National Technical Manager Alex Koodrin looks at how key person capital cover can be used to insure aspects such as debt, goodwill and lines of credit associated with a key person in a business.
*FOR ADVISER USE ONLY*
Key person insurance can compensate a business for the loss of a key person in two ways: for the loss of the capital value of a business (capital purpose) and for the loss of revenue (revenue purpose). This article focuses on the former.
A key person is an individual whose continued association with a business provides that business with a significant and direct economic gain. Economic gain means more than just profits. It can also include – inter alia – capital injections, cost efficiency, goodwill, access to credit and contacts with suppliers and customers. The principals of a business are generally considered to be key persons.
Key person capital purpose cover proceeds can be used to stabilise a business and to maintain its capital value, which may be impacted by the loss of a key person. They can compensate the business in the following areas:
- External debt: capital purpose cover aims to ensure that the business can repay, or at least reduce loans with financial institutions, easing the financial burden on the business
- Internal debt (loan accounts): loans owed to a business principal are generally ‘at-call’ meaning they may need to be repaid immediately to the departing key person (or to the estate). The benefits under the policy can be used to repay such loans, as well as loan accounts owed by a principal to the business
- Goodwill: personal goodwill associated with a departing key person can be compensated for via capital purpose insurance proceeds
- Credit standing: some businesses can secure finance and lines of credit more easily due to the personal assets and contacts of a business principal. Capital purpose proceeds can provide the business with an alternative source of funds.
Debt reduction or Guarantor protection
Although this may not adversely affect the capital value of a business, if principals have signed personal guarantees, it means that they secured a loan for the business directly or indirectly using all or some of their personal assets. The insurance taken for this purpose can, upon successful claim, generally repay in full the business loan, extinguishing the exiting principal’s guarantee (and potentially the guarantees of other principals as well).
A personal guarantee is an agreement that makes one liable for one’s own or another party’s debts or obligation (e.g., director’s guarantee for a company). Personal guarantees can be unsecured (i.e., a general guarantee not attached to a particular asset) or secured (i.e., where a security is created over land or another asset). The wording of the guarantee will dictate whether it is secured or unsecured and generally also include other amounts which may be claimed under the guarantee such as legal costs, interest rates etc. Even if a guarantee is unsecured, an unpaid creditor may sue and obtain a judgement in court, which may include a warrant of seizure and sale of the guarantor’s property.
Data provided by banks show that over 95 per cent of small to medium enterprises (SMEs) is secured, whereas only 70 per cent of lending to large businesses is secured.1 Unsecured loans to SMEs are typically covered by a personal guarantee or general security agreement with a business owner or director. The latest statistics on small business lending in Australia show that about half of all business loans are secured by residential property.2
Generally, a personal guarantee does not end on death (subject to the terms of the guarantee). The guarantee is not extinguished until the loan is repaid in full or revoked by the bank or creditor. In the event of a sudden death, the guarantees and loans generally do not die with the guarantor. Repayment or renegotiation of the loan is an issue that is usually inherited by other guarantors and/or the deceased’s family.
A several guarantee is where there is more than one party to the guarantee, but each party is liable only for its respective obligation. A joint and several guarantee differs in that each guarantor is both jointly liable (together with other guarantors) and individually liable (on its own separately) to the lender for the repayment in full of a borrower's debt.
Even if you go through a loan contract with a fine-tooth comb and understand all the fees, charges and conditions, it may not mean you are fully protected, especially if there is a ‘unilateral variation clause’. Basically, this clause usually allows banks and finance companies to change any of the terms and conditions at any time without giving you any notice.
Some of the things they can do include increasing the interest rate charged on your loan or even call in the loan at any time. They generally have a listed trigger event specifying that the death or disability of a director/principal/guarantor is deemed a mandatory notification event to the lender, which usually automatically triggers a requirement for the repayment of the debt within a particular time period.
The good news is that recent court decisions initiated by ASIC against Bendigo and Adelaide Bank have voided some of these clauses in the two banks’ standard small business loan contracts.
