Business continuity & succession: Are you protected?
Insurance is used as a funding solution for several different aspects of business continuity and succession planning. This article looks at the intent behind each type of cover and the structures possible.
Several ways insurance is used as a funding solution for different aspects of business continuity and succession include:
- Business succession planning (eg through a buy-sell agreements)
- Business protection/debt reduction insurance
- Key person insurance
- Business expenses insurance
- Guarantor insurance
Before considering what type of cover you might need, it is essential to understand the purpose behind each type of cover being considered along with understanding the business structure to ensure the cover will address the gaps.
There are a wide range of succession planning arrangements and policy ownership options to plan for the efficient and orderly transfer of ownership of a business on the death or disability of one of the equity parties or controllers.
Business succession planning encompasses more than just the insurance funding component. Whilst a specialist financial planner can help determine and advise on the type of insurance and how much, they can also be the facilitator between:
- the business equity owners – who must agree on valuation methodology and appropriate ownership structures;
- the business accountant – who values the business, establishes the transfer costs and identifies CGT issues; and
- the specialist lawyer – who drafts the agreements and perhaps manages estate issues.
It is important to understand that whilst it may be possible to recommend all the various covers, they may not be taken up for a number of reasons including cost and/or health of the people the strategy proposes to protect.
There are different types of business asset protections available:
- Buy-sell agreement – to provide a business/owner with sufficient funds to buy out another owner (or the owner’s estate) in the event of death, total and permanent disablement or a traumatic event;
- Business protection/debt reduction – to pay off any debts associated with the business in case one of the owners dies, becomes totally and permanently disabled (TPD) or suffers a traumatic event;
- Key person (revenue) – to provide cash flow to employ another person in place of a key person in the business;
- Key person (capital) – to provide a lump sum to replace the income/profit estimated to be lost in the event of a key person dying, suffering a traumatic event or becoming TPD;
- Business expenses insurance.
The orderly transfer of ownership typically requires the following two documents:
- Business Owners Agreement – such as a partnership, shareholders or unit-holders agreement dealing with issues including ownership details. It covers the rights of each business principal and outlines their obligations.
- Buy/sell agreement or bare/absolute entitlement trust.
A buy/sell agreement is a legal agreement between two or more principals facilitating an equitable and orderly transfer of ownership. It covers exit trigger events such as death, TPD or critical illness. This agreement, combined with funding put in place, ensures the successful transfer of a proprietor’s interest. There are three types of buy/sell agreements:
- mandatory agreements
- condition precedent agreements
- put-call options.
Areas that need to be addressed are:
- parties to the agreement
- events that would trigger the sale and purchase of business equity
- value of the business
- most appropriate funding solutions.
Bare/absolute entitlement trust
A bare/absolute entitlement trust occurs where a trustee owns life insurance policies on behalf of all the business owners. There may be some extra costs involved in establishing and administering the trust.
The Australian Tax Office (ATO) must consider whether the trust beneficiary is absolutely entitled to the trust assets and the trustee’s only obligation is to transfer the trust property to the beneficiary in accordance with the beneficiary’s direction. A bare trust is an example of an absolute entitlement trust. If this condition is not satisfied, capital gains tax may be payable on the proceeds.
Business Protection / Guarantor insurance
Many businesses have significant debt which is only manageable if existing revenue is maintained. Generally the guarantee given by the business principal is not extinguished until the debt has been repaid. Death, disablement or critical illness, will not release a principal or the estate from such obligations.
It is recommended that the level of cover be equal to the total amount of debt to be repaid (not just a business principal’s portion), ensuring the guarantor or their estate is not left with outstanding business debt.
Ownership and tax treatment
Generally there are two ownership options, either by the business entity or self-owned.
Key person insurance
Key persons impact the profitability of a business. Revenue or capital could be adversely affected if a business principal or a key employee becomes totally and permanently disabled, suffered a critical illness or died.
Insurance proceeds are used to compensate for a reduction in revenue, the costs of finding a suitable replacement or to protect the capital value of the business.
Identifying key persons
If the loss of a key employee or business principal will have an adverse financial impact on a business, then they are a candidate for key person insurance. Some examples are:
- founding business principal(s)
- key sales people
- employees whose unique skill, reputation, prestige or connections attract valued customers, or finance/venture capital
- IT staff – programmers and analysts
- project managers critical to meeting deadlines
- financial controllers
- key suppliers including service people.
Establishing the sum insured
The sum insured is an estimate of the cost incurred in the absence of the key person. Subjectivity may be involved but arbitrary methods of calculation should not be used without considering whether the result is reasonable in the circumstances and acceptable to the business principals and the underwriter.
If the loss of a key person impacts the business’ balance sheet, the purpose of the insurance will be capital. Some examples are:
- covering guarantees
- repaying money borrowed from the key person protecting the goodwill and capital structure of the business
- insurance on the life of a key supplier for the purpose of providing funds to buy the supplier’s business on the death of that person.
Purpose of the key person policy
Taxation rulings IT 2434 and IT 155 provide guidance on who may be insured for revenue protection purposes. Premiums are generally deductible to the business, although less commonly to sole traders. Key considerations are:
- Revenue purposes – premiums tax deductible to the sole trader, partnership, company or trustee(s) of a trust and the proceeds are assessable income to the business; or
- Capital purposes – premiums are not an allowable deduction, and the insurance proceeds are not assessable business income.
If insurance proceeds are seen to be for a revenue purpose, the receipt of sums insured may be assessable, even if no premium deductions were claimed and the documented purpose was a capital purpose.
Whilst the purpose may change from time to time or a decision could be made to use capital proceeds for a revenue purpose after they are received, this may not impact prior deductions.
If capital purpose insurance proceeds exceed the amount required, the excess is generally deemed revenue purpose and assessable income.
If deductions were claimed for revenue purpose premiums, but based on the available evidence the proceeds were intended for a capital purpose (at the time when the tax deduction was claimed), prior deductions may be denied and penalties may arise.
A key person doesn’t seem to exist where the loss of an owner/manager of a one-person business could result in the business being terminated. The ATO considers the proceeds would most likely be used for debt retirement, wind up costs or as a lump sum payment to the deceased’s beneficiaries. However, there is an exception to this rule. If a family member decides to manage the business or if it is sold to a third party e.g. a competitor, there may be sufficient continuity to satisfy IT 2434.
Adequate records must be kept in the form of minutes of the meetings recording the purpose and the method used to determine the sum insured. A review of the purpose should be documented annually to minimise the possibility of an adverse ATO outcome, such as denying deductibility.
Business expenses insurance
Business expenses insurance is designed to pay regular expenses if a business principal is unable to work due to illness or injury. An indemnity policy, a claim which can only be paid if there is a genuine reduction in revenue due to the business principal’s illness or injury. The following are the types of business expenses covered for a period, generally up to 12 months.
- Rent on business premises
- Regular interest instalment payments on business mortgage or loan
- Electricity, gas, water, telephone bills
- Cleaning and laundry
- Business property levies, rates and taxes
- Non-income producing employee’s salary and salary related costs
- Equipment or vehicle lease costs
- Net cost of a locum.
A negotiated waiting period normally between 14 and 90 days applies. A shorter waiting period usually means a higher premium. Three things should be considered when calculating the amount of business expenses insurance:
- How many business owners/partners are in the business?
- How much revenue does each owner/partner generate for the business?
- Does the business have any income producing employees?
Source: IOOF / Lonsdale (April 2016)