Buy sell insurance supported by a legal agreement can protect business owners and their respective estates from the impact of death, disability and critical illness. With the importance of buy-sell insurance there are surely businesses that are financially protected, considering there are almost two million small businesses in Australia, employing over three million people.
Buy Sell Insurance Agreements
Buy sell agreements can choose the following funding mediums to protect their business:
1. Life insurance & TPD Insurance – Death (as well as terminal illness) and TPD are clearly events that would warrant the departure of an owner from a business.
2. Life insurance can be chosen as the funding medium for an owner leaving a business due to death, total and permanent disability (TPD). If that is the case, it is vital for business owners to enter into a written buy sell agreement so they can set out their respective obligations regarding the transfer of the equity of the business. Plus, the choice of insurance solution for buy sell purposes depends on the trigger events being covered.
2. Trauma Insurance – trauma insurance may also be used in a buy \-sell agreement, but some complex issues must be considered. With a trauma event, there is some potential for the insured to return to work, in which case there is no immediate need to transfer his or her business interest to the continuing owner/s. The buy-sell agreement would need to address the criteria upon which the business interest must be sold and the extent to which trauma proceeds would be credited towards the future sale of the business if the insured does return to work.
Modern buy-sell insurance agreements commonly use ‘put and call options’, where if just one party wants the transfer of business equity to go ahead, it must proceed. 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 the agreement.
In the case of a trauma event, 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 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.
Level of cover for buy sell insurance
The sum insured should generally be the value of each owner’s share of the business, updated at least on an annual basis. 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 should be $500,000. The insurance trigger events should be death and TPD and possibly trauma.
Valuation of buy-sell insurance
Given that the Australian Taxation Office 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 (i.e. at least annually).
An alternative valuation method would 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 alternative would 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 is 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.
Small business CGT concessions
Small businesses may be eligible for CGT concessions if they satisfy the basic conditions for one or more of the relevant concessions, which in some cases may reduce any capital gain to zero. Advisers should seek the advice of their client’s accountant to establish if the client or the potential beneficiaries of their estate qualifies. If businesses do not qualify for these concessions, most insurers allow this CGT liability to be included in the buy-sell cover sum insured, at least for term life and TPD. Alternatively, the CGT liability may be insured through personal risk cover.
Policy ownership considerations for buy sell insurance
Certain ownership structures have tax implications depending on the type of structure chosen for buy sell insurance cover. In any case, it is important for business owners to seek advice that is appropriate to their individual situation and objectives. Regardless of the circumstances, the implementation of a buy-sell agreement is vital.
The most common types of structures are as follows:
- Self ownership – Each business owner owns his or her policy.
- Cross ownership – Each business owner owns an insurance policy on the life of each of the other owners.
- Trust ownership – An independent trustee of an insurance trust (also known as a bare trust) owns the policies on behalf of the insured (indirect self-ownership).
- Superannuation fund trustee ownership – A super fund trustee can own the policies on behalf of the insured.
Buy sell insurance provides vital protection for small business owners against the impact of death, disability and critical illness. You should be mindful of the important areas of buy sell cover, including the choice of risk products, the level of cover, business valuations, policy ownership structures and their tax implications.
As discussed there are a number of factors you should take into consideration when looking at buy sell insurance. To find the best solution that suits your particular situation you might want to compare a variety of keyman insurance policies from different companies.