This presentation covers the sort of protection your business clients might need, and some of the more advanced technical aspects you need to consider when advising them.
We hear a lot about business protection these days, but what is it? It’s about protecting businesses against the financial effects of losing a key member of their team, either through illness or death. We shall cover the three main risks: loss of profits protecting loans and ensuring that control of the business stays in the right hands.
This area of insurance covers a number of different potential clients – companies and the individuals who control them. The companies covered tend to be more the small to medium sized organisations who would suffer the worst, so need protection the most, but some large businesses need the cover too. The business is covered by key person or loan cover. Individual business people also need cover, to ensure that their family gets the value of their share if they fall ill or die.
We’re going to look at a fictional but typical smaller company, MJE Technology Ltd. It’s owned by three minority shareholders, Brian, David and Peter. We’ll follow their fortunes, looking at how different events would affect them and their company. The company has about 50 employees, and has grown rapidly. The expansion looks set to continue. What would happen to the company if one of the directors died?
This table shows the likelihood of it happening to an organisation. For example, if they have four directors in their early 40s, there is a 26% chance of one of them dying before they are 65.
None of us likes to think about getting seriously ill or dying, and businesses are no exception. They don’t plan for who will take over, and a smooth transition, and they don’t give sufficient consideration to the financial effects of losing a key member of their team. How many of you have thought about your own business in these terms? And how would it fare if you were suddenly not there any more?
The effects could be devastating. The bank may call in loans, or refuse to extend them Changes in leadership may lead to a drop in productivity and, thus, cash flow problems and loss of profits. Creditors may re-think payment arrangements Customers may no longer wish to deal with the company when a valued contact is no longer around A reduced management ream will put the remaining executives under stress They will have to find a replacement for the key person, and in the meantime the rest of the team will have to work harder than ever to keep the company going, while grieving for the loss of a colleague and friend.
And it’s not just the business that will be affected. Their family will have lost a partner and parent, and its income may change drastically.
The statistics on companies without adequate cover show how big a potential market this is.
I’d like to start with key person cover.
It protects the company against loss of profits if a key person is absent. Of course, companies change over time, so the cover needs to be flexible: Easily change when someone leaves New people join as the business grows Increase cover as key person’s value increases
Generally, the most insured key person is the managing director. But there may be several other people in the team whose absence would cause the company serious problems. You need to encourage clients to think ‘outside the box’ about the effects of illness/death of senior personnel. In the case of MJE, they probably need cover for Brian, David and Peter.
Let’s now look in detail at how key person cover is set up. The policyholder or owner is the company, and the policy is set up for its benefit. The life assured for each policy is the key person, but they don’t benefit from it. When a claim is made, the benefits are paid to the company. Key person cover should not be written in trust. If tax relief is taken on the premiums, there may be a liability to corporation tax on any benefits paid. There is never any tax implication for the key person.
For keyman and loan cover, the business is the owner of the policy, and it’s very straightforward. However, for partnerships, things can get more complicated. Unlike limited companies, many partnerships are not legal entities and cannot, therefore, own a policy.
When you’re dealing with a partnership, you can’t set it up in the same way as for a company unless it’s a limited liability partnership. One way to do it for partnerships is for the key person to take out an own life policy and write it in trust for the benefit of his or her partners. A legal agreement will ensure that any benefits are used for the intended purpose. If the premiums are paid by the partnership, they will be treated as a P11D benefit for the key person.
Business loan cover has many similarities to key person cover.
It protects the company against the loss of a key person or guarantor for the loan, and provides the funds to pay off the loan. It needs to be able to be assigned to the lender, and to be flexible for future company changes.
But it might also be very serious for their family if their home had to be sold to pay off the company’s debts.
You need to identify who in the company should be covered, and this may well turn out to be the same people as for key person cover.
Loan cover is set up in a very similar way to keyman cover – the company owns the policy, and the person who is guaranteeing the loan, or the key person, is the life assured. The benefits on claim are paid to the company. Again, the policy should not be written in trust. Because these policies are not to replace lost profits, the premiums can’t be offset against tax, and there is no implication for the benefits. Since the life assured does not benefit from the policy, there is no possibility of tax.
The final type of cover is for partners or shareholders.
This ensures that control of the company stays in the right hands, with people who want to be involved in running it. And it protects the individuals concerned against the effects of the death or illness of one of their colleagues, and ensures that their family gets the value of their share in the business.
As before, the first step is to identify all those who need cover, which is usually all the major shareholders. What would happen to MJE if Brian died? His share of the business would go to his wife, Sarah. But she has never been involved in the company, and does not wish to be. And she needs the cash value of Brian’s share to provide for her future. From David and Peter’s point of view, although they know Sarah socially, they would not want someone with her lack of business experience to be involved either in major business decisions, or in the day-to-day running of the company. Because MJE is a private company, there is no market for the shares outside the business.
When there are only two or three partners or shareholders, life of another policies are a simple way to set up the cover. Each individual takes out a policy written on the other life or lives. It does not need to be written in trust, and the policy proceeds are paid to the policyholder after a claim. There are no tax implications, and the business is not involved in the policy.
The advantages of doing it this way are: it’s simple to do, and no trusts are involved because the business is not involved, there are no tax implications for it and there are none of the potential IHT changes which there would be if a trust were used But there are some potential disadvantages: this method is less flexible if the business grows and more partners or shareholders are added. It really is not suitable for more than three people, so it’s potentially not flexible enough for businesses where there could be more lives to be covered in the future.
