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Tax treatment of income protection policies

 

Written by Ray Coman

 

Income protectionIncome protection is a type of insurance that pays out for long term sickness.  In general, the premiums are tax deductible for the employer and the payout is taxed via PAYE for the employee.  For private policies and those held by sole trader, the premiums are not tax deductible but compenstaion payments are not taxable.  If the business owner or contractor forms as a company, there is corporation tax relief on the income protection premium.  Income protection payments to a contractor will be treated as income.  However, as explained in the section below on Executive Income, a sharedholder/director has more scope than an employee as to the timing and nature of payments from the company.  This means income protection could be paid as dividend, salary or even capital distribution and across different tax years.

 

Insurance covers actual loss.  Assurance pays out a pre-determined benefit.  Life and sickness products are often sold as bundles.  Different products contain elements that are not mutually exclusive.  The guide below is an attempt to segregate the different types and assess their respective tax implications.  In practice, cover is often sold as a bundle of products for marketing purposes.  Common names for off-the-shelf schemes would not correspond to the categorisations attempted here to distinguish the underlying policy for tax purposes.  Health insurance, while closely related, is the topic of a further article.  Products marketed by insurers which are investment type, referred to a non-qualifying life insurance, is also the topic of a separate guide.

 

Income protection insurance

Mortgage protection

Individual policies

Group policies for income protection

Shared costs

Unincorporated businesses

Individual policies covered by employer

Executive Income

Keyman Insurance

Unemployment insurance

Capital gains tax

 

Income protection insurance

 

Personal protection insurance covers a period that the insured person has loss of income due to ill-health.  It pays out an agreed amount if a worker cannot work due to sickness or accident.  Benefits are not paid for income lost resulting from redundancy, and only for income lost due to illness or injury.

 

The insurance covers serious ill-health only and is not designed to cover for short term sick leave.  Typically, the insurance only pays if a person has been out of work for six months.  This is described as the deferment period.  Income protection was previously preferred to as Permanent Health Insurance, the latter label being more informative.  Benefit payments will typically last for a specified duration such as one year.  Pay-outs are usually dependent on medical reviews.

 

The protection is especially valuable where both risk of injury, and the resultant loss of income is higher.  This could apply to construction industry workers and sports professionals.

 

Mortgage protection

 

Some forms of the insurance are not tied to any particular debt while other will cover payments such as mortgage and/or other specified outgoings.  The tax treatment is not affected by the extent to which the payments are attached to any mortgage.

 

Individual policies

 

People without cover through their employer, or who want to top up any such cover can arrange insurance via an independent broker.  If paid by the person who is insured, the premiums are not tax deductible and the award is not taxable.  The broad principal is that premiums are paid from pay that has already been taxed.

 

Group policies for income protection

 

Employers can offer income protection cover as part of their employee benefits package.  Group cover covers the employer’s entire workforce.  Typically, other products such as life assurance, critical illness, and heath cover are included in the package.

 

Group policies are designed for larger employers.  The employer pays regular premiums to protect those staff on its scheme.  Benefits are received by the employer from the insurance company and forwarded to the insured in regular pay instalments.  The payments are passed on via payroll to provide continuity of pay.

 

The tax implications are as follows:

 

  1. Premiums are treated as a tax-deductible business expense of the employer.  The cost is deducted from profits of both companies and unincorporated businesses.
  2. Premiums are not taxable benefit in kind.  Therefore, neither employer nor employee pay national insurance on the premiums.
  3. Proceeds from a claim are treated as a taxable trading receipt.
  4. However, as the proceeds are passed on to the employee, the employer obtains tax relief on the pay-out.
  5. The payments, usually monthly, will typically be taxed via PAYE. Scheme benefits are therefore subject to both tax and national insurance. This includes employer’s national insurance.

 

Corporation tax relief overall is roughly equivalent to the cost to the business.  Schemes can be designed to cover employer’s national insurance costs.

 

Shared costs

 

The cost of insurance could be shared between employee and employer.  If not-fully funded, the employee funded part will be taxed as an individual policy.

 

That part of pay-out treated as employer for tax purposes is in proportion to that part of the premiums covered by the employer.  Benefits are taxed according to the proportion in which premiums are paid.

