Key Person Insurance:

A key person is someone who is fundamental to the running of the business, who through their knowledge, skill or expertise, contributes to the profitability of the business.  Steps need to be taken to ensure that if this person should die or become disabled, the business’s profitability will not be impacted on, or that the impact will at least be minimised.

Why is it important from the business’s perspective to have key person insurance in place?

  •  Should someone who is fundamental to the running and profitability of the business die or become disabled, the business will suffer a financial loss as it may struggle to replace their knowledge, skill or expertise easily.
  • If it does try to find a suitable replacement, it is going to have to compensate the new employee handsomely and may even have to lure this person from a competitor with an attractive offer. Consider what it would take to source an employee with similar knowledge, skill and/or expertise, the costs that may be incurred in employing a head hunter to fund this person, the cost of possibly having to pay for this person to relocate from one province to another, or depending on the scarcity of the skill, even overseas.
  • If the business is unable to find someone who is an exact match in terms of the key person’s skills, knowledge or expertise, it will have to up-skill the new employee. This may cost money and will also take time, during which the business’s profitability may drop. It is necessary need to ensure that the business has sufficient resources at its disposal to tide it over this difficult period.
  • If it is unable to find someone who has the key person’s knowledge, skill or expertise, it may have to consider changing the manner in which it does business or the nature of the business. The business will need to have funds available to ensure that this transition has as little impact on profitability as possible.
  • In the worst case scenario, if the business is unable to find someone who has the key person’s knowledge, skill or expertise, it may have to consider winding  up. In this event the business needs to have sufficient funding to ensure that the winding up is orderly and that there is no negative impact on the individual business owners or other employees.
  • If any of the business owners has a credit loan account in the business, it may want to consider using key person insurance to ensure that on his/her death, the business has the cash needed to settle this loan account. The executor of the deceased’s estate has an obligation to collect the amount owed from the business, and if it does not have the cash to pay the debt, it could have severe negative implications for the business. This loan account can also be catered for in a buy and sell arrangement.

The structure of the key person insurance:

The business will effect a life insurance policy, possibly with disability and/or dread disease cover, on the life of the key person. The proceeds of this policy will be paid to the business which will then use them as it sees fit. If business is a company, then it should conclude a board resolution indicating the reason for the life insurance policy and confirming the decision to put the cover in place.

Valuing the key person:

The starting point is to acknowledge that if the key person should die or become disabled, the business will suffer a financial loss. There are a number of methods to quantify that loss and while reference may generally be made to the business’s financial statements, the actual method used will depend on the particular circumstances of each case. As an example, three possible methods that may be used are:

  • A multiple of the key person’s salary; or
  • The number of years it will take for a replacement to reach the key person’s present level of profitability, multiplied by the difference in profits due to replacing the key person; or
  • Itemising the cost of replacing the key person

Payment of premiums:

The business will pay the premiums in respect of the life insurance policies that have been taken out.

The Income tax consequences:

The business, at inception, may elect to claim a tax deduction on the premiums, (the policy will then be termed a “conforming policy”.) The maximum deduction will be limited to the lesser of the premiums or 10% of the life insured’s taxable remuneration. When the policy pays out, the proceeds will be taxable in the business’s hands, at the rate of tax applicable to corporate entities, currently 28%. Note, if the business elects to claim the deduction at inception, it must continue to do so, as SARS will deem it to have claimed the deduction, even if it has not done so.

If the proceeds are taxable, the amount of life covered required will have to be increased to take the income tax into account, in order to ensure that the after tax amount is sufficient to purchase the interest in the business from the deceased business owner’s estate..

The business may, at inception, elect not to claim a tax deduction on the premiums, (the policy will then be termed a “non-conforming” policy) When the policy pays out, there will be no income tax payable on the proceeds.

Estate duty consequences:

The proceeds of the life insurance policy will not attract estate duty, provided that the following requirements are met:

  • That the policy was not effected by or at the instance of the deceased,
  • That no premium on such policy was paid or borne by the deceased, and
  • that no amount due or recoverable under such policy has been or will be paid into the estate of the deceased and that no such amount has been or will be paid to, or utilized for the benefit of, any relative of the deceased or any person who was wholly or partly dependent for his maintenance upon the de ceased or any company which was at any time a family company in relation to the deceased

A family company is one where the deceased, alone or together with any of his/her family members was able to exercise effective control over the business. Included in the definition of family member is the spouse of the person or anybody related to him/her or his/her spouse within the third degree. If the business was at any stage a family company in relation to the deceased, then even if this changes in the future, the estate duty exemption will be lost forever.

If there is any doubt whether the above mentioned requirements to qualify for the exemption will be met, provision should be made to increase the life cover. Where the estate duty exemption is not granted, then because the payer and beneficiary of the policy are both the same person (the business) there will be a saving in estate duty, in that the proceeds brought into the estate duty calculation will be reduced by return of premiums plus 6% p.a compound interest.

Steps to be taken in implementing a key person arrangement:

  • Establish the value of the key person – i.e. quantify the financial loss that will be incurred should this person die or become disabled
  •  Effect  the life cover and/or disability cover  required in order meet this need
  • All the necessary documents to obtain the life insurance with the relevant Life Office must be completed

Conclusion:

In the same way that a business insures its physical assets , so to should it protect itself against the loss of its most valuable assets – specialist knowledge, skill or expertise. Key person insurance assists it in achieving this.

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