This topic has been coming up a lot in the past month, so I’ve decided to add an entry here to stop having to “pull out the record and play it again”.
Buy/Sell Insurance for Small Businesses
There are over 2,000,000 small businesses in Australia, employing nearly 5,000,000 people.
Buy/sell insurance supported by a well-written shareholders 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 medium for an owner leaving a business due to death, total and permanent disability (TPD) or critical illness.
Death (as well as terminal illness) and TPD are clearly events that lead to the departure of an owner/shareholder from a business resulting in a need to transfer his/her business interest to the continuing owner(s).
In that case, it is vital for Directors/Shareholders to enter into a written buy/sell agreement so they can set out their respective obligations regarding the transfer of their equity of the business. Plus, the choice of insurance solution for buy/sell purposes depends on the trigger events being covered.
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.
For example, if the business consists of two shareholders/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 for the express purpose of buying the deceased/incapacitated owners share (that is, they need the insurance to cover other things like their dependents).
The insurance trigger events should be death and TPD and possibly some well-defined types of 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 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.
Please talk with your accountant and/or tax lawyer about the Capital Gains implications, to get some understanding of whether CGT liabilities should be incorporated into the buy/sell cover sum insured.
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.
I highly recommend one of the leading players in personal and business insurance – Risk & Business Consulting (www.riskandbusiness.com.au) – to guide you through the specifics of what you need for this complex but vital area of protecting your business interests.