The use of insurance for business succession planning

By Crissy De Manuele, Senior Manager - Product Technical, Life Insurance, BT

If your client owns a business with other people, it’s important for them to agree on how ownership of the business will be transferred, should one of the owners (or principals) pass away, become disabled, or leave the business for another reason; e.g. resignation or retirement. This is known as business succession planning.

Business succession planning is a formal process which enables the business principal(s) to develop preferred exit options, whilst they are still in a position of control. As part of that process, the business principals should establish a legal agreement such as a buy/sell agreement to provide more certainty in this situation.

Insurance can provide the surviving business principals with the funding to purchase the departing principal’s value of the business.

This article explains what is meant by a buy/sell agreement and how it works, as well how insurance can help businesses meet the requirements set out in a buy/sell agreement. 

What is a buy/sell agreement?

A buy/sell agreement is a legal agreement between business principals which stipulates what must happen to a departing principal’s interest in the business or partnership, should a particular trigger event occur. A buy/sell agreement can be structured to give the remaining principals the legal right to buy their interest in the business, for a specified amount. The agreement may also give the departing principal (or their beneficiaries) the right to sell their interest in the business to the other principals (or another interested party), should one of these events happen to them. The purchase can be funded by life insurance policies, taken out on the lives of each principal.

A solicitor will generally need to draft the buy/sell agreement. When drafting the buy/sell agreement, it’s important for the business principals to agree on what outcomes they would like to achieve. The buy/sell agreement should also take into account each of the business principals’ wills and the solicitor may suggest amending their wills to align with the buy/sell agreement.

Types of buy/sell agreements

There are generally two types of buy/sell agreements used. These are:

  • Mandatory agreements; and
  • Put and call options.

Mandatory agreements are also known as “must buy / must sell” agreements. With these types of agreements, the relevant parties must agree to buy and sell the business interest if certain trigger events occur.

With put and call options, if a trigger event occurs, the departing principal (or their beneficiaries or estate upon death) can exercise the put option (their right to sell) so the remaining principals can purchase the interest in the business. Alternatively, the remaining principals can exercise the call option (their right to purchase) so the departing principal (or their beneficiaries or estate upon death) must sell their interest in the business.

Put and call options can provide more flexibility because if both parties decide not to exercise their put or call options, the sale of the interest in the business does not have to occur. However, if either party exercises their option, the transfer of ownership must occur.

How can insurance assist with business succession?

Not all trigger events such as resignation can be insured for. However, insurance may be taken out on each of the principals for insurable events, such as death, TPD or critical illness.

The insurance benefit can provide the funding so that the remaining principals can purchase the departing principal’s value of the business (either indirectly or directly) if one of these events occur. 

If the business principals decide not to take out insurance or where there is a gap between the insured amount and the value of the departing principal’s share of the business, the remaining principals may have to:

  • Sell business assets;
  • Sell their own personal assets; 
  • Gradually buy out the share in the business or interest in the partnership; and/or
  • Borrow money or obtain vendor finance to provide them with the necessary funding.

If a new principal enters the business they may be able to provide the capital needed to purchase the departing principal’s interest in the business. However, this could take some time and the departing principal or their estate/dependents may require the proceeds during this time.

Valuing the business

Valuing the business is an essential part of business succession planning. A proper valuation can reduce the likelihood of potentially awkward or unfair negotiations on price, or even disputes with a departing principal or their beneficiaries. A proper valuation can also give the parties to the agreement, and their beneficiaries, much greater clarity about what their interest in the business is worth and how much they would need to pay to purchase an outgoing principal’s share.

This can provide guidance as to how much each of the principals should be insured for.

It is generally a good idea for the valuation to be updated each year, or when the circumstances of the business change. A regularly updated valuation may reduce the risk of disagreements and help enable a smooth transfer.

Without this adjustment, there may be a gap between the value of the business to be transferred and the amount of insurance cover to pay for it.

Who should own the insurance if the purpose is for business succession planning?

Where insurance is taken out for the purpose of funding a departing principal’s business value, the insurance can be:

  • Self-owned by each business principal;
  • Cross-owned by the business principals on each of the other principal’s lives;
  • Owned within a trust (trust ownership);
  • Owned by the company; or
  • Held within superannuation.

