Key person insurance and tax in Australia

Key Person Insurance & Tax in Australia: Everything You Need to Know

Key Person Insurance is common in small businesses and large corporations alike. If there is a person that your company could not continue to run effectively without, or would be significantly impaired if they had to, then that person is a Key Person and should be covered by Key Person Insurance.

Key Person Insurance is an insurance policy that covers the life of a person who has a key responsibility to a company. If the death or injury of an individual would significantly financially affect your business, then your business can apply for Key Person Insurance to cover lost revenue or capital for the business. 

Are you unclear about Key Person Insurance tax treatments, or want to understand how it helps with business risk management? If so, keep reading as we have broken down what Key Person Insurance is, and how it’s relevant to your business. 

What is Key Person Insurance?

Key person Insurance is a policy that is taken out by a company to compensate them for the financial losses that might arise if anything unfortunate happens to one of their key people. Key Person Insurance covers a range of situations from serious illness or injury to death. 

The difference between life insurance and key person insurance is that life insurance can be taken out by anyone, whereas key person insurance is reserved for people who have a significant role in a business and play a key role in the success of that business. 

The insurance is paid out in a lump sum, and it will be issued to compensate for the costs of finding a suitable successor and losses because of the inability to transact business. 

Key person insurance is distinct from employer-provided life insurance or critical illness cover in that it’s designed to insure risk for the business itself, and the business is the policy beneficiary. 

Who Can Be a Key Person in a Company?

A key person can either be the director of a company, a partner, salesperson, project manager, or staff member with a specialist skill. Anyone vital to generating revenue and sales – and whose absence could cause a significant loss – could be a key person. 

A key person also must be directly associated with the business – so for instance, you cannot take cover out for an important client or supplier, even if they are critical to profits. 

Insurers will have a set of criteria on which businesses qualify for key person insurance, and who can be a key person. For instance, the key person may need to contribute to a certain percentage of profits or share ownership of the company. 

Is Key Person Insurance Tax-Deductible in Australia?

Key Person Insurance premiums are tax deductible if they are used for revenue purposes. On the other hand, Key Person Insurance premiums used for capital purposes are not tax deductible. 

This means the purpose of taking out key person insurance determines whether KPI premiums are tax deductible or not. 

Key person insurance premiums are typically tax deductible if you take out key person insurance for revenue purposes. However, the insurance proceeds can still be taxable. 

On the other hand, if you take out key person insurance for capital purposes, the insurance premiums are not tax deductible. The tax considerations depend on the purpose, which we will discuss next. 

Keep reading to learn more about purpose when it comes to key person insurance. 

What Is the Purpose of Key Person Insurance? 

The purpose of key person insurance is to ensure that the company can continue to operate despite anything happening to the key person. The insurance protects the business from any financial losses that are associated with the occurrence of death, illness, or accidents that prevent the key person from working. 

Even if the revenue purpose can be deducted from the company’s taxes, the following proceeds can still be taxable for revenue and capital purpose, such as:

  • Any income that would have been generated if not for the loss of a key person in the business
  • The costs incurred with recruiting, hiring, and training a replacement
  • Payment of debts and outstanding balances that the key person guaranteed
  • Compensation for the loss of goodwill
  • Payment of business loans
  • Protection against the loss of a major supplier

What Is the Difference Between Revenue Purpose and Capital Purpose?

The difference between revenue and capital purpose is what the insurance is designed to cover. Revenue purpose is designed to cover the loss of revenue that would occur without a key person, while capital purpose is designed to offset capital losses to the business. 

There are two categories of loss, and key person insurance can compensate them, depending on the purpose. Taxation and tax deductibility of premiums for key person assurance also depends on the purpose. 

It may seem a little complicated at first, but you will understand how taxation works once you know the main difference between revenue and capital purpose. 

Revenue Purpose for Key Person Insurance 

A revenue purpose protects the business against the loss of revenue. If the absence of the key person affects the revenue and increases the cost of operations, if something very unfortunate happens to them, the purpose of your key person insurance should go towards revenue compensation. 

Losing a key person who makes a significant contribution that leads to the business’s profitability will definitely cause a major financial issue for a company. Still, if it happens—key person insurance with the revenue purpose can compensate you with the following:

  • Recruitment and training costs – Finding a replacement for someone valuable to the company is very challenging. Even if you can hire someone who is already an employee, it might take out a lot of resources for training them to become the next key person, and that is where most of the proceeds will go to. 
  • A decline in sales and profits – Losing a key person who is responsible for most of the sales and profits will definitely cause a sudden decline, and key person insurance will ensure and compensate the company for the potential losses that come with losing the key person.
  • Bad debts that the key person guarantees to address – If a key person guarantees a third-party supplier to pay specific debts, the key person insurance will ensure that those debts will be paid off, even with the absence of the key person.

    Although key person insurance with revenue purposes is tax deductible—the compensations and insurance proceeds are still taxable. 

Capital Purpose for Key Person Insurance 

The capital purpose protects the business through the provision of capital if the company loses the key person who greatly contributes to the business’ capital value. Losing a key person in a business can adversely affect the capital value of a business, and the insurance proceeds are used to stabilise the business.

