Financial protection11. Business protectionLearning outcome 10 Evaluate the needs and priorities for financial protection and the relevant factors in selecting the appropriate solutions
In this chapter we consider the specific protection needs and planning process applying in respect of businesses an...
Shortened demo course. See details at foot of page. ...on areas. This presentation will be of most benefit to those learning about this area for the first time:
Businesses routinely insure their material assets such as premises, plant and machinery and computer hardware/software. However, many businesses fail to protect one of their most valuable assets - their workforce.
Key person insurance is not a type of policy but an area of financial planning which deals specifically with this issue. The success of many businesses will often largely depend on a small number of key people, for example a product designer, a salesperson or a marketing manager. However, a key person need not necessarily be someone who is paid a very high salary or who holds a senior position. An individual is a key person if their absence from work would have a serious impact on the business’ ability to continue to function smoothly and profitably. A key person need not even be an employee, they may be a contractor. The loss of a key person, whether temporarily due to illness, or if they die, will impact indifferent ways for each business. The main financial costs incurred for a business losing a key pe... Shortened demo course. See details at foot of page. ...t is being considered, all managers involved will be key to the success of the buy-outIn manufacturing companies capital is often invested in specialist equipment that must be operated by an expert Technology companies are likely to rely on specialists Trading companies may rely on the skills of a few number of dynamic salespeople Any employee who contributes to the profitability of the company and without whom the company would face financial loss is considered a key person. In small to medium-sized businesses, the directors are also often the shareholders. A shareholder/director is likely to be perceived as ‘the company’ by customers, suppliers and those providing finance to the business. They are likely to be the individuals whose loss would have the most significant financial impact. Most key person insurance is arranged in respect of such small and medium sized enterprises. What are the two main financial costs to a business on the death or serious illness of a key person? Answer : Purchase course for answer Putting a financial value on the loss of a key person is difficult as it is impossible to predict the exact circumstances and the effect on profits. Some information can be taken from the company accounts and financial statements, but some assumptions will also have to be made. Useful information would be:
The cash position of the company Looking at the pattern of previous profits and projections for at least the next 12 months Predicted effect on profits if the key person was unable to contribute to the business The effect on special projects the key person is working on Estimated costs or recruiting and inducting a replacement Training costs and the length of time it would take for a replacement to become effective Any loans that could be re-assessed on the loss of t... Shortened demo course. See details at foot of page. ...r after tax= Many businesses will try and keep net profits low in order to minimise tax and net profit does not allow for fixed expenditure that will continue in the event that the key person is incapacitated or dies - Policy proceeds may be taxable - Therefore, using gross (pre-tax) profit is a better indication of the key person’s contribution to the business It may be difficult to come up with a relevant time factor If the company is showing a loss, the formula isn’t relevant The formula uses salary and, as for the multiple of salary approach, this may not reflect the key person’s full remuneration package What are the two main methods used for calculating the cover required for key person insurance? Answer : Purchase course for answer The choice of plan may be affected by the applicable tax rules.
The taxa position in respect of premiums paid and benefits received from a key person policy are complex as there is no directly applicable legislation relating to key person insurance. Tax relief on premiums Generally, premiums are an allowable trading expense, deductible in calculating corporation tax, if they meet the following conditions which are based on the ‘Anderson statement’ made by the then Chancellor of the Exchequer, Sir John Anderson in 1944: The sole relationship between the company and the life assured must be that of employer and employee: If the life assured has a significant shareholding (more than 5%) in the business, tax relief may not be granted The purpose of the insurance must be to meet lost profits arising from the death or critical i... Shortened demo course. See details at foot of page. ...d obtain guidance. Even if a company doesn’t claim tax relief on premiums, this does not guarantee that there would be no tax payable on the plan proceeds.Inheritance Tax The receipt of a cash sum into the business when a person dies could artificially inflate the value of the company and the cash holding may mean the partial loss of Business Relief, leading to a possible IHT charge on the deceased’s estate. An own-life policy written under trust could be used to ensure that payment is made outside of the life assured’s estate; however, the purpose of key person insurance is to compensate the business for financial loss and not the individual. What are the three “Anderson Principles” used to assess whether tax relief would be granted on premiums paid for key person cover? Answer : Purchase course for answer Underwriting would be carried out as in respect of any other type of insurance. However, there are a number of issues that are particularly relevant to key person insurance:
The sums assured are usually high compared with those for personal financial protection. The higher the sum assur... Shortened demo course. See details at foot of page. ...spect of new businesses that have a limited track record, and management accountsLoan agreements A supplementary financial questionnaire is often required in respect of larger sums assured As this is a specialised area, most providers have dedicated large case underwriting teams. The choice of term should reflect the needs of the business and the period of time over which cover is required. Longer term policies (including whole of life) can be used but tax relief on the premiums towards such policies is most likely to be disallowed.
