Setting up your own business, and saying no to the security and comfort that the proverbial 9 to 5 job can provide takes tremendous courage! On such a journey only hard work is inevitable, while the future is always unpredictable.
However, for those who can pull it off, the entrepreneurial lifestyle is not without its compensations. Aspiring entrepreneurs dream of the flexibility that comes from picking their own hours, the freedom of being their own boss, and the satisfaction of seeing a long-cherished vision coming to fruition.
One less glamorous but equally practical benefit of having your own business concerns taxation, more specifically the exemptions enjoyed by business owners from taxation or the need to pay national insurance contributions on any transaction that qualifies ‘solely and exclusively’ as a business expense. Which transactions can and which cannot qualify for these deductions is an open question.
What is a business expense?
Some common examples of legitimate business expenses include the hiring and training of staff, the renting of office space, and the purchasing of capital resources such as equipment.
In some cases, the line between the personal and professional can appear blurred, for example; the issue of life insurance.
On the one hand, it could be argued that since: ‘life’ encompasses a wide range of interests external to your business, life insurance should not qualify as an expense: ‘solely and exclusively’ in the interests of your business.
On the other hand, some might reasonably suggest that life is fundamental to the survival and success of any business. How can a business survive if those who manage it don’t? British tax law is quite generous in its definitions of life insurance as a business expense. Currently, there are 3 forms of life insurance that are tax-deductible.
Death in service
Often favoured by larger enterprises, the death in service benefit tends to come packaged as one of several perks and privileges intended to incentivise employees.
In the majority of cases moreover, the benefit is presented as one aspect of a company’s pension scheme to which employees can subscribe. Unlike key person or relevant life insurance, which aim to protect a company against the financial costs resulting from the death or critical illness of a key employee in the event of Key Person insurance and Relevant life assurance which is effectively a version of single life death in service benefit is designed to provide financial relief for that employee’s family or close personal relations.
To preserve the benefit from inheritance tax a company often places the money in trust, with the payment being authorised only after the death of the person concerned. Though the employer must pay the premiums on this insurance, they can treat these payments as business expenses, and therefore won’t have to factor in corporation tax or national insurance obligations.
Typically a payment of the death in service benefit amounts to a multiple of the deceased person’s income: (usually a multiple of between 2 and 4-fold), and is conferred on their next of kin, or to someone previously specified by the deceased person in a ‘nomination of benefits letter.’
In some cases, the transfer of money is managed by trustees, who are often able to make a better-informed decision as to who should receive it by factoring in recent developments in the employee’s life such as a marriage or separation.
The employee need not have died at their place of work or while performing activities relating to their job, instead remaining eligible for cover under any circumstance so long as they remain an employee of the company that provides it.
Often, people choose to take out traditional life insurance policies in addition to the death in service benefit. Though life insurance is not kept in trust and so is subject to inheritance tax as part of a deceased person’s estate.
Relevant life insurance
Premiums on relevant life insurance are also tax-deductible since they are owned and paid as a business expense by directors on their employee’s behalf.
So-called ‘micro businesses’ – which are classified as businesses hiring fewer than 9 staff members – comprised 95% of the UK’s business community in 2021. Such companies usually lack the spending power to invest in company-wide insurance schemes and instead favour relevant insurance as a tax-efficient means of securing themselves against the loss of key employees.
Unlike death in service insurance, relevant insurance is ‘portable,’ meaning that employees can retain their cover even if they decide to move to a new company. Generally, the amount of cover is calculated as a multiple of an applicant’s annual income, meaning their salary combined with any dividend drawdowns.
The maximum amount of cover that one can obtain is between 15 and 30 times their annual income, although the cap on this multiplier is inversely correlated with an employee’s age. In other words, while someone in their thirties might hope to obtain 30 times their income as part of their policy, a worker in their sixties is unlikely to obtain half this much. Cover stops altogether for employees over the age of 75.
Certain businesses such as sole traders who by definition have no employer, or certain employees, such as non-UK nationals are not eligible to claim relevant life cover.
This form of insurance also offers an advantage to higher earners with regard to pensions. If a high-earning recipient of the death in service benefit dies, and if the money due to them, once combined with the cumulative value of their pension exceeds the lifetime allowance: (currently set at £1,073,100) a punishing 55% tax penalty is administered. By contrast, relevant insurance is not in any way associated with an individual’s pensions and so does not incur this risk.
Directors and other high-ranking employees can claim tax on this type of insurance, although no surrender value or investment element can exist in such cases according to HMRC rules. Thanks to the savings they make on corporation tax and national insurance contributions, companies can expect to save as much as 50% in tax from adopting relevant life insurance policies. What’s more, since April 2006 employees have been exempted from having to pay income tax on relevant insurance.
‘52% of businesses would cease trading in under a year if a key person died or became critically ill*’
*Source: Legal and General SME Report 6th Edition. 2018
Key person insurance
A recent study conducted by the UK’s largest provider of ‘life assurance products’ Legal and general found that for half of the businesses they spoke to, the death of a single key employee would be fatal to their prospects. The Key man or Key Person insurance is especially vital for micro or other smaller businesses. Such companies tend to be more susceptible to the loss of a vital employee such as a founder, a key strategist, or someone trained to perform a highly specialised function.
A lump sum is paid directly to a company on the death of an employee or group of employees. The money is meant to help the company handle any costs stemming from the tragedy, for example, those involved in hiring a replacement, and in ameliorating any interim loss in profits that not having that employee or employees around would cause.
Key person insurance is also sometimes used for the repaying of any outstanding loans against the deceased person, meaning that some banks require a borrower to take out a key person policy before their request for a loan can be approved.
In addition to death, key person insurance can cover critical illness or a serious long-term disability which prevents an employee from performing their work, though what qualifies for a payout in this regard is seen differently by different insurance providers. As with relevant life insurance, the premiums on key person insurance are calculated with reference to an individual’s age health and lifestyle, and are paid on that individual’s behalf by the business.
Dating back to the stipulations of the then chancellor John Anderson in 1944, the key person criteria is notoriously complex. Claimants must for example prove that any insurance money granted will go ‘wholly and exclusively’ toward the running of their business. For this reason, major shareholders are ineligible, since in such cases the insurance might have the ulterior consequence of benefitting a deceased person’s shares or estate. Generally, a 5% share in a company is seen as a threshold, above which successfully obtaining a key person becomes very difficult. Unlike relevant insurance, key person is a ‘term’ insurance, meaning that employees can only benefit from it while working for the business that initially provided the cover.
Key person insurance is usually a tax-deductible business expense as long as all the other eligibility criteria are met.
Taxation is a highly dynamic field, and it’s always best to double-check with a specialist advisor before making any major insurance-related decisions. However, the options available at present mean that no matter the size or financial worth of your business, you will likely find a viable way of claiming life insurance as a business expense, and thus make some major savings in terms of tax.
Speak to a specialist life insurance advisor today and get the right cover for your circumstances today!