. 

(iii) Taxation of the policy proceeds 

As the premiums will not be deductible there should be no tax on the policy proceeds. For a policy which provides life cover and which is a non-qualifying policy, the payment of benefits will give rise to a chargeable event. As the policies are individual policies held in trust, any chargeable event gain would be potentially liable to income tax with any tax liability falling on the policyholder as settlor (or the trustees depending on circumstances). In most cases, though, because a policy will not acquire a surrender value, no chargeable event gain will arise. 

(iv) Inheritance tax 

The rules apply as they would for any policy written under trust. 

In practice, if cover is primarily against death the premiums would be comparatively small and so would usually be exempt under the £3,000 annual exemption and/or normal expenditure exemption. 

As mentioned in section 2(i) above, if the death benefit is to be significant the risk of an IHT charge can be minimised by establishing a number of smaller policies, each with its own trust and set up on a different day from the others.