In the event of a claim, the sum assured will be taxable as a trading receipt. Some providers will pay a claim out over several years to spread the impact of the tax liability over several company accounting years. Where cov... Shortened demo course. See details at foot of page. ... more appropriate in circumstances where:The key person is likely to remain of value over a long / indeterminate period The key person is expected to continue making a significant contribution throughout their working life Structuring the policy Key person policies should be written on a life of another basis, the company is proposer and owner and the key employee the life assured. In the event of a claim the company interacts with the insurer and receives the benefits. In respect of key personnel, death is not the only risk that could have an impact on the profitability of a business, long-term illness or disability can also have serious financial implications.
Income protection insurance A key person income protection insurance (IPI) plan provides regular sums to the company in the event that illness/incapacity prevents the key person from working. As with life assurance, working out an appropriate level of cover can be challenging. The policy benefits may be set at a level that enables the costs of replacing a key person to be met. This might be acceptable if a replacement is only required for a temporary period but doesn’t take account of loss of the key person’s contribution to profits. Alternatively, a multiple of the key person’s salary could be used usually up to two times. This could be used to pay the costs of securing a replacement and compensate for loss of profits. Due to limits in respect of maximum benefit levels from all policies, individually held IPI may limit the amount of key pers... Shortened demo course. See details at foot of page. ...rmally a scale of benefits, which increase in respect of more severe conditions; the highest level of benefit being paid upon death or total and permanent disablement.Premiums for sickness insurance are higher than those for accident only cover but less than for IPI. In the event of a claim income benefits are paid for a maximum of 24 months, explain why premiums are lower than for comparable IPI. The contracts are classed as general insurance and are annually renewable; the insurer can refuse to offer new terms or change the policy conditions based on their own claims experience. There are many restrictions in relation to the cover provided by these types of plan. However, they could be useful if used in conjunction with income protection where the sickness and accident plan is used to protect short-term liabilities and the income protection has a longer deferred period to provide cover for longer-term disability. What is the tax treatment of benefits paid to an employee from a key person income protection plan? Answer : Purchase course for answer It is common for policies to ...
Shortened demo course. See details at foot of page. ...ined on the premiums paid. Share protection insurance is designed to provide remaining shareholders with the funds that will enable them to buy the shares director who has died or become seriously ill. It is appropriate where all or most of the shareholders are also directors in the business. In companies with a small number of shareholders, a change in ownership can have profound effects on the business, especially where the change is sudden or unexpected.
When considering shareholder prot... Shortened demo course. See details at foot of page. ... the shares.Advance planning can help to avoid these problems, ensuring that: The deceased’s beneficiaries receive the full market value of the shares; and The remaining shareholders retain control of the company. This will consist of three distinct elements: An agreement on how to transfer the shares Insurance plans to provide the funds required to buy the shares Appropriate planning to mitigate any tax in respect of the funds received It is important that any agreement is aligned with the company’s articles specify in terms of the transfer of shares. The basis for calculation of a fair price must be agreed and the agreement should be structured in such a way that business relief in respect of IHT applies.
There are three main methods for arranging the transfer of shares and each one should be considered carefully in terms of the legal and taxation implications. Buy and sell agreement The shareholders agree that if any of them were to die their shares will pass to their estate, but: Their estate will be required to sell the shares, and The remaining shareholders will be required to buy them The method for valuing the shares should be written into the agreement. Each shareholder would take out a policy on their own life, written in trust for the benefit of the surviving share... Shortened demo course. See details at foot of page. ... the deceased’s family- A clause may be written into the agreement which requires the remaining shareholders to make up the difference One of the shareholders could change the terms of their will without informing the others; resulting in their shares and the proceeds from the life assurance policy both being left to their beneficiaries Equalisation With any of these arrangements, if the shareholder’s ages or states of health vary, the costs of funding policies could also vary. Where premiums differ materially (not just in respect of the size of shareholding), there may be some financial adjustments between the shareholders to achieve an equitable distribution of cost (known as ‘equalisation’). Which type of shareholder agreement would result in the loss of business relief in respect of IHT? Answer : Purchase course for answer The life assurance plan will provide the funds which will allow the agreement to be implemented. This will either be by providing the shareholders with the funds to buy back the shares from the deceased’s estate or by providing the shareholder’s beneficiaries with financial compensation for the value of the business that has been left to the surviving shareholders.
