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Understanding business insurance
Business insurance advice has grown significantly as a new avenue for financial advisers. While there are more than 2.3 million actively-trading businesses in Australia, research indicates that less than 20% of Australian businesses are equipped with a succession plan. This underinsurance gap presents an ideal opportunity for financial advisers to fulfill their best interests duty and add value to their customers.
THE IMPORTANCE OF BUSINESS INSURANCE
We all hope for an accumulation of wealth after a lifetime of hard work and diligent saving. For many business owners, their wealth is tied up in the business, and we need to protect this valuable asset.
Few business owners think about the fate of their business in the event of their death or disability because they are often too busy running their businesses to think about broader strategic and risk issues. Our role as risk advisers is to challenge businesses to think about succession risk and embark on the succession planning journey.
SUCCESSION PLANNING
Crucial questions which need answering include the following:
- Who will pay for the business owners’ share of the business in the event of their death or disability?
- Who do the business owners want to follow in their footsteps?
A succession plan increases the chances of a business’ survival when the owner chooses to leave on a voluntary basis, or their involvement is sadly terminated by death or disability.
The succession planning development process begins with a discussion between the adviser and the business owner about their future business plans. The discussion then focuses on the points of vulnerability of the business and the business owner.
What are these points of vulnerability?
Points of vulnerability include the following:
- Loss of revenue in the period following a business owners’ death or disability;
- Additional cashflow pressures caused by creditors such as suppliers who perceive a credit risk following a business owners’ death or disability;
- Foreclosure on a bank loan by a bank anxious to protect amounts advanced by it pursuant to an overdraft facility; and
- Stress between the deceased business owners’ family and the surviving proprietors over the future direction of the business. In the absence of a succession plan, there may not be a shared vision for the future.
Business owners and their advisers should conduct regular reviews of the business and the owners’ personal affairs to identify points of vulnerability and devise solutions that eliminate or reduce the risk associated with these points of vulnerability. There are a number of strategies and solutions which can be put in place to reduce or eliminate these risks.
ASSET PROTECTION
Asset protection is also known as Business Loan Protection, Debt Guarantor Protection or simply Debt Protection. Asset protection ensures that the business borrowings (and/or owners’ guarantees) can be extinguished or reduced in the event of death or disability.
Asset protection is important because the death or disability of a business owner may put a significant strain on the ability to repay business borrowings. There is a risk that the lender will call in the loan if they are not comfortable that the business can sustain the debt, and for secured loans, this may result in the sale of business assets or the business owners’ personal assets.
Ownership
The entity that owes the debt generally owns the policy – the entity will then use the insurance proceeds to repay the debt.
In limited circumstances, it may be preferable to have the life insured own the policy and gift the proceeds to the business entity. This strategy needs to be considered by the client’s taxation advisers as there may be issues with gifting and commercial debt forgiveness.
Tax
The premiums are generally not tax deductible being capital expenditure.
In terms of the claims proceeds, life policies are tax exempt if the policy owner is the original owner of the policy, or received the rights or interest in the policy for no consideration.
Total and permanent disability (TPD) and trauma policies are exempt if the recipient is the ill or injured party or a defined relative. Defined relatives of a person are defined as:
- a) the person's spouse (including de facto partner); or
- b) the parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendent or adopted child of that person, or of that person's spouse; or
- c) the spouse of a person referred to in paragraph (b).
The above exemption is not available to corporate entities.
Where capital gains tax (CGT) is payable, consider grossing up (100/[100-r]) where r = marginal tax rate expressed as a percentage – for example, a company with a 30% tax liability and $1 million death cover would be grossed up to $1,428,571.
REVENUE PROTECTION
Revenue protection is also known as key person cover or key person revenue cover. Revenue protection ensures that there is sufficient income for the business to meet its obligations in the event of the death or disability of a key income generating person.
Key person cover is not black and white – the important question is who can be considered a key person for revenue protection. Generally, a key person possesses proven knowledge and/or experience in a specified field of expertise; performs important tasks or processes; and/or has valuable personal and/or business contacts.
There are two main ways to calculate the relevant sum insured for revenue protection: the replacement cost method and the revenue protection method.
Ownership
Revenue protection policies would typically be owned by the entity that operates the business and employs the key person. Where businesses are operating multiple entities, it is important to determine the flow of income and expenditure to ensure the correct ownership of revenue policies. Where a discretionary or unit trust operates the business, the policy owner should be the trustee of the trust.
Tax
IT 155 states when cover is being obtained for revenue protection purposes, the associated premiums are tax deductible. In terms of the claims proceeds, the insurance proceeds will be assessable to the policy owner.
OWNERSHIP PROTECTION
Ownership protection is also known as equity succession or buy/sell cover. Ownership protection ensures the smooth succession of ownership between shareholders in the event of the death or disability of a business owner to provide business continuity post a trigger event. It also ensures that sufficient funds are available to compensate the family/estate of the life insured for the transfer of the life insured’s share in the business to the surviving business owners.
For buy/sell cover, the policy is generally owned by the individual/entity that owns the equity. Each business owner will own their own policy to value of their equity. The claims proceeds will be paid directly to the departing business owner as compensation for the disposal of their shares which will be transferred to the surviving business owner. The buy/sell agreement will generally provide the legal mechanism to ensure the transfer occurs.
Tax
In terms of how the premiums are funded, there are generally two ways they can do it:
- 1) The clients could treat the premiums paid in respect of the policies as a tax deductible employee benefit and subject the premiums paid to FBT; or
- 2) The premiums could be treated as the provision of a non-deductible shareholder benefit.
The clients should seek taxation advice on which approach best suits their circumstances.
The claim proceeds should be free of CGT in the case of a death claim, provided that the recipient is the original owner of the policy. The TPD claim proceeds should also be exempt under this structure. There is an exemption in the CGT legislation which exempts claim proceeds provided that they are received by the injured/ill person, a relative, or a trust of which the injured/ill person is a beneficiary.
ADDITIONAL RESOURCES
The risk of death and disability confronts everyone, and business owners have special needs in this area. Through appropriate risk mitigation strategies, we can prevent the loss of wealth and destruction of lifestyle which often accompanies death and disability and help create more sustainable futures for our business-owning customers.
David Glen is national technical manager at TAL.
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