Unlike the proceeds for revenue purposes, the proceeds of the key person insurance for capital purposes are taxable. Here is a list of where the proceeds can be allocated for capital purposes:

  • Goodwill – Sometimes people do business with a company because of the attractive force that the key person brings to the table. Losing that person will definitely cause a decline in sales because of the person’s unique skills, knowledge, and overall personality. Because the person adds value to the company, it can directly affect the goodwill associated with the business. 
  • Loan accounts and other debts – If the lost key person loaned money for the business’ capital, the loan can be repaid through insurance.
  • Credit standing – Some businesses have that key person who can secure a loan because they add value to the credit standing of a company. If losing that person affects the credit standing of a company, the key person insurance will give the company an alternative source of funds to credit what the key person guarantees. 

Dual Purpose for Key Person Insurance

A third option is obtaining separate policies for revenue and capital purpose to cover all the company’s needs. The tax-deductibility of a key person insurance policy is determined by the type of policy it is. The benefits of a revenue key person insurance policy are taxed while those of a capital policy are not. 

Neither is subject to capital gains tax unless the benefits are not paid to the policy owner. Dual purpose insurance will also change depending on if the person in question suffers from TPD or trauma, or if they pass away. 

Who Should Own a Key Person Insurance Policy?

If the key person in question is an employee of a business, then the policy would be owned by their employer. However, if the key person is the company principal of a one person business, the key person insurance is held by their spouse, or by the company’s policy itself.

Key person insurance is slightly different when it comes to sole traders. Key person insurance is often held by the person’s spouse for sole traders, however, it’s possible for a sole trader to hold their own key person insurance. This will depend on the sole trader’s company policy, as the company will technically no longer exist upon the death of the sole trader. 

How Are the Proceeds of Key Person Insurance Taxed?

The ATO treats the premiums as non-deductible and the proceeds as non-assessable if a life policy is involved. However, in the case of an accident or term policy—the premiums will be treated by the ATO as deductible and the proceeds as assessable. 

Depending on the case, key person insurance is taxable in Australia. And according to the Australian Taxation Office (ATO), whether the insurance purpose is for capital or revenue—the proceeds will be assessed for taxation in the process of making a claim. 

The premiums for key man insurance for revenue purposes are tax deductible, however, the insurance benefits are also taxed. Those insurance benefits for a capital key person insurance policy are not taxed, but the premiums are also non-deductible. 

Taxing proceeds differ depending on the cases. Most of the time, if a death is involved—the proceeds are non-deductible. However, if it involves an accident, all proceeds are assessable.

Capital gains tax (CGT) is not applied to the insurance benefits unless the entity receiving the payout is someone other than the policy owner, in which case CGT is applied. 

Is Key Person Insurance a Business Expense?

Since key person insurance is taken out by a business to compensate for the potential losses, it is considered a business expense. However, it is not always taxable—depending on the purpose and the assessable proceeds.

Key person insurance taken out for both revenue and capital purposes will have insurance premiums that are not tax deductible. However, the proceeds themselves from both revenue and capital key person insurance policies are classified as taxable incomes. 

Related Questions

How Much Does Key Person Insurance Cost?

Key person insurance in Australia can cost anywhere from $150 to $5000 a month, and the cost of the policy will depend on the level and type of coverage and the age, health, and occupation of the key person. A key person insurance policy for over $150,000 can cost a few hundred dollars in premiums each month. 

While this may sound steep, like any other form of insurance, it’s better to have and not need it than lose a key person in your business and not have any insurance at all. In short, if the key person is at high risk, the key person insurance will cost more, similar to life insurance.

When Would Your Business Need Key Person Life Insurance?

If your business either relies on one person that cannot easily be replaced, or you are the sole trader of your business, you should invest in Key Person Insurance as soon as possible. Sole traders should invest in KPI as the company is formed. 

Any sole trader or principal of a one person company should get key person insurance immediately. As the single working member of the company, you are inherently the key person of the business and are eligible to be covered by key person insurance.

Any business that has an indispensable key person should always think of getting key person life insurance to ensure the capital and revenue of a company. Key person insurance should be applied for as soon as a key person in the business is identified. Although some small companies may not need a policy, larger companies should think about ensuring their key personnel—especially if the loss will impact the standing of the business. 

Disclaimer:

This article is provided as general information only and does not consider your specific situation, objectives or needs. WealthVisory Private Clients makes no warranties about the ongoing completeness or accuracy of this information. It does not represent financial advice upon which any person may act. Implementation and suitability requires a detailed analysis of your specific circumstances.

Matthew Rutter, Director/Head Financial Advisor of WVPC

Matthew has a wide ranging background in business, finance, taxation and accounting with over 25
years’ experience, firstly as an Accountant before becoming a Financial Planner. Matthew has been in
the Financial Planning Industry since March 1998 and has been the principal of his own financial
planning practice since 2003.

Matthew has studied a Bachelor of Commerce degree from Newcastle University majoring in Financial
Accounting and the Diploma of Financial Planning from Deakin University. Matthew is a Registered Tax
Agent and is a member of the National Tax & Accountants Association (NTAA).

Matthew has particular expertise in the areas of retirement planning, superannuation, investments and
insurance. His emphasis is on building a professional, integral and lasting relationship with clients with
the objective of assisting them to achieve their financial and lifestyle goals.

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