Many employers will take out some form of insurance cover that will pay out in the unfortunate event of the death of an employee. This could be a policy where the proceeds of a claim will be paid to the employee’s family or whoever the employee nominates (death in service payments), or one which pays the employer to cover the financial impact on the business of losing a key employee (key person insurance).

The tax rules for death in service payments and key person insurance will vary depending on how the policy is set up. In owner managed businesses, the company might also pay for policies set up for the directors or their families personally.

Death in service payments

A death in service scheme is typically set up as a relevant life policy and the premiums paid each year are normally tax deductible for the employer.

The premiums are generally not assessed on the employee as a benefit in kind. The combination of being tax deductible for the employer and not taxable for the employee can make a death in service scheme a popular addition to an employee’s remuneration package.

It was originally unclear how lump sum payments under these schemes would be treated after April 2027, when the Inheritance Tax rules are due to change to include pension funds in death estates. It was feared that the lump sum payments could be subject to Inheritance Tax depending on how the scheme was set up. But HMRC have now confirmed that lump sum payments under death in service schemes will not be subject to the new Inheritance Tax rules, which is welcome news.

Key person insurance

This type of insurance is typically taken out where there are directors or employees who would be classed as ‘key personnel’ and their death or long-term absence due to accident, injury or critical illness would have a significant impact on the business. These policies tend to either pay out a single payment on death to settle loan finance or provide ongoing payments to support the business following the death or long term absence of the key person.

The nature of the insurance will impact both the tax relief for the employer on the premiums and the tax treatment in the event of a claim.

For policy premiums, if the key person insurance is intended to make good the loss of trading income, the premiums paid should be tax deductible from the employer’s trading profits if certain conditions are met. If the insurance is to cover the settlement of a liability such as loan finance, the premiums would not be an allowable deduction from the employer’s trading profits.

Where a claim is made, the starting point is whether the policy premiums met the conditions for tax relief. Where they did, the proceeds of the claim will normally be taxable on receipt. But there may be other deductible costs, such as the salary costs of replacement staff, that could be offset against the taxable proceeds.

If the policy premiums did not meet the conditions for tax relief, the proceeds of the claim would generally not be taxable on the employer. There could be a temptation to disallow all key person insurance premiums in the employer’s tax computation, but the key issue is whether the conditions are met as opposed to whether the employer actually claimed tax relief on the premiums. Disallowing premiums that are actually allowable would not, by itself, change the tax treatment of any future claim.

As key person insurance is for the employer’s benefit, there should be no employment tax issues for the employee as any proceeds on a claim are paid to the employer.

Payments to a director’s or connected person’s personal policy

In owner managed businesses, the company might pay the policy premiums for life insurance taken out by a director personally. Where this happens, the premiums should be treated as a benefit in kind on Form P11D (or via payroll from April 2027) and subject to Class 1 National Insurance via the payroll.

It can sometimes be unclear who the policyholder is, so for any new policies it is worth checking the policy documentation to make sure the correct tax treatment is followed.

Importance of financial advice

Aside from the tax rules on life insurance policies, it is important to take appropriate financial advice and an independent financial adviser would be best placed to assist with this.

This article reflects the position at the date of publication. If you are reading this at a later date you are advised to check that that position has not changed in the time since. 

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