There are over two million small businesses in Australia, employing over three million people and very few of these have documented buy/sell agreements that provide clearly defined and fair ownership exit options.
Why is buy/sell insurance so important? Buy/sell insurance is supported by a legal agreement can protect the owners of these businesses and their respective estates from the impact of death, disability and critical illness.
Life insurance can be chosen as the funding mechanism for an owner departing a business due to death (and terminal illness), total and permanent disability (TPD) or traumatic illness. If that is the case, it is vital for business owners to enter into a written buy-sell agreement, setting out their respective obligations with regard to the transfer of the equity of the business. The choice of insurance solution for buy-sell purposes depends on the trigger events being covered.
Death (and terminal illness) and TPD are clearly events that would warrant the departure of an owner from a business. 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 treatment of trauma proceeds if the insured does return to work.
Modern buy-sell agreements commonly use put and call options, whereby 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 CGT purposes, thereby triggering full CGT and stamp duty liabilities as at the date of signing of 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 6 or 12 months after the occurrence of the trauma event or until business turnover has decreased by a certain percentage.
Level of cover
The sum insured should generally be the value of each owner’s share of the business, updated at least on a yearly 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.
Given that the ATO 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, 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’s 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 are eligible for CGT concessions if they satisfy the basic conditions for one or more of the CGT concessions for small business, which in some cases may reduce any capital gain to zero. Advisers should seek the advice of their clients’ accountants to establish if the clients or the potential beneficiaries of their estates qualify. 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 and taxation issues
Certain ownership structures have tax implications depending on products 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 options are as follows:
Nick, Zoe and Liam have insurance taken out to cover today’s value. Ideally we will provide a current valuation to help with this, which will probably need to be submitted to underwriting. We would also suggest to also contact the underwriters upfront to see what they will cover given turnover, profit levels etc.
Fast forward a couple of years, and the business has grown exponentially and is now worth 25% more. Unfortunately Nick has discovered he has a blood disorder and can’t increase his cover.
In the best case scenario, we would put forward underwriting in place so this is no problem. Worst case, we would advise that their Buy-Sell Agreement can be drafted so that if the insurance does not cover the value when someone exits, the remaining partners can pay the difference over time.
If you want to protect your business interests in the case of an involuntary exit please give us a call today to discuss how we can put a solution in place for you.
General advice disclaimer
The advice provided is general advice only as, in preparing it we did not take into account your investment objectives, financial situation or particular needs. Before making an investment decision on the basis of this advice, you should consider how appropriate the advice is to your particular investment needs, and objectives. You should also consider the relevant Product Disclosure Statement before making any decision relating to a financial product.
Only financial planning advice provided by Ceebeks Financial Solutions is associated with MyPlanner Professional Services.
Chris Beks is a director of Ceebeks Financial Solutions and an Authorised Representative of MyPlanner Professional Services Pty Ltd, ABN 51 159 969 830; AFSL 425542 and is authorised to provide personal financial advice.