This is how it works for MJE, Brian is the life assured of one policy, with David and Peter as the policyholders . David is the life assured of the second policy, and Brian and Peter are the policyholders . And the third policy’s owners are Brian and David, and Peter is the life assured .
When you’re dealing with larger businesses, with more than three lives to be covered, this is how you should set up the policies. Each person had a policy on their own life, which they put in trust for the other shareholders or partners. A discretionary trust is usually used, which allows for changes to the partners or shareholders in the future. You can write all the policies in a single plan so that one person can look after all the administration of them.
So, for this type of arrangement, the person insured is both the policyholder and life assured, and the policy is written in trust. The benefits are paid to the trustees, and all the partners or shareholders at that time are potential beneficiaries of the trust. There are some potential IHT implications for this arrangement – please ask us if you would like more information about this. Since the business is not involved in the arrangement, there are no income or corporation tax implications for it The business is not involved.
Writing business protection in trust is no longer simple. The new charges introduced in 2006 and pre-owned asset tax mean that there are now far more choices to be made by you and your clients.
A discretionary business trust is still just as flexible, but now there is the possibility of IHT charges on the trust.
Using an absolute trust means that no IHT charges will be payable, but you lose the flexibility of the other trust. So a decision has to be made depending on each client’s individual circumstances.
One way to retain flexibility in the trust but avoid the IHT charges is to split the cover between several policies, under the Rysaffe principle. Each policy has its own NRB, and this drastically reduces the chance for 10-yearly or exit charges.
This example shows how it works in practice.
There are a number of benefits in using this principle …
… but you should also keep in mind that there are a number of potential disadvantages and risks.
Since pre-owned asset tax was introduced in 2004, if the Settlor is included as a potential beneficiary of the trust, tax may have to be paid each year. This situation can be avoided by excluding the Settlor as a beneficiary.
This slide shows the pros and cons of including or excluding the Settlor.
To sum up the taxation situation for these policies: You can’t normally offset the premiums against tax But the benefits are not subject to corporation or income tax. Again, clients should check with the Inland Revenue as to their particular tax situation. Pre-owned asset tax could affect these policies if the settlor is a potential beneficiary of the trust. You can ensure this does not happen by using a business trust with the settlor excluded. The only disadvantage of this is that it is then more difficult for the plan to be re-assigned to the settlor when he or she retires – you may recall that the directors of MJE wanted to do this, so they would still have cover at a time when it might be difficult to take out a new policy due to age or health. Since the 2006 budget, there are potential periodic and exit IHT charges on all trusts – we can tell you more about this on request.
A cross option agreement ensures that the benefits received by the other partners or shareholders are used for the purpose intended, and that the family can sell their shares. In the case of MJE, what happens if Brian Marsh dies? His wife Sarah gets the shares through his will , and his fellow shareholders get the death benefit of his shareholder cover. The cross option agreement ensures that Sarah will sell the shares, and David and Peter will use the money to buy them. MJE used a double option agreement, because the cover they had included life cover. In this, both parties agree to buy or sell on request. Skandia’s sample agreement also includes a single option agreement, which is used if total permanent disability is included, and ensures that the other shareholders will buy the share of the disabled person should they wish to sell. However, there is no onus on them to sell the share if they don’t want to. The claim benefits could then, for example, be used for the benefit of the company.
So, to sum up, there are three types of cover that your clients’ business might need. It might be just one type, or all three of them.
protecting your business clients Lavender Insurance is a trading style of pi financial ltd, Chartered Financial Planners, Company Number 3556277, which is authorised and regulated by the Financial Services Authority. pi financial ltd is registered in England, registered address Morfe House, Belle Vue Road, Shrewsbury, SY3 7LU.
Shareholders that survive have an option to buy ("call") the shares from the departed shareholder's representatives, and executors of the deceased shareholder have an option to sell ("put") the shares to the remaining shareholders. If the surviving directors decide that they want to buy the deceased shareholder's shares then the deceased estate must sell them. Similarly, if the shareholding is offered to the surviving shareholders then they have an obligation to buy. It could be that neither party exercises their option there is no binding sale and business property relief for inheritance tax purposes is preserved. The agreement must specify the method of valuing the shares and the time limit for exercising the options. Some life assurance companies will provide a specimen standard wording for a cross option agreement. It is still advisable for both parties to take legal advice to ensure that the agreement meets their requirements and it may be better to have a customised agreement drawn up, even if that entails higher legal fees.
the types of cover Key person cover The company Loss of profits and costs of replacing a key person against protects Business loan cover Effects of loss of a key person on its loans The company protects against Shareholder or partner protection Remaining shareholders/partners Shareholder/partner’s family Provide cash to buy shares for to
This presentation is based on Lavender Insurance interpretation of the law and HM Revenue & Customs practice as at 1 September 2010.
While this interpretation is believed to be correct, Lavender Insurance can give no guarantee in this respect.
Lavender Insurance is a trading style of pi financial ltd, Chartered Financial Planners, Company Number 3556277, which is authorised and regulated by the Financial Services Authority. pi financial ltd is registered in England, registered address Morfe House, Belle Vue Road, Shrewsbury, SY3 7LU.
If you would like further information or a chat you can contact us anytime Address 4 th Floor 12 Renfield Street Glasgow G2 5AL Telephone 0800 000 0000* Fax 0800 000 0000 Email [email_address] Lavender Insurance is a trading style of pi financial ltd, Chartered Financial Planners, Company Number 3556277, which is authorised and regulated by the Financial Services Authority. pi financial ltd is registered in England, registered address Morfe House, Belle Vue Road, Shrewsbury, SY3 7LU. * Calls to this number may not be free from all telephones