In recent articles, I have considered the (still) under-advised area of business insurance. The protection gap of £2.3trn is undoubtedly contributed to by the business protection gap.
The business protection gap may or may not include sole traders who need insurance to protect their family and dependants in the event of their death. On balance, sole traders are more likely to contribute to the personal protection gap. But the need for insurance for sole traders is indisputable.
Many would not count the life insurance put into effect to perform this task as keyperson insurance. An alternative view would be that a sole trader is the most key of all keypersons.
The death of a sole trader with no enduring business to continue after their death to provide financial support for their family is perhaps one of the most acute needs for cover.
There will be no cover under an employer’s scheme and state provision will be wholly inadequate. The ability to create justifiable anxiety among this category of business owner should be substantial and yet little seems to be written about it.
The required sum assured should be arrived at by determining the income and capital needs of the sole trader’s family and dependants. The trust should, of course, not be a business trust but a personal trust, most probably a flexible or discretionary trust but possibly a bare trust if the sole trader knows for sure who he wants to benefit and is happy that no change of beneficiaries an be made.
Naturally, if critical illness is added to the cover, then a split or reversionary trust could be appropriate, provided the reservation of benefit provisions can be avoided, which they usually would be with careful drafting and care taken over how the policy terms and trust provisions operate together.
Speaking of critical illness reminds me that I had occasion recently to consider the tax position if a critical illness is diagnosed and a business share purchase takes place. Obviously, I have in mind partners and shareholders. The great thing about death – taxwise that is – is that all of the deceased’s assets, including their share of or share in the business, are revalued for capital gains tax purposes. Not only that, there is no CGT payable as a result of that revaluation, regardless of who benefits from the revalued assets under the deceased’s will or intestacy. This means that a share purchase using life insurance policy proceeds following death will not usually trigger any (or much of a) CGT liability even though there will, of course, be a disposal by the personal representatives or trustees who sell the share in accordance with the (usually) double option agreement.
How about a purchase following critical illness? Regardless of whether the agreement dealing with the purchase is a double option or single option agreement, or even if there is no agreement and a sale just takes place, there is a disposal for CGT purposes. The disposer will be the business owner and he or she will not be dead. The share may be carrying a substantial gain which will be realised on sale.
I wonder whether everybody considers this when determining an appropriate level of cover to put in place to provide funds for a purchase following critical illness?
If a combined life and critical-illness policy is put in force, it is likely that the sum assured will be the same for both events. The point about CGT on sale following critical illness is that the liability could be substantial. Many businesses will have been started with little capital and value will have accrued in the holding over time.
At most, a liability of 40 per cent (reducing to 18 per cent from April 6, 2008) could arise on much of the disposal proceeds. The annual exemption, if available, could be applied and, for disposals before April 6, 2008, business assets taper relief. If this is available in respect of the whole gain, it could reduce the taxable gain by up to 75 per cent. At least two years ownership and no problems with the substantial investment rules (note of warning here for those advising private companies on investments) would usually deliver an effective 10 per cent maximum tax rate for a higher-rate taxpayer.
For disposals on or after April 6, 2008, taper relief is abolished as part of the move to tax all capital gains accruing to individuals at 18 per cent. However, a substantial liability can still arise because if the business share purchased is worth £1m and most of this is gain, up to £180,000 could be lost. It might be worth pointing this out to clients to see if the insurance arrangements, and possibly the terms of the agreement, should reflect this.
The price to be paid could be specified to be such that the amount received is sufficient to meet the CGT and leave the required net sum for purchase. An alternative would be for each owner who is party to the agreement to put in place critical-illness cover on an own-life, own-benefit basis to give the disposer enough cash to pay the CGT.