When advising clients on the policy ownership, consider:

  • The legal requirements and wording of the buy/sell agreement structured;  
  • The ability to transfer the insurance, if needed in the future;
  • The structure of the business and potential ownership changes in the future;
  • Who will pay the premiums and how to ensure that the policies don’t lapse; and
  • The taxation treatment of the insurance benefits.

Each type of ownership structure is explained in further detail below.

Self-ownership

Self-ownership involves each principal holding an insurance policy over their own life. The premium expense can either be shared, or each principal can pay their own premium. If a principal dies, the insurance benefit can be paid directly to their beneficiaries or estate. If they become disabled or suffer critical illness, they can receive the proceeds. The buy/sell agreement can be structured so as to reduce or eliminate the amount that the surviving principal/s must pay to acquire the departing principal’s share, by the insurance proceeds paid from the departing principal’s policy. This helps the surviving principal/s as the insurance proceeds will represent some or all of the purchase value.

Cross-ownership

Cross-ownership involves the business principals holding an insurance policy over each of the other principals’ lives. The buy/sell agreement can be structured so that the insurance proceeds are used to help fund the transfer of business ownership.

Trust ownership

The insurance policy may also be owned by a discretionary trust. Where this is the case, the trustee will distribute any insurance proceeds in accordance with the trust deed. Trust ownership may be useful when policies for other purposes are owned in the same trust, or where proceeds from a single policy are to be used for multiple purposes. Trust ownership is complex and therefore professional taxation and legal advice is essential.

Company ownership

When the insurance policy is owned by a company, the proceeds from a death, TPD or critical illness insurance claim may be used by the company to buy back the departing principal’s

share(s). The result is that the remaining principals will hold a greater percentage of equity in the business without actually purchasing additional shares. This may create a greater tax liability upon the eventual sale of their existing shares.

Super ownership

It can be tax-effective to fund a life insurance policy inside superannuation. The super fund can claim tax deductions for the cost of providing Term Life and TPD cover. Contributions made into the fund to cover the premium costs will also generally be tax-deductible, however contributions tax will apply to those contributions. Division 293 tax may also apply to those contributions, depending on the partner’s income.

Holding insurance within super for a buy/sell purpose can also create complexity, due to contribution caps, and restrictions on the types of insurance and features that can be held within super. For example, trauma insurance cannot be taken out within super.

There may also be tax consequences at the time of claim, especially where death benefits are paid to non-tax dependants. Nominated beneficiaries are restricted to dependants as defined under the Superannuation Industry (Supervision) (SIS) Act; and, if a death benefit is paid, this might be paid to someone other than the intended beneficiary.

More importantly, the Australian Tax Office (ATO) has previously expressed the view in ATO ID 2015/10 that holding insurance within a self-managed super fund (SMSF) for a buy/sell purpose is likely to result in a breach of the sole purpose test. Therefore, clients considering holding insurance within an SMSF for this purpose should seek legal advice or obtain a private ruling before setting up the insurance.

Matching the insurance ownership to the buy/sell agreement

If the ownership structure doesn’t match up with the buy/sell agreement, or if insurance is taken out and a buy/sell agreement is not entered into, problems can arise. In some instances, a departing principal (or their dependants) may end up with the insurance proceeds as well as the departing principal’s share of the business. Conversely, if the agreement and insurance are not set up correctly, the departing principal (or their dependants) could wind up receiving nothing when they depart the business.

What is that tax treatment of holding insurance for buy/sell purposes?

Where insurance is held for a buy/sell purpose, the premiums will not be tax-deductible except if the insurance is held within superannuation. Furthermore, if an insurance benefit is received, it will not be included in the assessable income of the recipient. However, there may be capital gains tax (CGT) payable on the benefit, or superannuation lump sum tax (if held inside superannuation).

Strategies to transfer business ownership can be complex and the needs of each business and its owners will be different. Buy/sell arrangements can be structured in many different ways. It is important that clients seek advice from a solicitor, accountant and financial adviser to ensure the rights and obligations contained in the buy/sell agreement reflects the wishes of all parties.


Next: Insurance advice for business clients
 

Running a business means taking all sorts of risks, many of which can be difficult to control. However, one type of risk a business can have a degree of control over is people. Learn more.

This article was prepared by BT, a part of Westpac Banking Corporation ABN 33 007 457 141, AFSL and Australian Credit Licence 233714. This information is current as at 2 July 2019. 

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