Business Succession Planning Guide

Business Succession Planning is essential for protecting your interest in a co-owned business and is an integral part of every business co-owner’s individual Estate Planning.
“Business Succession Planning” means:

• Planning for the sale or purchase of a co-owners’ interest in a business in the event of their death, permanent disablement, serious illness/trauma or other circumstances and funding for that sale/purchase, (achieved by the implementation of Buy/Sell Option Agreement see below), and
• Planning for the preservation and growth of a co-owners’ equity in a business by the implementation of agreements between co-owners governing the management and decision making of the business and ability to dispose of an interest/share (achieved by the implementation of a Shareholders Agreement – link to Transactions & Agreements page ).

Problems associated with a business co-owner suffering an untimely death or injury, as well as disputes between co-owners, can be managed or avoided by the consideration and implementation of suitable Business Succession Planning Agreements and related insurances. The avoidance of these problems will ultimately protect you and your family and preserve your Estate assets.

If you are a co-owner of a business you should consider the benefits for you and your family of having proper Business Succession Planning Agreements in place.

A Buy/Sell Option Agreement is an agreement between co-owners of a business granting each other options to buy or sell their respective interests upon the occurrence of specified Option Events. The Option Events are typically:

• the Death of a co-owner;
• the Permanent Disablement of a co-owner;
• Serious Illness/Trauma in connection with a co-owner such that they are no longer able to continue to work in the business; and
• the Retirement or Expulsion of a co-owner (although these circumstances would ordinarily be dealt with in a Shareholders’ Agreement/Partnership Agreement if one existed for the business).

Enforceable Buy/Sell Option Agreements overcome disputes in relation to the buy out of a co-owner’s interest in a business including in relation to:

• rights to buy or sell,
• valuations of interests,
• timing of payments, and
• funding arrangements.

Funding Agreements are frequently entered into in connection Buy/Sell Option Agreements and provide for the funding of the price for a co-owner’s share in the event that an option to buy or sell is exercised. Funding is usually provided by:

• the maintenance of personal insurances in respect of the co-owners,
• agreements in the form of vendor finance, or
• a combination of each.

In the absence of a Buy/Sell Option Agreement disputes between co-owners or their executors/beneficiaries following the occurrence of an Option Event are common. These disputes typically relate to:

• Who may purchase the co-owner’s interest;
• Whether the affected co-owner or their Executor can insist that the continuing co-owner(s) purchase the relevant interest;
• Whether a deceased co-owner’s spouse/children (or other beneficiary) are entitled to keep the interest and participate in the running of business;
• The price to be paid for the co-owner’s interest in the business;
• How the price is to be determined in the absence of an agreement, and
• When and how the price is to be paid.

Consider the implications for yourself and/or your family in the following circumstances which may arise in the absence of a Buy/Sell Option Agreement:

You have died unexpectedly or suffered a permanent disability or serious illness/trauma

However, your co-owners are unwilling or unable to pay you or your Estate the value of your share in the business. You or your Executor/Spouse may be forced to participate in the running of the business until a purchaser can be found. You or your Executor/Spouse may end up accepting an amount significantly less than the true value of your interest in the business in order to realize some capital for the same.

One of your co-owners has suffered a permanent disability or serious illness/trauma or died unexpectedly

You feel sorry for your co-owner or deceased co-owner’s family but either can not afford to buy out their share of the business or do not consider that such a purchase is a good commercial decision for you and your family at the time. You object to the eventual proposed purchaser of the deceased co-owner’s share of the business and/or can not agree on management and/or operational decisions. You eventually end up in dispute with the new co-owner. Your equity in the business diminishes or the business fails as a result of the internal dispute.

Alternatively, your disabled co-owner or deceased co-owner’s family want to maintain an interest in the business and actively participate in management decisions and operations. You would prefer to buy out the interest in the business but they do not want to sell or demand an unreasonable price. You do not agree with their suggestions for the management operation of the business and end up in dispute. Your equity in the business diminishes or the business fails as a result of the internal dispute.

When a co-owner exercises an option to buy or sell their equity in the business a liability will arise for the continuing co-owner(s) to pay an amount (“purchase price“) for the value of the outgoing co-owner’s equity in the business. Most Business Succession Plans involve the maintenance of personal insurance policies in respect of each co-owner so that a lump sum will be received under the policy to pay the purchase price when an option is exercised.
In some cases, funding can also occur under a Vendor Finance Agreement or a combination of vendor financing and personal insurances.