How much debt reduction or guarantor protection?
Perhaps a good place to start is to firstly determine how much of the business debt is required to be repaid so as to discharge the principal’s personal guarantee and any other personal securities if possible. The amount of debt reduction/guarantor protection cover required depends on the type of guarantee signed. Most bank loan or overdraft guarantees are joint and several.
With most bank loans or overdraft guarantees being joint and several, the options which can be considered for a business with a loan amount of $1.5 million, with three principals each having equal equity are:
- Assume (or hope) that the lender will request repayment of only their share of the debt – in the case, one third or $500k and insure each principal for that amount, or
- Assume that the lender will most likely recall the total of the loan. On that basis, insure each principal for the full loan amount, i.e., $1.5 million.
With a joint and several guarantee, it is usually difficult to ascertain from a bank or financial institution what loan amount repayment would lead to a release of the guarantee (apart from the loan amount being paid off in full), so advisers experienced in this area may take the second route or assumption and recommend insuring for the total debt. Yes, the insurance can become expensive, particularly where trauma insurance is involved and when one needs to also consider buy/sell cover, therefore it could be worth further consideration and discussion with an adviser.
At-call loan accounts and directors’ loans
In general, an ‘at call’ loan is a loan that does not have a fixed repayment term and is repayable on demand by the lender. An example of an ‘at call loan’ includes director’s loans accounts, which are loans to/from a director/shareholder. Amounts owed to a director are recorded in the company’s financial record as a creditor while amounts due from the director to a company are recorded as a debtor. This is usually a general unsecured debt, so it’s last in line to be paid if a business needs to be liquidated, unless there is a general security agreement with the company, registered on the Personal Property Securities Register (PPSR).
Goodwill is the intangible value of a business such as its reputation, branding, location, market penetration, customer loyalty, people and other value that makes the business. It is what makes the purchase price of a business higher than just the fair market value of all its assets less liabilities.
Types of goodwill include:
- Enterprise (Commercial) goodwill
- Personal (Professional) goodwill, and
- Non-transferable personal goodwill.
Personal goodwill derives from and attaches to the people or to an individual in the business because of their know-how, experience, expertise, ability and the personality to attract and retain customers. The ATO does not distinguish between personal goodwill and enterprise (‘site’ and ‘name’) goodwill. Goodwill of a business is a single capital gains tax (CGT) asset (Tax Ruling TR 1999/16).
Personal goodwill may be transferable or non-transferable. Business valuers have traditionally shied away from putting a figure on personal goodwill because they do not have an intimate knowledge of the contribution of the individual principals of the business, so they will generally focus on enterprise goodwill and perhaps transferable personal goodwill.
From a capital purpose insurance cover viewpoint, transferable personal goodwill would remain with the business while non-transferable goodwill would usually be lost with the departure of a key person. The value of goodwill when selling an existing business at arm’s length to a prospective buyer is different from its value following the loss of a key person, generally a business principal, due to death, terminal illness, total and permanent disability (TPD) or traumatic illness or injury. For the business, the aim is to maintain the capital value of the business.
For the departing principal or their estate, it is important to consider the ‘value-to-owner’ approach. As an example, take a situation where the business owner is drawing a salary of $180,000 from their business, with the level determined either by history or tax planning considerations. If the actual commercial remuneration of the owner is $300,000, the latter amount could be used for the departing owner to calculate an additional lump sum required upon death or permanent disability using various financial calculators. As this is relevant for the person insured and/or their family, this calculation would supplement existing personal insurance covers or create personal cover, if none exists.
Tax treatment of key person capital purpose cover
The purpose of a key person insurance policy will determine its tax treatment.
If the policy is for a revenue purpose, the benefit is usually subject to income tax (but the proceeds cannot also be subject to CGT). If the policy is for capital purpose, the benefit is usually not subject to income tax, but the proceeds may be subject to CGT.
If the cover type is a term life policy, the proceeds are usually exempt from CGT if paid to the original owner of the policy, provided that the owner did not pay money or give any other consideration for the acquisition of the rights or interest in the policy.
