Business protection: what is it, and how can it benefit you and your business?

Small businesses form the backbone of the UK economy, with small and medium-sized enterprises (SMEs) accounting for 50% of the total revenues generated by UK businesses, and 44% of the country’s labour force*.

The COVID-19 pandemic has obviously had an impact on many businesses, with up to 80% of SMEs** suggesting their revenues are declining as a result. For most business owners, business protection should be a key consideration, especially during these unprecedented times, and this article explores some of the risks involved in running a small business, in particular the risks to key personnel.

Planning is the key to success and sustainability. Even if you have run a business for a number of years, it is still important to consider potential hurdles you may face and create contingency plans if appropriate.

Even robust plans can be undermined by events beyond your control. As well as having adequate business insurance, a business interruption plan should be drawn up setting out how the business would continue to trade in difficult circumstances.

Most businesses insure their premises and equipment, but all too often they don’t insure their people. It is important to think about how the business would cope in the event of losing a key employee due to death or serious illness.

For example, if your business partner suddenly died, would the business have to find the money to pay back loans? Unfortunately, such an event can be catastrophic for the business, but insurance can help lessen the financial impact of such events.

The majority of protection policies are based on:

• The length of time you need the insurance for
• Your age
• Your health
• The amount of cover you want
• The type of cover

You can have life cover, critical illness cover or income protection, and these can be set up for a number of reasons, which is explored in more detail later.

The price rises as the chances of dying or getting seriously ill increases (for example, if you are over a certain age, a smoker or have pre-existing health conditions).

Business protection is a complex area often involving trust and taxation issues, so it is important to get impartial independent advice to receive the right cover for you and your business.

Most small businesses have some sort of debt, be it overdrafts, loans, commercial mortgages or directors loan accounts. A significant proportion of small businesses do not have any form of insurance backing this debt. Therefore, if an owner died, or was diagnosed with a critical illness, these liabilities could become a serious issue.

Due to the fact that some small businesses struggle to secure finance, many people end up investing their own money into the company, often by taking out a mortgage on their own home. Individual directors can safeguard their own investments by setting up a director’s loan account. This is a loan to the business that has to be declared via the company’s accounts. Almost one in three business owners are unaware that these loans have to be repaid in the event of the directors death. This could leave companies with severe financial difficulties at an already difficult time.

Business loan protection policies can be set up to ensure the debt is paid off in full in the event of the life assured dying or being diagnosed with a critical illness. The outstanding debt is then repaid, taking some of the pressure off the business financially.

Many business owners do not insure key individuals who are crucial to the future success and profitability of the business. This could leave them vulnerable should vital employees become critically ill or die.

Negative effects can include:

• Loss of profits or sales
• The cost of finding and training a replacement
• Potential loss of customers and suppliers or another reason

Key person protection is a life cover policy (with a critical illness option if chosen) or an income protection policy which the business takes out, where the employee is the life assured. The business pays the premiums, and if the insured person dies or becomes seriously ill during the policy term, the policy will pay the agreed lump sum or income to the business.

Key person protection is to protect your business, so it should not be seen as a replacement for personal life cover or death in service cover. A key person is someone whose death or critical illness would cause significant financial loss to the business. Almost anyone could be seen as key, but those typically seen to be are; managing directors, marketing directors, computer specialists, sales managers, technical experts, or many others.

Business owners should consider how long it might take to replace an individual, any potential loss to the business and any costs associated with finding/training a suitable replacement. The most common methods of calculating cover are:

• Based on earnings: Typically a multiple of annual earnings plus any additional costs of training and recruitment costs if appropriate.
• Replacing profits: This method looks at an individual’s contribution to business profits. Typically, firms may insure twice the gross annual profit they generate or five times the net profit directly attributable to that person. It may help to look at an average profit over a number of years.

It may be possible to offset the cost of key person protection against your Corporation tax bill, as it can be treated as an allowable business expense if certain criteria conditions are met:

• The policy must be short-term, although there is no clear definition of short term, generally five years would be acceptable (although it is possible to add a renewal option to extend)
• The policy must cover an expected loss of profits
• The policy must be for an employee (with a shareholding of less than 5% if a shareholder)

However, if corporation tax relief has been applied on the premiums, any pay-out after your claim is likely to be treated as a trading receipt and potentially subject to corporation tax.

The loss of an owner or partner can cause numerous problems, and such a loss can have a devastating effect on the business. When an owner or partner dies, their share of the business will generally pass to their family, which could leave the remaining owners or partners in a difficult situation. Some family members may be happy to act as a silent partner, some may prefer to take more of an active role, and some may just prefer to have the monetary value of the share of the business. The question is, will they be able to raise the funds to do this? This is how the shareholder agreement or partnership agreement, and shareholder or partnership protection can help.

The most common form of agreement is a cross option (or double option) agreement. This gives the surviving owners the option of buying the deceased owners share of the business, and the relatives the option to sell.  As this is an option, and does not happen automatically, it is the most efficient method from an inheritance tax perspective.

Each owner takes out a life cover policy (with a critical illness option if appropriate) equal to the value of their shares in the business, and written in trust for the benefit of the other business owners. The owners can choose to pay for their own premiums, or the business can pay on their behalf (subject to a benefit in kind tax implication). It is advisable to equalise the payments of these premiums in order to ensure the transaction is commercial in the eyes of HMRC.

It is important to try and get an accurate valuation of the business to ensure that cover is set at an appropriate level. An accountant may be able to help with an estimate of the businesses value, or a professional valuation can be sought. The most important thing to do is to review your insurance regularly as business values can change, and the cover may need to be altered as a result.

Relevant life cover is an insurance policy that is paid for by the business to cover directors or employees. The policy would pay a lump sum to the individual’s family in the event of their death. Many larger companies set up death in-service benefits for their employees, and relevant life cover can offer a more cost-effective solution for smaller companies.

Relevant life cover is one of the most tax efficient ways of providing personal cover through your company:

• The premiums are paid for by the company and they are usually classed as an allowable business expense, so can be offset against corporation tax
• The policy is in trust so there are no IHT implications on pay-out
• There is no benefit in kind tax implications for the employee
• The policy is separate from pension contributions, so could offer significant benefits to those who are worried about exceeding their lifetime allowance and paying additional tax charges

More than half of all small businesses in the UK do not have any type of business protection insurance in place. Some may have already looked at the risks they face, priced insurance products available and decided that, for some reason, this is not for them. However, most small business owners either have not considered the potential risks of an owner or partner falling critically ill or dying or have assumed there is little that they can do about it, and this could be a major oversight.

If this sounds like you or your business, maybe now is the time to take a moment away from your day-to-day issues and consider some of the longer-term challenges that you may face. The first step is to speak to a qualified financial adviser who will be able to provide you with tailored information, appropriate to your individual circumstances. Once you have all the facts you then will be able to decide whether you require any additional insurance policies in order to safeguard the future of your business, your employees and your family.

If you would like to get in touch with me or one of my colleagues to discuss this area further, please do not hesitate to contact us on 0117 450 1300.

Sources

*UK Department for Business, Energy & Industrial Strategy, gov.uk

**McKinsey UK Small and Medium Size Enterprise Survey 11/05/2020