Keyperson cover for partnerships and LLPs - Part II
17 December 2019
17 December 2019
Where the keyperson is a partner in a partnership or a member of an LLP.
In last month’s article we looked at keyperson cover for partnerships and LLPs where keyperson cover was required on the life of an employee.
In this month’s article, which is the final article on the topic of keyperson cover, we consider the situation where the keyperson is a partner in a partnership or a member of an LLP.
2. Partners/members as keypersons
Partners in a partnership/members of an LLP are key to the success of the business generally being the major generators of profit. When all of the partners/members in a particular partnership/LLP are considered to be keypersons there is generally a choice as to how any cover is arranged. If not all the partners/members are keypersons the choice of solutions is limited and will depend on the business structure.
(a) Arranging the cover
(i) Partnerships in Scotland/LLPs
As a partnership in Scotland and an LLP have a separate legal existence from its partners/members each can effect a life assurance policy as a contracting party in its own right – the so-called “life of another” route. This avoids the need for trusts (which can be cumbersome) with the policy being held, effectively, as a capital asset on the balance sheet. This method will be suitable if not all the partners/members are keypersons.
Alternatively, cover can be structured on the “own life in business trust” basis as described in 2(a)(iii) below. It is likely that in most cases where the lives to be assured are all the partners or members the “own life in business trust” route would be adopted. This is especially so given that whether this, or the life of another route is used, the tax treatment of the premiums and the sum assured would be the same – see later.
(ii) Partnerships (except in Scotland)
The partnership trust approach will be appropriate if it is intended that the policy will be an asset of the partnership. In these circumstances, each partner who is considered to be a keyperson would effect a policy on his or her own life subject to a partnership trust.
Briefly, the partnership trust provides that the trust asset, i.e. the life assurance policy, is held as a partnership asset on the partnership’s balance sheet. This means it belongs absolutely to the partners in the partnership for the time being, including the estate of a deceased partner. In effect, it would be treated as a capital asset of the partnership with its value apportioned between the partners in the same way as other capital assets owned by the partnership.
It would be usual for one partner (e.g. the managing partner) or two partners to apply for the policy. He/she or they would be the settlor(s) under the trust and the other partners would be appointed to act as additional trustees. In the event of a claim the trustees, in effect acting on behalf of the partnership, would have the power to use the funds which they receive exclusively for the benefit of the partnership.
The partnership trust is particularly useful if the partnership requires cover for its business borrowing because the life cover should be effected for the benefit of all of the partners. This means using a partnership trust because a business debt reduces the value of the partnership and, as a consequence, the value of the business interests of all of the partners will also reduce. Therefore, any repayment of the debt should be made by the partnership, with a corresponding increase in the values of the business interests of all of the partners.
(iii) All partnerships/LLPs
If all of the partners/members are considered to be keypersons and they are also funding to purchase a deceased partner’s/member’s business interest, they may wish to put in place a composite “own life in business trust” arrangement.
This arrangement would provide funds to meet the dual needs of business continuation and business succession ie. keyperson and business interest purchase. In this case, for each partner/member a business trust would “host” a policy, the sum assured under which would be sufficient to meet the business continuation (keyperson) needs and the business succession (business interest purchase) needs. On a claim being paid, the amount needed by the business would, typically, be lent by the partners/members to the business and the sum to be used for partnership/LLP business interest purchase used directly by the partners/members for that purpose.
It’s important to remember that, if this “composite “solution is adopted, the sum assured needs to be sufficient to deal with all of the purposes for which it is intended ie. delivering financial compensation to the business via a partner’s/member’s loan to the partnership/LLP and a sum big enough to satisfy the need to pay the requisite sum in relation to the need to purchase or provide “compensation” in relation to the deceased or critically/seriously ill partner’s/member’s interest in the business.
In composite arrangements it will be necessary to keep funds outside the business to fund the purchase of a business interest. However, such an arrangement only works if all the partners/members who can benefit are effecting policies subject to business trusts for the other partners/members. This is because, to ensure that the arrangement between the partners/members is at arm’s length (an important factor – see section (d)), all the partners/members who can benefit must join in the arrangement. For this reason the business trust should include a commerciality clause which excludes from all benefit partners/members who are not effecting similar policies in trust for the other partners/members.
In particular if, say, only one of the partners is a keyperson and so the policy is effected on his or her life only, the business trust will not be appropriate. Instead, the partnership trust should be used as explained in 2(a)(ii) above. A partnership trust by definition is not suitable for use by an LLP or a member of an LLP.
(b) Deductibility of premiums
Regardless of how any policy is effected, the premiums payable would not be tax deductible as they would be an expense of the partner/member met by the partner/member personally out of post-tax income. Alternatively, the partners/members could enter a memorandum authorising the partnership/LLP to pay the total premiums as a first charge on post-tax partnership/LLP profits.