If it is a TPD or trauma policy, the proceeds are only exempt from CGT if the person entitled to the proceeds is the person insured or a relative as defined in section 995.1 of the Income Tax Assessment Act 1997 (Cth). A company, therefore, does not qualify for an exemption for TPD or trauma cover.
Business entity ownership: The conventional method of owning key person capital purpose insurance (including debt reduction cover) has been to hold it in the name of the business entity (debtor) because it is the business that owes the debt to the creditor. This is a form of cross-ownership. For a company, this would not result in CGT payable with respect to a death benefit being paid to a company but would have a CGT liability (30 per cent) for company-owned TPD and trauma proceeds. For greater affordability, this could generally mean linking and grossing up term life cover.
One could consider increasing cover to account for the CGT liability (which would also mean a higher cost of premiums), but this may present the company with another tax problem in respect of the payment of a death benefit. Because the death benefit is received tax free, the company would usually not be able to obtain a franking credit of 30 per cent on it to pay future dividends to the shareholders, thus subjecting them to a higher tax rate.
Self-ownership: Each principal signs a personal guarantee with joint and several liability and generally provides security over property. Each principal takes a policy on their own lives with sums insured covering either the entire debt (preferably) or their proportion of the debt. Self-ownership satisfies CGT exemptions on receipt of term life, TPD and trauma proceeds and those proceeds would be received by either the person insured or their estate. This subjects the parties who rely on the debt being repaid (e.g., the business, the continuing proprietors and the creditor) to the risk that the person insured (or the executor of their estate) will not make the payment. In the absence of a contractual obligation, they would likely have no legal remedy to enforce the payment.
Insurance trust ownership: Insurance (absolute entitlement) trust trustee owns term life, TPD and trauma policies, satisfying CGT exemptions on policy proceeds. Upon successful claim, the trustee is directed (no discretion) by the beneficial owner (person insured) via the trust agreement to repay debt by first crediting the proceeds to the continuing proprietors, who then lend the proceeds to the business so it can repay bank/creditor, thus creating new loan accounts owing to the proprietors in substitution for the external debt to the bank/creditor.
Documentation: Substantiating the purpose
It is important to document the purpose of the cover in order to substantiate it for taxation purposes. Income Tax Ruling IT 155 is the governing ATO ruling for the tax treatment of key person insurance. It states that: “…all the surrounding circumstance may properly be taken into account in seeking to determine the purpose for which a policy was effected.” Though not conclusive as to the purpose of the policy, a taxpayer’s minutes or book entries are of some value. Although it is possible to vary the purpose of a policy, it may be unlikely that a policy for which a premium deduction has been claimed (i.e., for revenue purpose) can thereafter be used for capital purpose (i.e., proceeds would not be assessable) at claim time. If there is a need for both revenue and capital purpose cover (if not using an insurance trust), one can consider taking separate policies and documenting as appropriate.
Note that some insurers (including ClearView) do not charge a policy fee so there would be no extra cost, and the sums insured are aggregated for separate policies for the same product. This usually results in lower overall premium costs due to large benefit amount discounts, which may be relevant when somebody takes out cover for both personal and business purposes.
Level of cover
We have already discussed recommendations of the level of cover for debt reduction and the value of the loss of goodwill to the business upon the departure of a key person. What would be the reduction in capital value and yearly capital appreciation based on the loss of goodwill and the loss of profitability and perhaps loss of credit standing due to the departure? Will the increase in capital value due to loan repayments compensate for this loss? These are but a few of the many issues that an adviser would usually discuss with business owners to ensure their insurance needs are appropriately met.
A multifaceted approach is required by financial advisers who are arranging key person capital purpose insurance cover for their clients. Considerations may include their clients’ business structures, the level of external and internal debt, the value of goodwill lost by the business (and the value lost by the key person themselves) by the departure of a key person, the guarantees associated with obtaining credit, the appropriate policy ownership structure(s), as well as the buy/sell requirements of the business.
Alex Koodrin, National Technical Manager
FOR ADVISER USE ONLY
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