Buy/sell purpose cover can be an important component of business succession planning if a buy/sell agreement is funded, as much as possible, by life insurance.
Without an effective business succession strategy in place, business owners may find themselves working with a departing owner’s family members, who most likely cannot contribute fully to the management of a business while still drawing a full share of the profits.
Life insurance can provide a funding mechanism for owners should a co-owner depart the business due to death, terminal illness, total and permanent disability (TPD) or traumatic illness. An alternative to life-insurance funding may be a cash buy-out of the departing owner’s business interest, but this may not be possible without obtaining external or vendor finance. In either case, it is essential for business owners to enter into a written buy/sell agreement, setting out their respective obligations regarding the value and transfer of the business equity.
The choice of insurance solution for buy/sell purposes depends on the trigger events being covered. Death, terminal illness and TPD are clearly events that would warrant the departure of an owner from a business.
Trauma insurance may also be recommended in a buy/sell agreement, but some complex issues must be considered. With a trauma event, there may be some potential for the insured owner to return to work, in which case there may be no immediate need to transfer their business interest to the continuing owner/s.
For instance, the owners may elect to postpone the exercise of the option for six or 12 months after the occurrence of the trauma event or until business turnover has decreased by a certain percentage. The buy/sell agreement would need to address the criteria upon which the business interest can be sold, and the treatment of trauma proceeds if the insured does return to work. Alternatively, the agreement may include a trauma event as a compulsory exit trigger.
It is generally recommended that non-insurance trigger events (resignation, retirement, bankruptcy, criminal activity, etc.) be addressed in a separate buy/sell agreement.
Buy/sell agreements commonly use either put and call options, whereby if just one party wants the transfer of business equity to go ahead, it must proceed, or mandatory obligations with conditions precedent. Properly drafted, both these options avoid the possibility that the date of execution of a buy/sell agreement itself might constitute the date of disposal for capital gains tax (CGT) purposes, thereby triggering full CGT and stamp duty liabilities as at the date of signing of the agreement.
Level of cover
The sum insured should generally be the value of each owner’s share of the business, ideally updated on a yearly basis (or more frequently if warranted). If the business consists of two owners with an equal share of a business valued at $1 million, the sum insured on the life of each business owner would be $500,000.
Additional sums insured may also be applied for to cover stamp duty, legal fees and CGT on the equity transfer (i.e., sale). If – for reasons of limited insurability or uninsurability (due to health, age or other factors) or a shortfall of cover due to product limitations – full funding via insurance is unavailable, business owners may need to consider vendor finance or bank loan provisions (or a combination, if applicable).
Given that the ATO will most likely deem that the disposal of a business interest under a buy/sell agreement occurs at market value, it may be prudent to use current market value as the preferred valuation method. This value would need to be updated on a regular basis, for example annually.
An alternative valuation method could be to base the sums insured on the current market value of the business and either index them to inflation or by the anticipated growth rate of the business. Another option could be for the business principals to use a particular formula, reflecting either an industry standard or a method appropriate to that specific business. In this case, it would be prudent for the owners to recalculate the value using the formula, and then subjectively determine whether the outcome is realistic and acceptable.
It may be worthwhile having the business’ accountant review the valuation and confirm that it is justifiable on ordinary commercial terms, which – depending on the sums insured – may also be an underwriting requirement.
CGT and small business CGT concessions
There may be CGT payable on any net gains generated from the disposal of a CGT asset (i.e., the sale or transfer of a business) triggered by the operation of a buy/sell agreement. For business insurance purposes, it is possible to estimate this liability and have it covered by insurance.
Small businesses are eligible for CGT concessions if they satisfy the basic conditions for one or more of the CGT concessions for small business, which in some cases may reduce any capital gain to zero. Advisers should seek the advice of their clients’ accountants to establish if the clients or the potential beneficiaries of their estates currently qualify.
Certain ownership structures have tax implications depending on products chosen for buy/sell purpose cover. It is important for business owners to seek advice that is appropriate to their individual situation and objectives. Regardless of chosen structures, the implementation of a buy/sell agreement is essential. The most common policy ownership options are as follows:
Since the introduction of CGT legislation in 1985, self-ownership has been the most popular structure for owning buy/sell purpose cover, as it satisfies the CGT exemptions in sections 118-300 and 118-37 of the Income Tax Assessment Act 1997 (ITAA97) for term life, terminal illness, TPD and trauma policies. Needless to say, in the absence of a properly drafted buy/sell agreement, any insurance proceeds could be claimed as being for personal risk protection purposes.
One problem with self-ownership is where individuals do not own business assets in their own name, but use third-party owners, such as a spouse, a company or a family trust. This means that the actual vendor in a buy/sell agreement (i.e., company or trust) does not receive the insurance proceeds but is expected to sell its equity in the business following an insurance event, which may present a number of problems. In the above examples, it is preferable for the owning entity to also own the insurance policies.
Cross-ownership is where each business owner owns an insurance policy on the life of each of the other owners. Insurance proceeds are paid to the purchaser (continuing owner/s), who then pays them to the estate or departing owner in return for the transfer of the equity in the business. The proceeds of term life and terminal illness cover are exempt from CGT if there is no change in original policy ownership (s118-300 ITAA97). If the proceeds are paid as a TPD or trauma benefit, they are CGT exempt only if paid to the life insured’s spouse or a defined relative (s 118-37 ITAA97).
A buy/sell agreement is still essential with cross-ownership, given there may be disagreements over value of the business and the various buy/sell obligations of the owners.
Insurance trust ownership
The trustee of an insurance trust (also known as an absolute entitlement trust) owns the policies on behalf of the insured. In other words, legal ownership rests with the trustee, whilst beneficial ownership rests with the insured persons (thus satisfying all CGT exemptions on insurance proceeds).
In addition, insurance trust ownership can also provide a rebalancing mechanism whereby the sum insured can be reduced in relation to one purpose, such as key person capital, and increased in another, such as buy/sell purpose cover. This would happen where a business reduces debt, which generally leads to an increase in its value.
Superannuation fund trustee ownership
In March 2015, the ATO released an Interpretive Decision (ATO ID 2015/10) regarding the issue of holding buy/sell insurance inside a self-managed superannuation fund (SMSF), whereby an SMSF purchased life insurance on the life of a member based on an agreed market value of the member’s shareholding in a company he owned together with his brother.
It ruled that the SMSF trustee’s purchase of the life policy contravened both the sole purpose test and the financial assistance provisions of the Superannuation Industry (Supervision) Act 1993, which can lead to the SMSF being non-complying, and result in monetary penalties. Though not a public ruling, this decision brings into question not only SMSF ownership of buy/sell cover but also holding this cover within a retail risk-only super fund. Advisers and clients should seek professional advice with respect to this strategy.
Trading entity ownership
A company or unit trust owns the policies and receives the proceeds. The company buys back the exiting owner’s shares, then cancels them, or units in a unit trust are redeemed. However, there is no CGT exemption for a company on TPD or trauma proceeds, and the cancellation of shares or redemption of units may lead to the remaining owners acquiring more equity, but not increasing their cost base for those shares or units, thereby generally increasing their tax liability on the transfer of the business interest to remaining owners.
There are a number of issues to consider in arranging buy/sell purpose cover for a business. Financial advisers, who generally manage this process, need to ensure that their clients get professional and specialised legal and taxation advice to help implement the correct legal documentation that reflects an appropriate ownership structure. This ensures a smooth and orderly process for the transfer of business equity should a trigger event occur.
Alex Koodrin, National Technical Manager