16 minute read
Insurance
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Volume 16 Issue 01 I 2021
Structure and taxation of key person income cover
Generally, a key person income policy can only be owned by the business, and can be used to cover both key person owners and employees.
The policy may not be available to cover sole traders, however, it could be used to cover the key employees of a sole trader.
Because the purpose of key person income insurance is to protect the revenue of the business, the premiums are likely to be tax deductible and the proceeds will be assessed as income.
Business overheads cover
Business overheads cover, also known as business expenses cover, allows a business to continue to pay its fixed expenses if one of the business owners becomes sick or injured.
This type of cover pays a monthly benefit to the business, in respect of its day-to-day fixed costs, generally for up to 12 months, if the insured person is disabled and is unable to work in the business at their full capacity.
Insurance policies to cover business overheads are usually owned by the business entity, sole traders or partners (in the case of a partnership).
The premiums for business overheads policies are generally tax deductible, and the proceeds treated as assessable income to the business. Key person lump sum cover—capital protection
At some point, many businesses will borrow money from a financial institution or a director—this may be to provide a business with capital for a major purchase or improvement, or simply to provide a source of working capital.
Such loans may include: • a business overdraft • a secured loan from a bank • a loan from a director or business owner.
On death, permanent disablement, or a specified trauma event in respect of a key person, a business could experience financial difficulty and may find it hard to continue to meet all of its loan repayments—a default could result in a demand for a loan to be repaid in full. Alternatively, the lender may call in a loan if the key person was a guarantor, or was specified in the loan agreement.
The purpose of debt reduction insurance is therefore twofold: it is used to protect the business against its debts, but also to protect the guarantor and their estate against any claim over their personal assets.
Lump sum policies can also be used to protect the capital value of a business. For example, the loss of a key person could diminish the goodwill of the business or affect its credit rating. In the latter case, this could impact the ability of the business to secure credit lines or overdraft facilities. Key person insurance proceeds in these circumstances would give the business an alternative source of funding.
How much insurance is needed?
For debt reduction policies, the appropriate amount of insurance will depend both on the business owner’s requirements, and the requirements of the lender. As a first step, it is important to understand the terms and conditions of the loan contract. For example, the lender may require a personal guarantee and on the death of the guarantor (if there is no substitute), the loan may need to be repaid in full.
The business owner will also need to consider the ability of the business to continue servicing the loan upon the death or incapacity of the key person. They will need to decide whether to cover the whole loan facility, or only the amount of the facility drawn.
The availability of insurance cover, from an underwriting perspective, will normally depend on a number of factors, including the size and type of the debt, and the credit rating of those debts. It will also depend on whether the borrowers/guarantors for the loan are jointly and severally liable for the debt, and the purpose of the loan. For example, whether the loan was used to purchase a business or non-business asset.
Finally, capital gains tax (CGT) may be payable on insurance proceeds (see next section of this paper). In these circumstances, the business will need to consider grossing up the sum insured to account for this tax liability.
Where the purpose of the insurance is to protect the capital of the business, such as to pay out an outstanding loan, the premium will generally not be tax deductible and the proceeds will not be treated as assessable income. CGT may apply to the proceeds, depending on the ownership structure.
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CGT does not generally apply on term life proceeds, regardless of the ownership structure, unless ownership of the policy has previously changed and consideration was paid for that transfer (see Income Tax Assessment Act 1997 (ITAA 97) section 118-300).
CGT legislation applies differently to TPD and trauma insurance proceeds. The CGT exemption in ITAA 97 section 118-37 only exempts proceeds on such policies from CGT when those proceeds are paid to the life insured, a relative or a trust (where a beneficiary of the trust is the life insured or a relative).
A company is neither of these entities, so when a company owns and receives the proceeds from a TPD or trauma policy (and that policy is held for a capital purpose), CGT will generally apply.
To avoid this problem, it may be possible to have the TPD cover owned by the life insured themselves, and establish a legal agreement (called a debt reduction agreement), which requires the life insured to pay the proceeds of the policy to the lender on behalf of the company. In this way, the CGT proceeds are not immediately subject to CGT, however, the arrangement is not without its potential complications.
Establishing a debt reduction arrangement can create a ‘right of contribution’, which entitles the insured to be reimbursed for the amount they have paid to the lender. Removing this right can itself create separate CGT consequences.
As a separate alternative, the insurance policy could be owned by a specifically drafted trust. In this arrangement, the insured would direct the trust to pay the lender on their behalf. While it may be possible to remove CGT consequences entirely by using such trusts, these arrangements can also give rise to negative outcomes. Therefore, thorough legal and taxation advice is recommended.