 

In recap, if the employee pays, premiums are taxed and the pay-out is tax exempt.  If the employer pays, the premiums are not taxed but the pay-out is treated as taxable employment earnings.

 

Unincorporated businesses

 

Income protection is available to unincorporated businesses just as it is to companies.  Group schemes, explained above, will be available for employees.

 

Plans to cover employees are taxed according to the regime for group scheme outlined above.  However, policies for business owners will be treated in the same way as individual policies.  This follows a landmark speech made in 1944 by the then Chancellor Sir John Anderson, and is sometimes referred to as Anderson

 

Since financial security during ill health is an attribute a person should want regardless of the business, it cannot be wholly and exclusively for the purpose of the business.  The principal is contentious, however the consensus for its application has followed Anderson ever since that famous speech.  Companies with only one director can obtain tax relief on premiums due to the veil of incorporation.  Small business and sole traders could consider tax benefits of insurance as a reason to place the business into a company.  This is explained below n the section about Executive Income.

 

Individual policies covered by employer

 

The following table illustrates how it would be more tax efficient to increase salary by an amount equal to the policy than to pay via group policy

 

  Individual policy Group policy
Corporation tax relief on premiums/equivalent Yes* Yes
Income tax on premiums/equivalent Yes No
Income tax on payout No Yes
Income tax relief on premiums No No
Corporation tax on proceeds No Yes

 

*To make the two scenarios equal, salary has been increased by the amount equal to the cover foregone.

 

The popularity of group policies owes more to the nature of the employer/employee relationship than it does to tax efficiency.

 

There is no ready availability of products that enable companies to pay for protection owned by the employee.  The group policy allows the employer to retain control of funds. However, for keyman insurance, the employer could pay for the employee’s premium, and have it taxed as a benefit in kind.  This has the further advantage that P11d benefits are not subject to employee’s national insurance.  This is explained in the section below.

 

Executive Income

 

This income protection plan is designed for small and medium sized business.  It offers the flexibility for insurance benefits to be retained in the business rather than passed onto employees.  Where passed onto employees, the tax regime follows that of a group policy.

 

Where retained in the business, the employer is the assured, and the employee is simply the life assured, i.e. the person against whose life the policy is written.  The tax position is neutral for an employee who does not benefit from the policy.

 

Payments of premiums are a tax-deductible expense. Any benefits received from the insurance are treated as taxable receipts for corporation tax purposes.  The company is the beneficiary.

 

The main condition for obtaining tax relief is that the term of the insurance cannot exceed the period during which the employee is useful to the company.

 

Such a scheme can be attractive to small business owners and single person limited company.  The scheme provides flexibility as to the timing and form of eventual extraction of profit from the company.  For instance, dividend structure or proceeds of a liquidation could result in less tax than PAYE.

 

Keyman Insurance

 

An employer can take out a policy in their own favour to cover loss of profits resulting from the death, sickness, disability or illness of an employee.  This is sometimes known as Keyman insurance.

 

This type of insurance is not suitable for a single person company.  Leaving the company with no business in operation is likely to invalidate the terms of the policy.

 

Unemployment insurance

 

Products exist to cover the insured usually for an unemployment period of up to 12 months.  The policies require the redundancy to be involuntary.

 

This type of insurance is not part of a standard benefits package.  The reason is partly that employers would not want to build in an incentive for an employee to leave, and partly because redundancy regulation deals with termination pay. Any redundancy payment which is contractual would be taxed as income.  By contrast, the first £30,000 of redundancy which is compensation is tax free in nature.

 

Consequently, the tax treatment of unemployment insurance is the same as that for Individual Income Protection policies.  The pay-out is not taxable where premiums are paid out of net pay.

 

A self-employed person does not have the same protection as an employee.  A sole trader or partner does not get redundancy pay, statutory sick pay, holiday pay or payment in lieu of notice.

 

Tax treatment for loss resulting from sickness, disability is explained in the section above on unincorporated businesses.  However, there is no readily available product that covers unemployment.  The nature of the employment relationship provides a framework within which to prove that an employee lost work through no fault of their own.  However, in practice, this is near impossible for the sole trader while he or she remains healthy.

 

Capital gains tax

 

Given that the surrender value of any plan is likely to less than the sum of premiums paid it is highly unlikely that the plans will be subject to capital gains tax.

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