Have I effectively tax structured my life insurance and income protection insurance policies?
Life insurance and income protection insurance is a significant component of the succession plan for many family businesses around Perth. And the tax structuring of life, trauma and income protection is a key impact when trying to determine the after-tax cost.
Sadly, the tax position around insurance policies and the tax outcome of their payout is not always clear.
The general concept of personal vs business tax deductions
The ability to claim a tax deduction for a person is much more limited than it is for a business.
The tax deduction for a person requires that the expense is incurred in gaining or producing assessable income.
The tax deduction for a business is that the expense was necessarily incurred in the course of carrying on a business for the purpose of gaining or producing assessable income.
The difference is subtle, and the end result is that a business has a greater ability to claim tax deductions than a person can.
How tax deductions relate to life insurance
So, in order to understand how tax deductions can work for insurance, we need to look through the payment to understand the nature of the benefit sought.
If a person makes a payment for life insurance, the life insurance, when ultimately paid, will not be taxable income.
If the law had the capacity to make life insurance payments taxable as a capital gain: the tax legislation expressly excludes these types of payments as a taxable capital gain (s118-300 1997 Tax Act).
So as the payment of life insurance, on eventual payment, does not create taxable income: the payment for life insurance is not incurred in gaining taxable income. So, life insurance paid by an individual is not tax deductible.
How to make life insurance payments tax deductible
Of course with tax advisory, nothing is straight forward. There is always an exception. So for life insurance, we can make life insurance through super tax deductible.
A superannuation fund can claim a tax deduction for life insurance policies (295-465 1997 Tax Act).
So while a person is not able to claim a tax deduction on life insurance proceeds, they might be able to enjoy the same effect by making tax concessional contributions to their superannuation fund.
John, who lives in Northbridge, earns $125k and pays $10k a year in insurance and he contributes $11,875 to his superannuation fund.
The taxable income of John is $125,000 so he pays a tax of $36,242. So after tax and after the life insurance is paid John has $78,758.
If John salary sacrificed an extra $10k to his SMSF he would now earn $115,000 from his employer. The SMSF would have more income with an equal tax deduction for life insurance.
The taxable income of John is now $115,000 and he incurs $32,192 in tax as a result. There is no insurance to pay personally as it is paid by the superannuation fund.
So the net outcome to John, by salary sacrificing his life insurance is that he has $82,808 available to spend.
The competent tax advice on structuring the life insurance, coupled together with the product advice from the life insurance company has resulted in an extra $4,230 a year for John.
Traps for the unwary in tax structuring life insurance
If your life insurance policy is paid the proceeds will go to your superannuation fund. And if the superannuation fund then passes on your superannuation balance (as you are deceased) the net proceeds can go to your spouse or your under 18 children tax-free.
If the proceeds of your life insurance (via super) go to your adult children, there might be tax payable to the superannuation fund.
Further, if you are already contributing the maximum monies you can to your superannuation fund the tax effectiveness of this strategy is not as great – you cannot reduce your taxable income for the life insurance.
Also, some insurance companies might charge more for life insurance via a superannuation fund. So it is always prudent to talk to your life insurance company (or the insurance broker) about the cost implications of structuring your life insurance policy tax effectively.
Tax structuring for income protection insurance tax deductions
If you are structuring a policy of income protection to claiming income protection on tax, you have an easier proposition. The payment from an income protection insurance policy will give rise to taxable income (the monthly payment is ongoing and replaces lost income).
As the policy payments are directly related to the production of taxable income the payments themselves become tax deductible. They are incurred in the course of gaining taxable income.
Some insurance policies cover a range of benefits payable. So the insurance company should provide a statement indicating what portion of the payment relates to what outcome in the event of an insurance claim.
So even if you choose to salary sacrifice your income protection policies the net outcome will be the same. Of course, the ongoing paperwork might be easier if your employer pays for your income protection policy.
How tax structuring can make keyman policies tax deductible
A business will often have life insurance policies for key staff members. And the concept is to give the business a cash payment so that the business can afford to employ new staff (recruitment agents) and pay for expenses associated with inducting the new staff member.
Again the purpose of keyman insurance is important.
If the Keyman insurance policy is to help find a suitable replacement, cover wages for temporary labour hire company and to replace lost income for the death of a key staff member: the insurance policy is covering the replacement of tax-deductible items. So the insurance policy payment will also be tax assessable.
So a Keyman insurance policy paid for by a business will be tax deductible in those instances.
However, if a keyman insurance policy is to repay a loan, buyout a shareholder, or to buy a business to replace goodwill: the purpose of the insurance policy is capital in nature. As such the payment for that policy will also be capital in nature.
Generally, the insurance payment for a lost employee is considered capital in nature (Taxation Ruling 155). However, if the intention is to replace lost revenue items such a policy will then be tax deductible (TD 95/42).
An objective review of the facts is necessary to understand the purpose. However, a good example of the purpose could be found in the director’s minutes.
The increasing cost of life insurance, keyman insurance and income protection insurance across the family group is impacting business families with their succession planning. So independent advice from a tax professional as part of the overall succession plan is a critical step for a family in business.
The overarching succession and transition of wealth are of critical importance. Poor tax advice (or no tax advice) provided only to create a net lower immediate insurance cost can result in significantly higher tax outcomes later.
If this advice is coupled with good insurance products promoted by a financial planner, great after-tax outcomes can be achieved. In this instance, an independent advisor for tax advisory and an independent financial planner can collaboratively achieve more than what can be done individually.