Underwriting considerations
When assisting a client to apply for insurance to cover a key person for a business, underwriters will want to know the purpose of the cover, and why the amount of the insurance is required. The more information you can provide in the application, the better. There is a far greater chance that the underwriters will allow the insurance cover if they have the whole picture.
The details of the client’s business and why they want to insure a key person may be included in the statement of advice (SOA) which can then be provided to the underwriters. Otherwise, a detailed explanation will need to be provided in the financial questionnaire.
So, prior to completing the application for a client, it is best to spend some time understanding the client’s situation and their business. There needs to be an explanation as to why the cover is needed and why the insured person is, in fact, a key person.
If the insurance is for capital purpose to cover debt for instance, it may be more obvious as to why the cover is needed and how much cover is needed. If the insurance is to cover a key person for revenue purpose, the underwriters will want more information as to what role the person plays in the business, particularly if it is an employee they are looking to insure.
When considering applications, underwriters want to know the whole picture, so it may help to provide a detailed explanation which includes: • the type of business • whether the insurance is for the owner or partner of the business or an employee • what would happen to the business if the key person could no longer work in the business (either temporarily or permanently)
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Insurance
CPD Questions
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1. If the same key person needs to be insured for revenue and capital purposes:
a) Their portion of the premium for revenue protection ceases to be tax deductible b) The business cannot increase the sum insured if revenue or debt reduction needs change c) Separate policies must be used d) A single policy can be used
2. A key person income policy:
a) Can only be owned by the insured key person b) Can only be owned by the business c) Is not subject to tax on the proceeds d) Does not cover sole-trader key employees
3. According the author, key person cover in Australia typically does not address:
a) Term life b) Total and permanent disablement c) Trauma d) Temporary disablement
4. Which of the following statements regarding taxation of key person capital cover is correct?
a) If the cover is to protect business capital, the premium is generally not tax deductible b) A company is treated the same way as the life insured or a relative in terms of CGT on TPD or trauma proceeds c) Term life proceeds are always subject to CGT d) Trusts can be used to remove all CGT consequences
5. Insuring against decreased goodwill is capital-purpose key person cover.
a) True b) False
6. Insuring against increased expenses is revenue-purpose key person cover.
a) True b) False
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• why the person is a key person (e.g. they have unique skills or relationships with clients) • how long would it take to replace the key person • how easy it would be to replace the key person.
It also helps to have a good relationship with the underwriters. Before applying for the cover, it can be beneficial to speak to an underwriter to explain the client’s situation. In more complex cases, the underwriting team should be able to let you know exactly what information they need to assess an application. If the right information is not provided, additional questionnaires may be required.
How much should a key person be insured for?
The amount of insurance required will be determined by a number of factors and will depend on each scenario. However, as a guide, key person revenue cover could be calculated as: • the cost and time associated with recruiting and training a replacement person • the loss of net profit while the replacement is working towards their predecessors’ previous capabilities • the key person’s income in proportion to the net worth and profit of the business, taking into account their age and current duties.
Alternatively, the amount could be calculated based on the remuneration of the key person. For example, this may be calculated as somewhere between five to 10 times their salary for the purposes of death and TPD cover, and three to five times their salary for trauma cover.
Where it is likely that a business loan would be partially (or totally) called in, or the business would suffer a capital loss due to the death, disablement, sickness or injury of an individual, key person capital protection may be calculated based on the amount owed or the amount of goodwill which would be affected by the absence of the key person. If there are several key people in the business, then the level of cover should be apportioned between them accordingly.
Conclusion
There are a number of factors to consider when giving advice for key person insurance needs. When providing this type of insurance, it is best to know your client well and understand their business and their business needs. If you are new to providing this type of insurance advice, underwriters can assist you, so it is beneficial to have a good relationship with them. Advising clients with key person insurance needs can appear at first to be more difficult than advising on personal insurance, but it generally proves to be worthwhile. fs
BT and its related body corporates do not take any responsibility for the content of this article and reliance should not be placed on any matter without further independent research and advice.
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Retirement:
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52 Implications of renting out the family home
By Rahul Singh, Challenger
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Retirement
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CPD
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Worth a read because:
Centrelink’s assets and income tests have a bearing on renting out the family home when its owner moves into aged care. This paper examines concession and exemption eligibility, taxation implications, and Age Pension reductions in light of this situation.
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Implications of renting out the family home
Rahul Singh W hen a client moves into aged care, given that for many, a significant proportion of wealth is tied up in the family home, it is important to understand the impacts on social security and aged care means testing where the home is kept and rented out. While many clients appreciate that renting out the family home may assist with cash flow to fund ongoing aged care fees, there are many intertwined considerations such as social security and aged care means testing, tax and cash flow requirements.
