The success of any business depends on certain key personnel, for example Directors, Managers of even technical staff with specialized skills. The premature death, disability or severe illness of any of these persons, can have a detrimental financial effect to the business and endanger the continuation of the business. For specifically this reason, an instrument was created to protect the business and to compensate it for the loss suffered due to the premature death of these key individuals. This instrument is referred to as key person insurance, or keyman insurance.
HOW DOES KEYMAN INSURANCE WORK?
1. Types of policies
1.1 Company owned Policy for the benefit of the Company in the event of the premature death, disability or severe illness of a manager or other employee:
An employer (company) identifies a specific individual in his workplace who he is of the opinion is vital to his business and that the business will suffer a loss in the event that anything happens to this individual, being it an untimely death, or a disability or severe illness that has the effect that the individual cannot perform his / her duties anymore. Once this person has been identified (more than one person can be identified), the employer takes out a life insurance policy on the life of that person. The employer:
1.1.1 Is the owner of that the policy;
1.1.2 Pays the monthly premiums on the policy;
1.1.3 Is the beneficiary of the policy.
In the event of the premature death, disability or severe illness of the person, the proceeds of the policy is then paid to the employer.
These proceeds will be available to protect existing credit facilities, to replace the employee, promote another employee, recruit another skilled employee or train an existing employee to increase his field of specialization. The proceeds must be used for the purpose it is meant for, i.e. to benefit the business in the event of the person’s death, disability or severe illness.
1.2 Company owned Policy for the benefit of the Company in the event of the premature death, disability or severe illness of a Director of a Company / Member of a Close Corporation / Partner in a Partnership:
The premature death, disability or severe illness of any of the abovementioned persons, will have a detrimental effect on the value of the company in more than one way:
1.2.1 The Director’s position needs to be filled;
1.2.2 The value of the Shareholding / Member’s Interest can decrease;
1.2.3 The Shares of the Director will form part of his deceased estate in the event of his death, and the heir of the shares will not necessarily have the necessary skills to benefit the business, or will not want the shares and sell it (or the executor of the deceased estate will sell it) to a third party who is unknown to the other Director’s or to the type of business.
In order to compensate the Company for any of the above, the Company takes out a life insurance policy on the life of that Director. In the event of the disability or severe illness, the Company will use the proceeds to purchase the shares from the Director, and in the event of his death, the Company will purchase the shares from his deceased estate or heirs.
2. Tax implications of keyman policies
2.1 Income Tax payable by the COMPANY
2.1.1 Premiums payable
Section 11(w)(ii) of the Income Tax Act, Act 58 of 1962 (hereinafter referred to as the “Income Tax Act”) allows a deduction where the premium is not included in the gross income of the employee / director if the following requirements are met:
(aa) the Company is insured against any loss due to death, disability, severe illness of a director or an employee of the Company; and
(bb) the policy is a pure risk policy with no cash/surrender value; and
(cc) the Company, and no other person, is the owner of the policy at the time of the payment of the premiums (is the policy is ceded as security it does not change ownership status and the deduction will still be allowed).
If all the requirements above are met, then the tax payer has a choice, under (dd), regarding the deductibility status of the premium.
(dd) In respect of a policy entered into:
(A) on or after 1 March 2012, the policy agreement states that this paragraph applies in respect of premiums payable under the policy, or
(B) before 1 March 2012, it is stated in an addendum to the policy agreement by no later than 31 August 2012 that this paragraph applies in respect of premiums payable under the policy.
Therefore, if the requirements in terms of paragraphs (aa), (bb) and (cc) are met, and the Company elects to have the premiums deducted in the circumstances as set out in paragraph (dd), the premiums will be deductible for Income Tax purposes. In the event that the election does not take place, the premiums are not deductible.
From 1 March 2012, paragraph (m) of the definition of “gross income” in the Income Tax Act, includes in the gross income of the company, the proceeds of policies owned by the company and that are received by the company. This policy must relate to the death, disablement or severe illness of an employee or director of the company. The proceeds will form part of the gross income whether the premiums are deductible or not. However, if the premiums were not deductible under Section 11(w)(ii) as from 1 March 2012, then the proceeds will have a full exemption under Section 10(1)(gH) of the Income Tax Act.
Therefore, the proceed received by the company will be included in the company’s gross income, but if the premiums were not deductible for Income Tax purposes, the proceeds will be exempt and listed under “exemptions” in the Income Tax calculation.
2.2 Estate Duty payable by the DECEASED ESTATE upon the death of the employee / director
2.2.1 Deemed Property
In terms of Section 3(3)(a) of the Estate Duty Act, Act 45 of 1955 (hereinafter referred to as the “Estate Duty Act”), included as deemed property any life insurance policy on the life of the deceased, irrespective of who the owner of the policy was or who paid the premiums. The policy is included in the deemed property of the deceased if the following requirements are met:
126.96.36.199 the policy must have been on the life of the deceased;
188.8.131.52 the policy must be a “domestic policy”; and
184.108.40.206 there must be an amount due and recoverable under the policy in the event of the death of the deceased.
The FULL proceeds are not included as deemed property in all estates. Where the policy proceeds are not recoverable by the estate, but by the company, and the company also paid the premiums, only the amount by which the proceeds exceeds the total premiums paid plus 6% compound interest thereon, is deemed to be property. For example, if the proceeds is R150,000.00. The premiums paid were R10,000.00 per annum for five years (R50,000.00). The premiums paid plus 6% compound interest is equal to an amount of R59,753.00. The amount included as deemed property is R150,000.00 – R59,753.00 = R90,247.00.
Section 3(3)(a)(ii) of the Estate Duty Act contains an estate duty exemption to these policies. If the following requirements are met, the policy is exempt and therefore is NOT included in the deemed property of the deceased at all:
220.127.116.11 the policy was not effected by or at the instance of the deceased;
18.104.22.168 no premium was paid or borne by the deceased;
22.214.171.124 no amount due or recoverable under the policy has been or will be paid into the estate of the deceased; and
126.96.36.199 o amount has been or will be paid to, or utilised for the benefit of, any relative of the deceased or any person wholly or partly dependant for maintenance upon the deceased or any company that was at any time a family company of the deceased.
Therefore, if the company was not a family company, i.e. a company which was at any time controlled or capable of being controlled:
(a) through a majority of shares; or
(b) any other interest therein; or
(c) in any manner whatsoever by the deceased;
(d) or by him/her and one or more of his/her relatives;
and the company owned the policy, paid for the premiums and it was taken out on the life of the deceased, the policy will be exempted in terms of Section 3(3)(a)(ii).
2.3 Capital Gains Tax
In terms of Paragraph 55 of the Eighth Schedule to the Income Tax Act, the proceeds of these policies are exempt from Capital Gains Tax in the following instances:
2.3.1 Paragraph 55(1)(a)(i): where the person is the original beneficial owner of the policy;
2.3.2 Paragraph 55(1)(b) – where the person, whose life is insured, is or was an employee or director and any premiums paid by the person’s employer were deducted in terms of Section 11(w) of the Income Tax Act;
2.3.3 Paragraph 55(1)(e) – where the policy is a risk policy with no cash or surrender value;
2.3.4 Paragraph 55(1)(f) – where the policy’s proceeds are exempt from Income Tax under Section 10(1)(gH).
The South African Financial Planning Handbook, Chapter 40
Business Insurance: understanding the tax implications – Sanlam
Income Tax Act, Act 58 of 1962
Estate Duty Act, Act 45 of 1955
By Suné Smit (B.Comm (Law), LL.B, AIPSA Ins. Law, Dipl. Fin. Plan.)