What if you lost a key person?
Take a small manufacturing firm with three directors. One of them, Sarah, is the technical lead. Client relationships and product quality sit with her.
If the business lost Sarah through death or serious illness, it could lose a significant chunk of profit while it found and trained a replacement.
To protect against that, the company takes out a policy on Sarah's life, with critical illness cover added. That is key person insurance. But as we explain below, the structure and purpose of the policy determine whether the premiums are tax deductible.
Why the set-up matters
The type of policy the company chooses changes the tax treatment.
Option 1: a term policy
A term policy runs for a fixed period. In Sarah's case, that might be five years, matching how long she is expected to be central to the business.
Where a term policy meets all four of the conditions below, the premiums are tax deductible and any claim paid is treated as taxable trading income.
The four conditions for deductibility
All four must be satisfied:
- The sole purpose of the policy is to cover a loss of trading income, not a capital loss such as the loss of an asset.
- The policy is pure term insurance, covering only the risk of death within the term, with no other benefits.
- The term of the policy does not extend beyond the period during which the key person is useful to the business.
- The sole relationship between the company and the key person is that of employer and employee.
A note on critical illness cover
Sarah's policy in the opening example includes critical illness cover. This raises two distinct questions. First, where a critical illness or accident policy carries an investment content — meaning the premiums contribute to a capital investment — those premiums are capital expenditure and will not be deductible. Second, and separately, adding critical illness cover to a term life policy may itself engage Condition 2's requirement that the policy provides cover only against death within the term, with no other benefits. That question is not resolved by the investment-content rule alone. Where critical illness cover is to be added to a term life policy, specialist advice should be taken before proceeding.
Who must receive the payout
For the above tax treatment to apply, the proceeds of the policy must be payable to the employer (the company), not to the employee or their family. The purpose of the policy is to compensate the business for the financial damage caused by losing that employee, and as a result there is no benefit in kind for the insured employee.
If the company subsequently decides to make a payment to the employee's estate out of the policy proceeds, that is a separate matter and is likely to give rise to a tax liability.
Proceeds and tax: a warning
A payout is not automatically free of tax simply because the premiums were not deductible. Proceeds that compensate the business for a loss of trading profits may be taxable as trading income regardless of whether the premiums were allowed. There is no automatic exemption arising from the fact that the premiums were not deducted.
Director and shareholder policies: additional risk
Where the insured is a director who, or whose family, holds a substantial shareholding in the company, HMRC is likely to challenge whether the premiums are deductible at all. The question is whether the policy was taken out solely for the purposes of the trade, or whether it also served the personal interests of the director-shareholder. That is a question of fact in each case, and purpose is the determining consideration.
Option 2: a whole-of-life policy
A whole-of-life policy pays out eventually on death, whenever that happens. It may well run for decades, well past Sarah's retirement.
Premiums on a whole-of-life policy are capital expenditure and are not deductible. This is a matter of principle. It is not simply a consequence of the policy running past a particular point in time. The result is that the company pays for cover whose premiums attract no tax relief.
A third scenario: protecting Sarah's family
Sometimes the aim is not to protect business profit at all. Instead, the goal is to make sure Sarah's family receives a payout if something happens to her, separate from the business.
That usually calls for a different product entirely. A relevant life policy, paid for by the company, can provide a lump sum for Sarah's family if she dies. If the aim is to let the other directors buy Sarah's shares from her estate, shareholder protection is the usual route. These policies are normally written in trust, so any payout goes straight to the right people rather than through the business.
Policies written in trust carry their own inheritance tax and pre-owned assets considerations that are outside the scope of this article. If you are considering a trust-based policy, specialist advice should be taken before proceeding.
Similar-looking policies, different outcomes
The policies can look alike, but the tax results are very different, so getting the structure right from day one matters.
| Policy | How it works out |
|---|---|
| Term policy | Premiums deductible where all four conditions are met; payout taxable |
| Whole-of-life | Premiums not deductible (capital expenditure) |
| Written in trust (e.g. relevant life, shareholder protection) | Paid outside the business; own inheritance tax and pre-owned assets rules apply, so specialist advice is needed |
Before taking out cover, speak to your financial adviser about the policy, and to us about the tax treatment, so it is set up correctly and tax-efficiently.
This article is for general information only and must not be relied on as tax or financial advice. Acting on any of the information is entirely at your own risk.