Mastering business succession risk

There are almost two million small businesses in Australia, employing over three million people. Many business owners believe they will take over the business if their partners or co-directors retire or leave the business.

Regretfully, most of these businesses never set a contingency plan in the event of an owner being physically unable to work in the business due to illness, injury or death.

In order to fund an easy transition for an owner to leave the business due to illness, injury or death, and for the remaining owner(s) to continue to manage the business, it is worthwhile to consider life insurance (term life, trauma and total and permanent disablement (TPD)).

Once life insurance is accepted as the funding medium for an owner departing a business due to illness, injury or death, it is vital for the owners to enter into a written buy-sell agreement, setting out what they are to do with their respective interests.

Traditional buy-sell agreements have been primarily concerned with the transfer of business equity between owners.

However, it is increasingly common for agreements to also deal with liability issues (debt reduction, guarantor protection and key person insurance). These are usually known as business succession agreements.

The most important issues surrounding buy-sell insurance are: valuation of the business (and of each owner’s share); policy ownership and taxation issues (with regard to premiums, proceeds and transfer of ownership); and the buy-sell agreement.

The best way to analyse these issues is through a case study:

Monsters ‘R’ Us

Hermann and Gomez are the co-owners of a boutique toy-manufacturing company called Monsters ‘R’ Us.

They each own by 50 per cent of the business with their wives for income-splitting purposes. The business was started from scratch in 1993, with Hermann injecting $200,000 of capital and Gomez providing the business premises, valued at $1 million.

The accountant has valued the business at $2 million gross (based on five times after-tax profit of $400,000).

The business has long-term debt of $600,000 with a financial institution, with the directors providing personal guarantees, plus an overdraft of $200,000 (currently drawn to $90,000) and a loan account to Hermann for the $200,000 seed capital.

The net value of the business is $1 million. The business has 10 employees, four of whom generate an income for the business, and has allowable business expenses of $15,000 per month. Neither of the wives works in the business.

Hermann works in the business and is 100 per cent responsible for sales and account management. He has a salary package of $150,000 per annum and was paid $200,000 of the 2006-07 profit. He has a non-working spouse, a young child and an older niece, whom he has adopted.

Gomez does not work in the business. He was paid $200,000 of the 2006-07 profit, and has a working spouse and two young children.

Buy-sell insurance

The choice of insurance solution for buy-sell purposes depends on which trigger events are being covered.

Death and TPD can readily be insured for by way of life and TPD insurance.

Insurance to cover traumatic and terminal illness insurance can also be used in a buy-sell agreement, but some complex issues must be considered.

With trauma insurance, there is the potential for the insured to return to work and therefore there is no urgency to sell an owner’s business interest.

A business succession agreement would need to deal with the criteria upon which the business interest must be sold and the extent to which trauma proceeds would be credited towards a future purchase price of the business.

Put and call options are now commonly used in buy-sell agreements, whereby if just one party wants the transfer of equity to go ahead, it must proceed.

These options can be postponed until a satisfactory test about the insured’s fitness to continue in the business has been satisfied.

For instance, the business owners may choose to prevent the exercise of the option for six months after the occurrence of the trauma or until business turnover has decreased by, say, 20 per cent.

Buy-sell sums insured

The sum insured should generally be the value of each owner’s share of the business, usually valued on an annual basis.

In this case, the value of each owner’s share would be 50 per cent of $2 million, or $1 million. The insurance trigger events should be death, terminal illness, TPD and critical illness (trauma).

Policy ownership and taxation issues

Different forms of ownership have various tax and other implications in the context of buy-sell insurance and other forms of business insurance. We have provided a very brief summary of these.

Individual circumstances will always differ, so it’s important that individuals seek advice appropriate to their situation. Please note that in all the following scenarios, it is vital that a written business succession agreement be entered into.

Cross-ownership

Each business owner owns an insurance policy on each of the other owners.

Insurance proceeds are paid to the purchaser, who then pays them to the estate or outgoing business owner in return for the transfer of equity. The proceeds of death cover are exempt from capital gains tax (CGT) as there is no change in original beneficial ownership (s118-300 ITAA97). If the proceeds are paid as a result of terminal illness, TPD or trauma, they are CGT exempt only if paid to the life insured’s spouse or a defined relative (s118-37 ITAA97).

Self-ownership

Each business owner owns his or her own policy and there is no CGT liability on death. Because the policies are self-owned, the recipient of any TPD, trauma or terminal illness is the insured. The proceeds are, therefore, not subject to CGT.

Other advantages of self-ownership are simplicity and portability (if owners leave the business, for instance, they can take their own policy with them).

Trust ownership

An independent trustee of an insurance trust (also known as a ‘bare’ trust) owns the policies on behalf of the other business owners (indirect cross-ownership) or the insured (indirect self-ownership). Advantages of trust ownership include those under self-ownership, as well as cost savings, with respect to lower policy fees and volume premium discounts, and comprehensiveness; a multiple purpose trust can allow other cover (such as debt reduction, key person and personal cover) to be held on the same policy.

