Tax Efficient Director Life Assurance Cover
Relevant Life policies offer Companies the ability to put in place Life Assurance Benefits for individual employees (workers and employed Directors) in a tax efficient way. The policy is taken out by the company on the life of the individual and the benefit is payable under trust to their family. Distinct from personal life assurance cover, these polies offer:
Benefits can be set up based on a multiple of earned income and for shareholding directors, this can include benefits in kind and dividends paid. These are extremely tax efficient policies.
Key Person Cover
Most business have taken appropriate steps to protect themselves from risks such as fire, theft, accidents and claims under employment law, but often ignored are the risks associated with the loss of a key individual. It is often the case that certain individuals within a business are crucial to its success which might include
- individuals who had the initial original business idea
- someone who has specific technical or product knowledge
- a person who has key contacts or business relationships
- someone who has particular skills in navigating regulation
- maybe they are a genius with your back-office and IT systems or perhaps they developed them
- they could be the person who knows exactly how your business functions on a day-to-day basis, keeping all those plates spinning, and you’d be lost without them
Whoever the key individuals are and whatever their role within the business, it is often the case that the business will suffer financially if they were to die or be seriously incapacitated. The effect on the business could be felt in a number of ways but most often it is in the form of a loss of profits caused by short term disruption to business-as-usual activities. In addition, there might be pressure from lenders to paydown debt or reduction or removal of overdraft facilities.
There might also be additional costs associated with the recruitment of a replacement or taking on temporary staff to plug the gap and to get the right individual with the skillset you need might mean paying above market, especially where skills are specialised or in demand.
Fortunately, just like many of the other risks that a business can insure, it is possible to cover the risk associated with such a loss. A simple life assurance or critical illness policy, where the employer is the beneficiary in the event of death or serious incapacity could help the business meet the short- term financial challenges. Life assurance cover costs relatively little and subject to the health of the key individual is pretty simple to arrange.
It is usual for the level of cover to be determined in one of three ways;
Payroll-based approach – suitable when the recovery period would not exceed five years and the key person’s salary and total payroll are fairly stable. It is arrived at by using the following formula:
Key person salary x sales turnover x expected years to recover / Total payroll
Salary-based approach – suitable when the aim is to find an equally competent replacement, but does not allow for the key person’s contribution to overall turnover. A popular multiple to use is five times the key employees total remuneration package.
Profits based approach – suitable when there are few (or only one) key persons. Popular multiples are either two times gross profits or five times net profits. Gross profit is taken as total sales less cost of sales. Net profit should be taken before tax.
Examples of where such cover might be appropriate: –
- Product Manager
Whilst some individuals can be replaced easily within any organisation, those that have specialised knowledge of process, product or formulation are much more difficult to replace. Detailed knowledge can make such an individual key to the success and even perhaps the future of the business and the cost of having to replace them with a similarly knowledgeable person can be insured.
- The Face of the Company
Many businesses have one key individual who is the face of the organisation; for key customers, that is the person they first think of when they consider purchase decisions and the first port of call if they have any problems. They are the face that gives the customer confidence that their needs will be met and the reason they do business with you. Their loss may well mean orders fall, those customers become willing to give someone else a try. The financial consequences, such as loss of profits should be considered and the need to replace them quickly with someone of equal stature.
- Key Driver
A business in which most of the key decision making concentrated in one key individual who has been responsible in the past for the set-up and growth of the business and who is key in terms of its future direction. The loss of this individual might lead to the business losing direction, profitability falling and its value, if it is to be sold, being far less than would otherwise be the case. Cover can be put in place to cover any short-term reduction in profits.
- Borrowing for Expansion/Acquisition
If your business has borrowed to expand via acquisition or to fund the building or purchase of new business premises, the loss of its owner/Managing Director might put at jeopardy its ability to service its loan or lead a bank to rearrange an overdraft facility. Cover can be arranged on a reducing basis to cover the outstanding capital of the loan or provide funds into the business so that external borrowing facilities are less important.
Most businesses are subject to one form of regulation or another and in some key individuals know and understand these regulations inside out. They ensure the business meets their obligations but helps it to do so without disrupting its day to day operations. A financial controller may be easily replaced, but someone with specialist chemicals knowledge or safeguarding compliance may be harder to find.
Arranging such cover is relatively simple, but it must be done correctly to ensure the correct tax treatment appliescase studies
Shareholder / Partnership Cover
The death or diagnosis of a critical illness of a Director or Partner can put huge strain on a business and not just in a financial sense. It is not uncommon and recent statistical evidence suggests that in a business with four Directors/Partners aged 40, there is a 24% chance of one of them dying before reaching age 65 and a 74% chance of one of them suffering from a critical illness.
The financial strain might take the form of loss of profits leading to cash flow problems and potential issues with lenders or simply additional costs in terms of recruiting a suitable replacement to the business. However, one key issue that many businesses miss is how the death will be dealt with in terms of the ownership of the share of the business belonging to the deceased.
The physical and emotional strain can also be huge. Not only do the remaining directors/partners have to cope with the loss of a close colleague with whom they have worked for many years, but they have to almost immediately pick up all of their work, some of which may be very unfamiliar to them e.g. financial accounting, to ensure the business continues to operate as if nothing has changed.
The death or incapacity of a Shareholder/Partner affects two groups. The family of the individual and the ongoing shareholders/partners.
Planning in advance can address the concerns of both sides. Putting life assurance and/or critical illness cover in place means that in the event of the loss of one of the Directors/Partners, money is made available quickly to those remaining. They can use this to hire replacement staff or outsource work to third parties, such as accountants, and importantly, they will also have funds to ensure the family of the deceased can receive money for their share of the business.
What do I need to consider?
- In a Partnership, do you have a formal Partnership Agreement in place? If not, a Partnership must be automatically dissolved on death of one of the partners – what would this mean for you? If you do have a Partnership Agreement in place, is it up to date and effective for Inheritance Tax Purposes?
- In a Limited Company, what do your Articles of Association say will happen to your shares in the event of your death? Often, they confer rights to the automatic transfer of the shares to other individuals which can be ineffective for Inheritance Tax Purposes and lead to large unexpected bills. If not covered in the Articles, have you created a Shareholder Agreement?
- What is the value of your business and your share of it and how would its buyout be financed in the event of your death or critical illness? Could the remaining Directors/Partners afford to buy out your share? Would a bank support them at such a difficult time?
- Would you want to work with or be answerable to the family of your deceased Co-Director/Partner in the event of their death? If not, buyout is the logical answer and is something which also gives them financial certainty and security.
Dealing with the transfer of ownership can be a simple process if planning has been undertaken and can significantly relieve the pressure on remaining Directors/Partners.
Step one is to put in place a suitable agreement at to what should happen to the share of the business in the event of a death or critical illness of one of the Directors/Partners. Such an agreement needs to be worded correctly to ensure it doesn’t lead to any unintended tax consequences but will normally take the form of a simple exchange of options where the survivors in the business have the right to insist the family of the deceased sell their share in the business and the family of the deceased have the right to insist that the survivors in the business buy it.
Step two is to then ensure sufficient funds are available to enable the transaction to take place by putting in place an appropriate Life Assurance and/or Critical Illness policy on the life of each of the Directors/Partners which would pay out to the surviving Directors/Partners allowing them to purchase the share of the business from the family of the deceased. Such cover is simple to arrange subject to the health of the individuals involved.factsheet
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