Can key person insurance proceeds be used for any business purpose?

Key person insurance proceeds should be used for the purpose documented at policy inception. Using capital-purpose proceeds for revenue purposes, or the reverse, can trigger ATO re-characterisation and adverse tax outcomes under Taxation Ruling TR 2009/2.

This is general advice only. Engage a registered tax agent before redirecting proceeds away from the documented purpose.

The two permitted purpose categories

Capital-purpose proceeds are used for:

• Buying out a deceased or disabled owner's equity from their estate
• Repaying business loans or director guarantees (debt protection)
• Funding recruitment of a replacement key person (search, signing bonuses, onboarding)
• Funding business restructure or wind-down costs
• Replacing capital lost as a result of the insured event

Revenue-purpose proceeds are used for:

• Replacing lost business income
• Paying ongoing fixed business expenses (rent, utilities, non-revenue staff salaries)
• Funding interim management or locum costs
• Maintaining profitability during the transition period

The taxonomy is set by ATO Taxation Ruling TR 2009/2, which is the canonical capital-versus-revenue framework for Key Person cover. TR 2003/9 (life insurance policies), TD 94/35 (buy/sell premiums), TR 95/35 (IP premiums), and TR 85/36 (insurance proceed receipts) are supporting rulings.

Tax consequence by category

| Category | Premium deductibility | Proceeds assessability | |----------|------------------------|------------------------| | Capital | Not deductible under ITAA 1997 s8-1 | Generally not assessable; CGT exemption under ITAA 1997 s118-37(1)(a) for original beneficial owner | | Revenue | Deductible under s8-1 | Assessable as ordinary income |

What happens if proceeds are misapplied

The ATO examines two facts when assessing Key Person proceeds:

1. How the premiums were treated (deductible or not deductible in prior tax returns)
2. How the proceeds are actually used at and after claim

Misalignment between the original purpose and the actual use can lead to:

• Re-characterisation of capital proceeds as assessable income
• Loss of the s118-37(1)(a) CGT exemption if proceeds are paid to a non-original-beneficial-owner
• Reopening of prior-year premium deductions if the ATO concludes the cover was always revenue purpose
• Penalties and interest for incorrect treatment

There is no statutory ban on using proceeds however the business wishes. The constraint is tax: misuse triggers re-characterisation, not contractual breach.

Practical safeguards

Four steps reduce re-characterisation risk:

• Document purpose at inception with an accountant's letter referencing TR 2009/2 and ITAA 1997 s8-1
• Mirror the purpose in premium treatment (claim or do not claim deduction consistently)
• Pay proceeds into a separate account at claim time (a "Key Person Reserve" account) so application is traceable
• Retain working papers showing application of proceeds against the documented purpose

Mixed-purpose policies

Where a single policy serves both purposes, document the apportionment in writing at inception and apply it consistently:

• Allocate premiums between capital and revenue components in the tax return
• At claim, allocate proceeds in the same ratio
• Pay each component to the appropriate account

Separate policies for separate purposes are simpler at claim and harder for the ATO to challenge. AIA's Business Safeguard Forward Underwriting (Section 8.12 of the AIA Priority Protection PDS 9 November 2025) and Acenda's Business Safeguard Option (pages 56 to 58 of the Acenda Insurance PDS 27 September 2025) both support multiple cover increases for different documented purposes.

Buy/sell and partnership-funded buyouts

Cross-owned policies (each partner owns cover on the others) maintain the s118-37(1)(a) CGT exemption cleanly because each policy owner is the original beneficial owner. Business-owned or trust-owned policies require careful drafting so the exemption survives the structure. Cross-references: TR 2003/9, TD 94/35, and Corporations Act 2001 Part 2J (transactions with related parties).