Superannuation fund trustee ownership

A super fund trustee can own the policies on behalf of the insured.

The obligation to pay the outgoing owner or the estate the insurance proceeds and to transfer the outgoing owner’s business interest should be contained in a business succession agreement.

On the death of the life insured, benefits could be paid directly to the deceased’s estate.

TPD and trauma may be unsuitable to be held through a super fund as conditions of release from the superannuation fund may not be met upon the occurrence of the insured event.

TPD, terminal illness and trauma may not be suitable, as benefits will probably be subject to tax as a superannuation lump sum benefit.

Business entity ownership

Policies can also be held by the operating entity, which would receive the proceeds upon the occurrence of an insured event.

In this scenario, the company would buy back the share from the deceased’s estate, and then cancel them.

This may lead to the remaining business owner(s) acquiring more equity but not increasing the CGT cost base for those shares, thus possibly incurring an additional tax liability.

Insurance proceeds from a TPD, terminal illness or trauma claim would also have a CGT liability.

CGT on transfer of business equity

While it is usually important to minimise any tax implications on insurance proceeds, it is imperative to consider the tax implications on the transfer of equity following an insurable event.

CGT provisions apply when there is a disposal of a CGT asset (generally a post September 20, 1985, asset).

Disposal is any change of ownership, including a sale, transfer or assignment of an asset or an interest in an asset.

Death, as such, is not a disposal of an asset, and thus the estate/beneficiary of a deceased person has no immediate liability to pay CGT.

Under a normal buy-sell agreement, the estate/beneficiary would only need to pay CGT following the exercise of a put-call option, requiring the outgoing business owner to sell their interest in the business in return for the insurance proceeds.

Thus, it is possible to estimate the CGT liability payable upon a sale of the deceased owner’s equity under a business succession agreement.

The taxable capital gain would be determined by deducting the taxpayer’s cost base from the proceeds of the disposal.

This liability cannot normally be insured for, in the same way that an outgoing owner’s tax liability due to retirement or resignation cannot be provisioned for.

The surviving business owner’s cost base in relation to the shares acquired from the departing owner would be their value at the time of equity transfer.

Key person insurance

It is important to consider both the income tax and the CGT treatment of key person insurance.

The income tax treatment of key person premiums and proceeds depends on the type of policy used and its purpose. Income Tax Ruling IT155 is the ATO’s governing ruling for key person insurance. The tax treatment depends on whether the insurance is for a revenue or capital purpose.

Revenue purpose insurance premiums are tax deductible to the business and the claim proceeds are assessable.

Tax deductibility is achieved provided the following six requirements are met:

1. the policy must be a term insurance policy (IT155, paragraphs 4 and 7) (not whole of life nor endowment);

2. the policy must be owned by the trading entity on the life or disability of a key person (IT155, paragraph 4);

3. the purpose in effecting and maintaining the policy must be of a revenue nature (IT155, paragraphs 4 and 7);

4. the employee must be a key person. That is, ‘…the loss of that employee would result in a significant loss of profits being derived by the employer’; (IT2434, paragraph 23)

5. revenue purpose insurance premiums can only be deductible if the business will continue despite the loss of the key person (IT2434, paragraph 23); and

6. the sum insured is based on a reasonable estimate of the loss of revenue that would be likely to occur. (EDR3 paragraph 27)

Losing a key person can also adversely affect a business’ capital value, impacting on areas such as goodwill, credit worthiness, the repayment of loan accounts (money lent to the business by a key person) and the repayment of other business debt (including guarantor protection).

Key person (capital purpose) insurance can be used to maintain the capital value and stabilise the business. From a tax viewpoint, this type of business insurance is normally non-deductible and non-assessable, but it would still trigger a CGT liability on proceeds from a TPD or trauma claim if the policy is owned by the business entity.

Monsters ‘R’ Us recommendations

Buy-sell insurance

Gomez should purchase term-life cover to the value of $2 million, and TPD and trauma cover to the value of $1 million (for his 50 per cent share of the business, plus the value of the business premises); the policy should generally be self-owned (or through an insurance trust).

If he should die, his estate would receive the $2 million proceeds. As there has been no change in original beneficial ownership, there would be no tax liability on the insurance proceeds.

Under the terms of the business succession agreement, the estate would then transfer the deceased’s equity in the business ($1 million) plus the title deeds to the business premises to Hermann.

The estate’s cost base (assuming the business premises are a pre-CGT asset) would be zero. The taxable gain on Gomez’s share of the business would be $1 million. The potential tax liability to the estate would be $232,500. Hermann would acquire Gomez’s share at their current market value of $1 million. This would form his cost base.

Should Gomez be permanently incapacitated, he would receive the TPD proceeds of $1 million.

As he owns the policy and receives the proceeds, there is no tax liability on the insurance proceeds.

