Insuring the life of a key executive can be vital for business continuity
If there is no plan to replace this key individual, the whole company could be at risk
Most small companies involve a key individual with the skills, knowledge and contacts that are key to the company's success. The question arises as to what happens if that person dies?
The risk is that if there is no plan to replace this key individual, the whole company could be at risk.
Replacing a highly skilled individual is not cheap, and normally entails poaching another skilled individual. Where will the company obtain the funds to do this?
The solution is to put in place what is known as a keyman structure. This will entail the company taking out a policy on the life of the key individual. This is the cheapest way to raise the cash to replace the key individual on their death or disability. The company will own the policy and pay the premiums. On the death or disability of the key individual, the company will receive the proceeds from the policy, which will enable it to recruit another key individual to replace the disabled or deceased one.
Avoid estate duty
As long as the requirements of the Estate Duty Act are complied with, the policy will be exempt from estate duty. To paraphrase the act, the three requirements are:
• The policy proceeds cannot, at the time of death or any time in the future, be paid into the estate of the deceased, or utilised for the benefit of any relative of the deceased or any company which was at any time a family company in relation to the deceased;
• The policy must not be taken out by or at the instance of the deceased; and
• The deceased must not have paid any premiums on such policy.
A family company in relation to the deceased is defined as "any company (other than a company whose shares are quoted on a recognised stock exchange) which at any relevant time was controlled or capable of being controlled directly or indirectly, whether through a majority of the shares thereof or any other interest therein or in any other manner whatsoever, by the deceased or by the deceased and one or more of his relatives".
As long as the company does not fall within the definition of a family company, then it is likely that the keyman policy will not be subject to estate duty.
If you are considering keyman insurance you should check with your financial adviser whether the company qualifies as a family company. If it does, estate duty will have to be catered for by increasing the value of the policy. The formula to calculate how much to increase the cover by is: amount required divided by 0.8 (assuming the deceased estate will be less than R30m).
Income tax consequences
In terms of section 11(w) of the Income Tax Act, keyman policies are one of the few types of life policy for which the company can deduct the premiums.
The requirements are:
• The person assured must be an employee or director of the company (or any other entity) and the company must be covering itself against any loss by virtue of the death/disability of the person assured;
• The policy must be a pure risk policy with no cash value;
• The policy must be owned by the company/employer; and
• The company/employer must make an election that the policy will be deductible or not. This means that the company/employer has the choice, if the policy qualifies under section 11(w) of the Income Tax Act, to decide whether to make the policy deductible.
Note that if the policy premiums were deductible, then on a policy payout the proceeds will be taxable in the company/employer's hands. Assuming the policy was owned by a company, the proceeds will then be taxed at the company tax rate of 28%.
However, if the company/employer elected upfront when the policy was taken out that it would not be a deductible one, then the policy premiums will not be deductible, but the proceeds will pay out tax-free.
This is an important decision, and you should discuss the best option with your financial adviser before the policy is taken out. In practice, most policies should be taken as nondeductible, so the proceeds can pay out tax-free. If your company owns a keyman policy, it is very important to find out whether it has a deductible or a nondeductible policy, so the company can manage the tax and premiums correctly.
A keyman structure funded by life insurance is the best way to ensure continuity of the business on the death or disability of its key individual. Sadly, I have seen many cases where there was no policy, resulting in the company not surviving.
If your business does have such a policy, ensure you check the tax and estate duty consequences with your financial adviser.
• Joffe is the head of legal services at Discovery Life.