This would have the effect of reducing each partner’s/member’s profit share but not his or her income tax liability.
(c) 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. If cover has been provided by individual policies held in trust under an “own life in business trust” arrangement, any chargeable event gain would be potentially liable to income tax with the charge falling on the partner/member who created the trust as settlor (or the trustees depending on circumstances eg. if the settlor is non-UK resident). The tax liability would be due from the partner’s/member’s estate but his or her personal representatives have the right to reclaim tax paid from the trustees who would pay it from the trust fund.
If cover has been proposed for by a partnership in Scotland or LLP, or is set up under a partnership trust, any chargeable event gain would fall to be taxed on the partners/members, apportioned according to their profit/capital sharing ratios.
It would be comparatively unusual for a chargeable event gain to arise as this is normally determined according to the surrender value of the policy immediately before death and most term assurance policies will not have a surrender value.
(d) Inheritance tax
When a trust-based approach is adopted (ie. partnership trust or business trust) it is essential to ensure there are no adverse inheritance tax (IHT) implications. Provided, as it usually will be, the arrangement is a commercial one at arm’s length there will be no “donative” intent.
Commerciality can be achieved by ensuring that premiums are paid by the partners/members in such a way or in such proportions as would be expected between unconnected persons dealing at arm’s length. This means attributing premiums to the likely benefit and ensuring that the same kind of benefit is provided under each policy.
For commerciality, using the business trust route it is also essential to ensure that the only beneficiaries under the trust are partners/members joining in the arrangement. This means that there will be no gift and, if there is no gift, there can be no “gift with reservation”. The absence of a gift would mean that the settlor/life assured could be a potential beneficiary which is usually the case because, under the business trust, the benefit could automatically revert to the life assured if he/she, say, leaves the partnership/LLP or retires, and this gives valuable flexibility.
The commerciality aspect will not, according to HMRC, protect the arrangement from being subject to the pre-owned assets tax (POAT) rules. However, it is unlikely that the rules will have any practical impact as the trust will only have any real value when the life assured dies and, even in those circumstances, the proceeds will normally be paid out of the trust quite soon afterwards.
One would need to consider the IHT relevant property regime with the business trust. Under the relevant property regime, IHT charges can occur on the 10-yearly anniversaries of the creation of the trust and when property leaves the trust but, where the underlying investment is a term assurance policy, this should not cause a problem because the policy is only likely to have any value on death.
Where a partnership in Scotland or LLP proposed for the policies there should be commerciality so long as the same kind of benefits are provided under each policy and benefits are fixed at an appropriate level for each partner/member.
On the death of a life assured the benefits would pass free of inheritance tax to the partnership/LLP (ie. to the surviving partners/members in effect). The value of the deceased partner’s/member’s share of the policy would form an asset of his or her estate for IHT purposes where the policy is effected by the partnership/LLP in the same way as under a partnership trust.
Under the business trust, for trusts effected after 21 March 2006, there would be no value in the estate of the deceased partner/member.
(e) Income tax and capital gains tax
For an arrangement founded on a partnership trust, while the only asset in question is a life assurance policy there will be no income tax or capital gains tax implications.
If the policy proceeds are not used by the partnership immediately, each partner will be assessed to tax individually on his or her share of any income and capital gains subsequently generated by the proceeds.
For an arrangement founded on a business trust, while the only asset of the trust is a life assurance policy, there will be no income tax or capital gains tax implications.
If benefits are paid under the policy on death a cash amount will be paid to the trustees for distribution to the beneficiaries (ie. the surviving partners/members). If the benefits remain in the trust and earn interest, income tax consequences will depend on the type of trust. If the trust is discretionary this interest would be taxed on the trustees at 45% with the first £1,000 of interest taxed at the 20% basic rate (the standard rate band). In the unlikely event of the cash proceeds being reinvested, dividend income would be taxed on the trustees at 38.1% and other income at 45%, subject to the rule that the first £1,000 of annual gross income is taxed at 7½% for dividend income and 20% for other income.
On distribution of income to the beneficiaries, the trustees have to account to HMRC for tax at 45%. The income distributed will be assessed to tax on the recipient beneficiaries who will have a 45% tax credit for tax paid by the trustees.
If the trust is an interest in possession trust, the beneficiaries (partners/members) entitled to the income will be taxed on it at their marginal rate(s) (with the trustees having a basic rate liability only on the income they actually receive).
Capital gains will be assessed on the trustees at 18% to the extent they exceed the trustees’ annual CGT exemption.
This document is believed to be accurate but is not intended as a basis of knowledge upon which advice can be given. Neither the author (personal or corporate), the CII group, local institute or Society, or any of the officers or employees of those organisations accept any responsibility for any loss occasioned to any person acting or refraining from action as a result of the data or opinions included in this material. Opinions expressed are those of the author or authors and not necessarily those of the CII group, local institutes, or Societies.