Key person insurance tax: are the premiums deductible?

The tax treatment of key person insurance is not especially complicated in principle, but it is very easy to over-simplify.

A company paying the premium does not automatically make it tax deductible. HMRC looks at why the policy was taken out, what loss it is intended to cover and, in the case of life cover, how the policy itself is structured.

For a straightforward policy taken out to protect trading income, a Corporation Tax deduction may be available. Where the policy also protects a shareholder’s interest, the capital value of the company or some other non-trading purpose, the position becomes less clear.

HMRC’s test

The main HMRC guidance is in BIM45525.

HMRC says the premiums may be allowable where the sole purpose of taking out the policy is to meet a loss of trading income caused by the loss of the key person’s services.

That wording matters. It is not enough that the company would obviously suffer if the person died or became seriously ill. The policy needs to have been taken out for a trading purpose rather than, for example, to protect the capital value of the business or the interests of a shareholder.

For life insurance, HMRC also expects the policy to be term insurance, providing cover only against death during the policy term. The term should not run beyond the period for which the person is expected to remain useful to the business.

So if a company takes out a ten-year policy on a commercial director who is expected to remain central to the business for roughly that period, the structure is easier to justify than a much longer policy which bears little relationship to the person’s expected role.

Director-shareholders need more care

This is the area most likely to catch out small owner-managed companies.

A director can plainly be a key person. A major shareholder can plainly be a key person too. The problem is that, where the same person is both, the policy can start to serve more than one purpose.

HMRC’s guidance at BIM45530 specifically points to policies taken out on directors who are major shareholders.

If the purpose is simply to protect the company’s trading profits, that is one thing. If the policy is also there to protect the value of the shares, strengthen the shareholder’s estate or support an ownership arrangement after death, HMRC may regard the policy as having a non-trading purpose.

That does not make the policy inappropriate. It may still be perfectly sensible protection for the business. It simply means the company should not assume the premiums qualify for Corporation Tax relief.

The Beauty Consultants case

HMRC refers to Beauty Consultants Ltd v Inspector of Taxes [2002] SpC 321 in its guidance on this point.

The significance of the case is not that every shareholder-director policy will fail. It is that a policy can have a commercial benefit to the company and still fail the tax test if there is another significant purpose behind it.

In Beauty Consultants, the Special Commissioner found that the disputed premiums were not paid wholly and exclusively for the purposes of the trade. One of the policies was considered to have a dual purpose, including protection of the value of the directors’ shareholdings.

That is the real danger area: mixed purpose.

What about the payout?

Where the premiums are deductible, HMRC’s position is that the policy proceeds will generally be treated as trading income.

For companies, HMRC refers to section 103 Corporation Tax Act 2009. In practical terms, if the company receives a claim payment under a policy whose premiums qualified for a trading deduction, the proceeds will usually be brought into account for Corporation Tax purposes.

This can matter when deciding how much cover to buy. A £500,000 policy does not necessarily leave the company with £500,000 available after tax.

Where the premiums were not deductible, the proceeds will not normally be taxed as trading income. HMRC does, however, treat the tax position of the receipt as a separate question, so it is not sensible to assume that a payout must be tax-free simply because the premiums were disallowed.

Critical illness cover

The same broad principles apply where the policy includes critical illness cover.

HMRC’s guidance refers to insurance against loss of profits caused by death, critical illness, sickness, accident or injury. The important point is still the purpose of the policy: is it protecting the company’s trade against the loss of the person’s services?

See our separate guide to key person critical illness cover for the practical differences between life-only and wider protection.

How much evidence should the company keep?

There is no special HMRC form to complete when the policy is taken out, but it is sensible for the company to keep a record of why it arranged the cover.

For a small limited company, a short board minute or file note is usually enough to record the commercial reasoning. It might set out the person’s role, the likely effect on turnover or profit if they were lost, expected recruitment costs and the basis on which the level of cover was calculated.

This is particularly useful where the insured person is also a shareholder. The documentation should make clear whether the purpose is to protect trading income, rather than the value of the shares or the shareholder’s personal position.

Paperwork will not rescue a policy which has a different purpose in reality, but it is far better to have the commercial rationale recorded at the time than to try to reconstruct it years later.

Does the level of cover matter?

HMRC does not require the sum assured to match a precise forecast of lost profit. Even so, the figure should make commercial sense.

If a company says a policy exists purely to protect against loss of trading income, but the amount insured bears little relationship to the person’s contribution to the business, that may be harder to explain.

Most companies will base the figure on some combination of profit contribution, revenue at risk, recruitment cost, debt exposure and the period needed to recover. We cover those methods in more detail in how much key person cover does a limited company need?

Key person cover is not shareholder protection

The distinction is important for both tax and policy structure.

Key person insurance protects the company against financial loss. Shareholder protection is generally used to deal with ownership of shares following the death or serious illness of a shareholder.

A founder-director may need both types of protection, but they are doing different jobs. Trying to make one policy serve both purposes is exactly the sort of situation that can muddy the tax treatment.

What to ask your accountant

If the company wants to claim the premiums as a deduction, give your accountant the actual policy details rather than asking whether “key person insurance is tax deductible” in the abstract.

They will usually want to know who is insured, whether that person is a shareholder, the policy term, the amount of cover, whether critical illness is included, who owns the policy, who receives the proceeds and, most importantly, why the company took it out.

The cleaner the trading purpose, the cleaner the tax argument tends to be.

For many small limited companies, that is the point to focus on. If the policy exists solely to protect trading income and is structured accordingly, there may be a good case for relief. If it also protects capital or shareholder interests, the position is more likely to need careful review.