Keyperson cover for partnerships and LLPs

Introduction 

In this and next month’s article we look at keyperson cover for partnerships and limited liability partnerships (LLPs). It is instructive to first briefly consider the constitution of these two business entities as this can affect the considerations as to the way in which keyperson cover is arranged. 

A partnership in England, Northern Ireland and Wales is not a separate legal entity from its partners which means the partnership cannot enter into a contract in its own name - only all of the partners or certain partners nominated for the purpose. In contrast, a partnership in Scotland is a separate legal entity from its partners so the partnership can enter into a contract, in the same way as a company which has a separate legal identity from its shareholders. 

An LLP is a cross between a limited company and a partnership. The LLP is constituted as a body corporate, like a company, so that it has a separate legal existence from its members. This means that, like a partnership in Scotland or a company, it can enter into contracts and hold property in its own name, albeit only on behalf of its members. 

However, for tax purposes an LLP is treated in the same way as a partnership, i.e. as a collection of individuals. 

Keyperson cover for a partnership/LLP falls into two areas. 

1. Cover required on the life of an employee of the partnership/LLP.
2. Cover required on the life of a partner/member. 

In this article we will look at area 1 in detail and area 2 in the next concluding article.

 

Cover on the life of an employee 

(a) Arranging the cover 

In this case the usual way to provide cover would be by a life assurance policy effected 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. It should be noted that where the expression “salaried” partners is used this will, in reality, refer to individuals who are employees of the partnership.

(i) Partnerships (in Scotland) and LLPs

A partnership in Scotland or an LLP could propose for the policy and hold it as an asset of the partnership/LLP.

(ii) Partnerships (except in Scotland) 

The position is more difficult where a conventional partnership in England, Wales or in Northern Ireland wishes to effect a life assurance policy on the life of a key employee, with the intention that the policy (or proceeds of the policy) will be owned by all of the partners as a partnership asset. 

As mentioned above, unlike a limited company, an LLP or a partnership in Scotland, a partnership in England, Wales or in Northern Ireland is not a legal person.  This means that a life assurance policy cannot be taken out by such a partnership. Instead, any contracts made for the benefit of the partnership, including life assurance contracts, must be entered into by the individual named partners. The problem here is that these individuals may be different from the partners in the firm at the time when the proceeds of the policy are paid out. Therefore, where the intention is that a life assurance policy is to be held for the benefit of the business as a whole (ie. all the partners for the time being of the business), rather than particular individuals, the only method available to achieve this is to use a special trust. Such a trust is generally known as a “partnership trust”. 

The trust provides that the trust asset, ie. 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 (eg. 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. In practice, of course, it is expected that in the event of death or critical/serious illness resulting in the payment of a benefit, the funds will be paid to the trustees who would then use them for whatever purpose the policy was effected. This could include the repayment of any borrowing or to replace lost profits or in any other way depending on the circumstances. 

If a partnership trust is not to be used then all of the individual partners could apply for the policy as every partner normally has the capacity to contract for the partnership within the scope of the partnership business. Ideally, all of the partners would apply together. Failing this, one or more partners could apply on behalf of the partnership and it would be prudent to have some evidence of this eg a resolution at a partners’ meeting.  

Arranging cover on this basis though is unsatisfactory. Technically, the policy is owned by the partners who applied for the policy and it is not a partnership asset.  On the face of it the partner(s) will have taken the policy for their own benefit which could make it difficult to support a claim for a tax deduction for the premiums. Furthermore, it may be prudent to take legal advice as to how matters should be arranged to protect the interests of the partners who have not joined in the application for the policy. 

(b) Deductibility of premiums 

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 where the following conditions are satisfied:- 

1. The sole relationship is that of employer and employee. 

2. The policy has been effected 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). This would preclude relief on premiums paid on policies that acquire a surrender value – see 3 below. 

3. The policy is a short-term temporary assurance. Long-term temporary 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 be excluded as they would fail the test under 2 above 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 assurance policies 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 during which the employee would need to be replaced or, alternatively, linked to a multiple of his earnings. 

HMRC will apply broadly 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.

(c) Taxation of the policy proceeds 

If the premiums (paid from partnership or LLP income) have been allowed as a deduction, any proceeds that are paid and are referable to the deductible premiums will generally be taxed as a trading receipt.

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 can be sought from HMRC.  

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 chargeable event 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. The chargeable event gain would be apportioned between the partners/members according to their profit/capital sharing ratios – this applies where a partnership/LLP effects the policy and where the policy is subject to a partnership trust. In most cases, though, because the policy will not acquire a surrender value, no chargeable event gain will arise. The policy will not be subject to the loan relationship rules as it is not owned by a company. 

(d) Inheritance tax 

(i) Partnerships (in Scotland) and LLPs 

For a policy effected by a Scottish partnership or LLP on the life of an employee, as no trust is involved there are no inheritance tax (IHT) implications on the payment of premiums or benefits.  However, the policy will be an asset on the balance sheet of the partnership/LLP and, on a partner’s death, an appropriate portion of its value will be attributed to each partner/member to form part of his/her estate. 

(ii) Partnerships (except in Scotland) 

When cover is arranged under a partnership trust, the creation of the trust will not give rise to a transfer of value for inheritance tax (IHT) purposes and should give rise to no other tax implications provided the first premium (as well as subsequent premiums) is/are paid from the partnership’s bank account. It is important that the premiums paid by the partnership are apportioned between the partners in the same way as they are entitled to share in the partnership capital and debited from their post-tax profits. Care should be exercised if the profit sharing ratios of the partners are different from their capital sharing ratios. The debiting of costs should be discussed with the client’s accountants. 

The payment of continuing premiums by the partnership and apportioned appropriately as described in the preceding paragraph will not normally give rise to any adverse IHT consequences. In effect, each partner will pay a proportion of the premium in return for being entitled to a proportionate share of the policy. 

Although, strictly speaking, the partner(s) creating the trust will be “settlor(s)” and will benefit from the trust by virtue of having an entitlement to a part of the partnership capital, there should be no adverse IHT consequences provided the partnership pays the premiums and debits the premiums to the accounts of  the partners appropriately so that it can be clearly seen that this is a commercial arrangement on arm’s length terms. 

Provided the partners’ respective interests in the partnership qualify in full for IHT Business Property Relief (BPR), there should be no adverse IHT implications on the death of the life assured. However, if there is a substantial amount of cash in the firm’s bank account that is not needed for business purposes in the short term, this may be classified as “excluded property” which would result in that part of the value of the interest that reflects such excluded property not qualifying for BPR. 

While the policy is in force and has little value, the value of the policy on the balance sheet would usually be low to zero. If the policy proceeds are paid to the partnership, via the trustees, they will increase the asset value of the partnership and, as a result, the value of each partnership interest. However, any increase in the value of the partnership following the receipt of the proceeds of the policy would be countered by any debt that the amount of cover may be intended to repay and/or any reduction in the value of the partnership resulting from the loss of the keyperson. This debt would therefore, in effect, neutralise the receipt of the cash from the policy from the standpoint of placing a value on the business. 

(e) Income tax and capital gains tax 

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. 

 

In the next article we will consider the arrangement of keyperson life assurance cover on the life of a partner/member of an LLP.