Under the terms of the agreement, he would transfer his equity in the business to Hermann. The tax liability would be the same as for the equity transfer upon death. The difference would be that Gomez would continue to lease the business premises to Hermann on an arm’s length market value. Hermann’s new cost base would be $1 million, as per the share transfer upon death.

Should Gomez suffer a traumatic or terminal illness, he would receive $1 million. As he owns the policy and receives the proceeds, there would be no tax liability on the insurance proceeds.

Under the terms of the business succession agreement, the proceeds would be held in trust for a period of 12 months. If, within that period, there is a reduction of turnover of more than 20 per cent, either owner can exercise a put/call option. If exercised, there would be a transfer of equity as per agreement.

The tax liability for Gomez and Hermann’s new cost base would be the same as for the transfer of equity for death and permanent incapacity.

Hermann should purchase term-life cover, TPD and trauma cover to the value of $1 million (for his share of the business).

If he should die, become permanently incapacitated or suffer a traumatic event, his estate would receive the $1 million proceeds, then transfer the equity in the business to Gomez as per the buy-sell agreement. There would be no tax liability on the insurance proceeds.

Loan protection insurance

As the business owns the debt, it makes sense for the company to own the insurance policies.

The company purchases $1 million of term-life cover on Hermann’s life. There is no tax on the proceeds if there is no change of beneficial ownership on the term life.

However, $1 million of TPD and trauma cover paid to the business would trigger a CGT liability and therefore should be grossed up. The grossed up amount of TPD and trauma cover to account for 30 per cent CGT would be $1,428,571; because TPD or trauma cover cannot exceed the life cover component in a bundled policy, the term life cover must also be $1,428,571.

The loan protection insurance on Gomez’s life should be $800,000. The total debt relating to Gomez is $200,000 less than for Hermann, as there is no loan account for him.

However, for the reasons outlined above, TPD and trauma cover (and term life cover) should be grossed up to cover the CGT liability, providing a sum insured of $1,142,857.

Insurers (underwriters) vary as to the percentage of the loan amount they are prepared to insure. Insurers will generally approve cover for business debt based on the percentage ownership of the business.

Some insurers will approve a higher percentage based on a sliding scale (for example, 75 per cent of the first $2 million of term life cover for a two-owner business).

The rationale for this is that most bank loan or overdraft guarantees are ‘joint and several’, so that all guarantors are 100 per cent liable for the loan, regardless of their share of the business.

The alternative to the business entity owning the cover is for Hermann and Gomez to own the policies themselves (or through an insurance trust).

This would avoid the CGT liability on the TPD and trauma proceeds, but may give rise to a Commercial Debt Forgiveness (CDF) liability upon the terminating principal repaying a debt on behalf of the company.

Key person (revenue) insurance

This cover should be taken out on the life of Hermann as Gomez does not work in the business.

The amount of cover should be based on the loss of profit and/or the cost of replacing Hermann as a key person. A multiple of the key person’s remuneration may be used, but this should be determined with the client. In the case, a multiple of two ($300,000) has been used.

The company would own the policy and it is important that the purpose (revenue) and related details are minuted by the business owners to ensure tax deductibility.

As the proceeds are tax assessable, it has been suggested that the sum insured should be grossed up to cover the tax liability.

However, as the proceeds should be fully utilised to replace revenue and/or the cost of replacing the key person, this should have a net affect on the revenue (that is, income should equal outgoings).

Business expenses protection

With four income-generating employees in the business, besides Hermann, it is vital to assess the percentage of allowable expenses that Hermann generates (that is, what monthly expenses of the business would not be met if he were sick or injured for a period of, say, 12 months). Let’s say that this is calculated at $8,000 per month, this should then be the sum insured.

The business expenses policy should, in most cases, be owned by the company. As the proceeds of business expenses insurance are used for a revenue purpose, the premiums will generally be tax deductible on the proceeds assessable.

As you know, insurers have certain limitations on sums insured per individual.

While there is notionally no limit on term-life cover, most insurers will not exceed a total of $3 million of TPD cover or $2.5 million of trauma cover.

Although our case study falls within these limits, there are times when these limits will impact on the recommended sums insured.

In this situation, it is up to advisers to consult with their clients to prioritise what levels of cover should apply to which core business insurance concepts, namely:

n buy-sell insurance;

n loan or guarantor protection; and

n key person insurance.

Summary

Business insurance is a specialised area of insurance that involves undertaking a full and detailed interview to determine your client’s needs, including the:

n needs of the business;

n amount of insurance to satisfy these needs;

n cost of the insurance;

n prioritisation of the business needs and insurance (having regard to the cost and insurance product limits); and

n underwriting requirements necessary for the amount of proposed insurance

Addressing these needs, making the appropriate recommendations and implementing them, in consultation with legal and accounting professionals, should ensure the optimum business insurance outcome for your clients.

Jeffrey Scott is the executive manager of business growth services at CommInsure.