This paper, through a case study, discusses some of the implications of renting out the family home, focusing on the means testing for social security and aged care and tax considerations. As there have been recent changes around the assessment of rental income from the family home, this paper is scoped for those who enter aged care for the first time on or after 1 January 2017.
Introducing Virushka
Virushka, aged 83, is single and lives by herself at home. She has been managing with informal care from her family, however, recently her memory is starting to fail with early signs of diagnosed dementia. The family agrees that with Virushka’s ‘round-the-clock’ care needs, she is best served by full-time care in an aged care facility.
Virushka’s main asset is her home, valued at $1 million, which she has lived in for the last five decades. She also has $50,000 saved up in a bank account and $10,000 in household contents.
She has entrusted her daughter, Olga, to be her enduring power of attorney. Olga seeks advice and guidance around issues relating to keeping and renting out the family home.
Before we get to the technical discussion When it comes to retaining or selling the family home, based on many conversations with advisers, there are some common themes. It is apparent that many clients usually have their minds set firmly on a particular outcome. For example, some clients are specific on their instructions for which they want advice upon selling the home, whereas others want to understand the impact of keeping the home and make a subjective decision upon understanding the relevant issues.
Some of the common themes which often come to surface are examined in the following discussion.
Keeping the family home while the aged care client is alive Faced with a lifetime of memories in the family home, clients’ families often want to keep the home for as long as their parents are alive. For many, leaving a property vacant for an extended period of time may not be palatable and, therefore, discussion often turns to renting out the family home while the parents are alive.
Appetite to be a landlord Some clients express that they do not wish to be a landlord, whereas
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others are perfectly accepting of renting out the family home. While many clients are happy to outsource the administrative aspects of being a landlord to property managers, there are those who see this as another layer of complexity in the quest for simplicity of affairs.
Recently, COVID-19 has brought about further complexity particularly relating to temporary rent-relief to tenants. For some, while leases may be secured for a fixed period of time, the potential prospect of having the property untenanted brings about further challenges. There may be an apprehension from some clients if they have never been a landlord during their lifetime, whereas those who have had experiences with renting out properties may be more accepting of renting out the family home.
Is the family home in a position to be rented out? For many clients, especially when they have lived in the family home for a relatively long time, it may have been perfectly habitable for them while they were there. Some of the common issues which are usually up for discussion include: • Is the family home suitable to be rented out to tenants? • Does the family home need renovations to make it attractive to tenants? • If renovations to the family home are required, who will fund the renovations? • Is there sufficient liquid assets to fund any improvements to the family home?
By unpacking these issues, clients start to show a specific preference in terms of keeping and renting out or selling the family home.
State of the property market Often, clients base their decision on keeping or selling the family home on their own view of the state of the property market—whether it is a good time to sell or worth waiting to pick the right time to do so.
Advisers may have constraints based on specific licensee guidelines around the framing of advice relating to retention or disposal of property.
Social security and aged care implications For many clients, retaining or maximising social security entitlements is a significant emotive and financial consideration in keeping or selling the family home. As discussed later in this paper, there is an assets test exemption for two years from a social security perspective for the family home upon vacating to move into aged care. Further, the net value of the family home, when not resided in by a protected person, is usually assessed but capped (currently $171,535) from an aged care perspective. These concessions can also a be a consideration in terms of keeping the family home.
Funding aged care fees Where most of the client’s wealth is tied up in the family home and they do not have sufficient assets to pay the advertised Refundable Accommodation Deposit (RAD), the client incurs the government-prescribed interest rate, Daily Accommodation Payment (DAP), on the unpaid RAD (currently 4.10%). Retaining the family home may come with the additional cost of having to pay the DAP, placing pressures on cash flow.
Virushka—base situation Virushka’s family sources an aged care facility with which they are really happy. The facility has an advertised RAD of $500,000. Table 1 shows her cash flow position upon entering aged care.
Table 1. Base situation cash flow position
Cash flow
Age Pension Investment income
Incidental expenses
Total
$24,552 $500 ($2,600)
$22,452
Aged care fees
Basic daily care fee Daily accommodation payment Means-tested care fee
Total
Net cash flow
Source: Challenger $19,071 $20,500 $602
$40,173
($17,721)
Rahul Singh, Challenger
Rahul Singh is a technical services manager at Challenger. He has been in the industry since 2004, commencing his career with Clearview and working in technical services teams in AMP, ANZ and MLC prior to joining Challenger in 2019. Rahul is passionate about supporting advisers to deliver technical solutions to retail clients.
