Key Person Insurance | How does it work?

Adrian Gore, the CEO of Discovery Holdings, is a perfect example of what a key person is.
For our international readers, think of Richard Branson, Bill Gates, Warren Buffett, and Steve Jobs!

While Discovery, or Microsoft for that matter, won’t close their doors should either leader pass away, surely it would impact on investor confidence? After all, who’s going to fill their shoes one day?

Now you and I aren’t Discovery or Microsoft. Large companies are fortunate enough to have business continuity plans in place with managers who are being mentored to take over as CEO one day.

But what happens when the small business owner passes away or becomes disabled?

In most cases we’re small business owners with huge salary bills (Some of our clients have to sell a R1 million a month just to meet the salary bill…Talk about sales pressure!) 😯 , and massive liabilities.
Or maybe you employ highly specialised staff vital to the smooth running of your business?
How much would it cost – in both time and money – to replace your software engineer who happens to know your information systems and website inside out?
That’s the reason why key person insurance exists in the first place! 🙂

Key person insurance is perfect for protecting your line of credit should one of the owners pass away…or to pay for recruiting and training your next computer guru.

Imagine also the impact of an estate duty claim against the company?

Doug, who owns 50% of the company, passes away. Doug’s estate now owns 50% of your R5 million company…but the estate is not interested in the 50% shareholding – what they want is their R2, 5 million in cash (we’ll get to buy and sell arrangements in a later post)!
Paying out Doug’s estate claim would take R2, 5 million off the balance sheet immediately (or cripple what’s left of the business 😥 )…
What better way to solve this problem than with key person life insurance?

Of course the purpose of key person insurance is to provide the company with a benefit…and not the actual employee or director.

If the only purpose of the key person insurance is to pay an amount to the sole owner’s estate then it’s a no-no.
Because the insurance could be taxed in your hands as gross income!

There’s two ways the company can take out key person insurance:

  1. By using a “conforming” policy, or
  2. A “non-conforming” policy

Why would you choose a “conforming” type policy?

Key person insurance is owned by the company and paid for by the company. Since many companies would prefer to claim the monthly contributions as a tax deduction, the payout on death or disability is taxed as gross income in the hands of the company (To provide a net amount after income tax simply divide the insured amount by 0.72 and then insure for the higher amount). Since the proceeds are included as ‘income’ by the company they are also free of any capital gains tax.

Why choose a “non-conforming” policy?

Monthly contributions are not deducted as an expense by the company which makes the payout tax-free!
Unfortunately, the taxman changed the rules in January 2011. They still haven’t as yet clarified what constitutes a “non-conforming” after 1 January 2011…as soon as we know you’ll be the first to hear.

To qualify for the tax deduction the life insurance policy would need:

  • To be owned by the company
  • An employee or director of the company needs to be the insured
  • The life insurance must be a pure risk policy (Most are anyway!) with no cash value
  • Must be owned by the company at the point when they claim the contribution for tax deduction purposes, and the policy cannot be ceded to the employee whose life is insured when claiming the tax deduction.
  • The eventual beneficiary of the payout must never be the employee, his estate, or his dependents.

Wouldn’t it make more sense for the sole owner to –

  • Own the life insurance in his own name,
  • Claim nothing from tax, and
  • Get the payout tax-free?

Next week we’ll discuss capital gains tax and estate duty and how they would affect a key person life insurance policy (and if there’s space we’ll chat about what happens when the policy is ceded back to the employee/director upon retirement or resignation).

InsuranceFundi has partnered with some of SA’s most reputable insurance and investment companies. We believe that everyone should have access to a wide range of comprehensive and affordable solutions. Pick the product you are interested in below, and expect a call-back from our partners.

Kind regards,

The InsuranceFundi Team

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