The most suitable type of plan will depend on the circumstances of each case: Term assurance is the cheapest way to provide cover - A renewability options can add flexibility - Indexation options can be included to make sure the sum assured is not eroded by inflation - It may not be possible to alter the sum assured significantly in the future - A conversion option may be helpful if the shareholder / director considers that it is possible they may wish to arrange a whole of life plan at a later date, for IHT planning A whole of life assurance is much more flexible and will remain in place for as cover is required and premiums are maintained - The policy could be used in the future for IHT planning if it is no longer required for shareholder protection, for example, if the shares have been sold and the assets no longer qualify for BR Calculating the sum assured The main purpose of a shareholder protection arrangement is to ensure that the surviving shareholders have sufficient funds to buy out the deceased’s shares or that the shareholder’s beneficiaries receive sufficient compensation where the shares ... Shortened demo course. See details at foot of page. ...usually be treated as a disposal for CGT purposes. As the deceased’s family will have received the shares at probate value this is likely to have little or no tax consequences. Where no agreement is received the sale is treated as a distribution and would be liable to income tax.Taxation These arrangements are complicated and great care is required to ensure that they are set up correctly so as avoid any unexpected legal or financial implications. It will be necessary to liaise with other professional tax and legal advisers to ensure the validity of the information provided and to ensure that no actions taken are contrary to other planning that is already in place. Normally, the participants in a shareholder protection agreement would pay the premiums from their own taxed income Where premiums are paid by the company on behalf of a director, the amount paid would be treated as additional income and liable to income tax and National Insurance contributions (NICs); the company may treat the premiums as an allowable business expense but may be liable to employer’s NICs Where the arrangement qualifies for business relief (BR) then no IHT would be payable on the proceeds from any life policy underpinning the arrangement or in respect of the premiums paid to the policy If a company with four shareholders wishes to set up a shareholder protection arrangement, why would an own-life policy written under trust be more appropriate than a life of another policy? Answer : Purchase course for answer Partners face problems similar to those of the shareholders of limited companies, in that if a partner dies or suffers serious illness, the remaining partners would have to make some payment to the partner’s legal personal representatives or the partner themselves.
What happens on death of one of the partners is dictated by the Partnership Act 1890 or this can be overruled by a valid partnership agreement. If no partnership agreement is in place, the Partnership Act 1890 dictates that the partnership will automatically dissolve on death. This will mean that: The partnership will have to cease trading The capital accounts are distributed to the partners <... Shortened demo course. See details at foot of page. ... and the basis of calculating the sums assured are similar to those relevant to shareholder protection.Limited Liability Partnerships (LLPs) incorporate some of the features of both a limited company and a partnership. They have their own separate legal identity and are liable to the full extent of their assets. The LLP allows for members to organise their internal structure with the flexibility of a traditional partnership but with limited liability. The partnership protection arrangements discussed in the next section are equally effective for LLPs. Which act of parliament applies where no partnership agreement is in place? Answer : Purchase course for answer As mentioned above, the arrangements that can be used for partnership protection are similar to those used for shareholder protection.
Buy and sell agreement The partners agree that, for instance, if any of them were to die, their estate is required to sell the deceased partner’s share of the business and the remaining partners are obliged to buy it. Each partner takes out a policy on their own life written in trust for the benefit of the surviving partners. The sum assured should be equivalent to the agreed value of their share in the business. On the death of a partner, the trustees pay out the policy proceeds to each survi... Shortened demo course. See details at foot of page. ...he value passing to the remaining partners, the remaining partners may be required to make a payment to the beneficiaries of deceased partner’s estate.With any of these arrangements, if the partners’ ages or states of health vary then the costs of funding each of the policies could vary. Where premiums differ materially (not just in respect of the partner’s share of the business), there may be some financial adjustments between the partners to achieve an equitable distribution of cost (equalisation). What are the three main arrangements that are used for partnership protection? Answer : Purchase course for answer Where a business borrows funds, it should consider what protection (if any) is required.
In the case of a sole trader, the risks of required repayments not being maintained are considerable. Should long-term disability or death occur, life and critical illness cover may be a condition of granting the loan. Business partnerships obviously face simi... Shortened demo course. See details at foot of page. ...loans. For example, applicants may be given the option of taking interest repayment holidays for an initial period, after which the rolled-up interest is added on to the outstanding loan. In these situations, cover would need to be taken out with a sum assured that reflects this need, having greater cover after a certain period than is needed initially. It is very important that any business protection is arranged on a purely commercial basis. For example, a recommendation for shareholder protection cover of £1million should not be made if the value of the shares is only worth £500,000
Factors which may affect commerciality Are there beneficiaries under a trust who wi... Shortened demo course. See details at foot of page. ...sually the case with a business trust, this will create a gift with reservation should the arrangement be considered non-commercial by HMRC. If this occurs the policy proceeds will be treated as part of the deceased’s estate for IHT purposesWhat is the effect of the loss of commerciality? Answer : Purchase course for answer This revision test (opens in a new... Shortened demo course. See details at foot of page. ... test will be added to your CPD certificate. |
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