Structuring Policy Ownership for Business Succession Planning

The following options exist with respect to the structuring of ownership for personal insurances policies under a Business Succession Plan:

• Self Ownership
• Cross Ownership, and
• Trust Ownership.

Super Fund Ownership is also an option for Policy Ownership due to the argument for tax deductibility of premiums. However, significant uncertainty remains in connection with the legitimacy and tax-effectiveness of Super Fund Ownership, in particular, in relation to the strategy complying with the ‘Sole Purpose Test’.

Capital Gains Tax (‘CGT’) & Business Succession Planning

Generally, CGT is payable on the proceeds of a claim on an insurance policy unless an exemption is available. Traditionally, the choice of ownership of personal insurance policies for business succession planning has been determined based on the availability of an exemption for Capital Gains Tax (‘CGT’) on the insurance proceeds.

In Australia, the CGT laws differentiate between tax payable for Death Benefits and tax payable for Non-Death Benefits (such as Total and Permanent Disablement, Trauma and Terminal Illness Benefits).

Death Benefits

Pursuant to section 118-300 of the Income Tax Assessment Act 1997, insurance proceeds paid on the death of a person (‘Death Benefits‘) will be exempt from CGT if the recipient of the proceeds is the person or the entity who was the “original beneficial owner” of the policy. Therefore, a Death Benefit will potentially be exempt from CGT whether the policy was self owned, cross owned or owned by a trust . CGT will only be payable on a Death Benefit where the recipient is not the original beneficial owner of the policy, for example, where:

• The benefit of the policy is purchased by a third party;
• The legal owner of the policy makes a declaration that it thereafter holds the benefit of the policy on trust for a third party, or
• A Court finds that a third party had an equitable or beneficial interest in the benefit of the policy.

Non-Death Benefits

Non-Death Benefits (such as Total and Permanent Disablement and Trauma Benefits) received under an insurance policy are not specifically dealt with by the CGT legislation. The exemption for these proceeds is more limited and does not depend on the notion of “original beneficial owner“. Section 118-37 of the Income Tax Assessment Act 1997 provides an exemption for “compensation or damages you receive for any wrong, injury or illness you or your relative suffers personally“. The exemption is only available if the person who receives the proceeds was the injured person or a relative of that person. The ATO’s current view is that Non-Death Benefits will only be exempt from CGT for Self Ownership and Trust Ownership .

Therefore, the Cross Ownership of an insurance policy for total and permanent disablement and/or trauma will result in a liability for CGT in the event of a claim.

Terminal Illness Benefits

On 28 March 2007 the ATO issued Tax Determination 2007/4 in which it expressed the view that a benefit received under an insurance policy as a result of a terminal illness is to be treated as if the benefit was a Death Benefit. The result of the Tax Determination is that the proceeds of insurance as a result of a Terminal Illness Benefit will be exempt from CGT regardless of the nature of the legal ownership of the policy, provided that the recipient of the proceeds is the “original beneficial owner“.

Self Ownership refers to the ownership of the insurance policies by the relevant Life Insured. Traditionally, insurance policies in connection with Business Succession Planning Agreements have been Self Owned as a result of:

• there being certainty that the insurance proceeds would be exempt from CGT; and
• an unfamiliarity with the concept of Trust Ownership by advisors of business owners.

Self Ownership is appropriate when a co-owner’s equity in a business is owned by them personally and not a related company or family trust or spouse. When a policy is self owned the insurance proceeds are paid to the Life Insured or their Estate and credit is given for those monies to the purchasers of the equity of the business under the related Buy/Sell Option Agreement.

The benefit of Self Ownership, especially where the equity in the business is owned by the Life Insured, is that both Death in Non-Death Benefits are exempt from CGT. The only real limitation of Self Ownership, where the equity in the business is owned personally by the Life Insured, is that the continuing owners are unable to control the application of the insurance proceeds, where necessary, to the:

• extinguishing of any loan secured over the outgoing owner’s equity in the business; or
• use of the funds for debt reduction purposes of the business, where the debt reduction was contemplated in the business succession planning arrangements.

The main implications of Self Ownership where the equity in the business is owned by a related company or family trust (‘Related Entity Owner‘) of the Life Insured are as follows:

The Sale Price is not received by the Seller
Self Ownership will result in the purchase price being paid to the wrong party, namely, the Life Insured and not the Related Entity Owner. This can have significant implications where, for example:

• if the Related Entity Owner is a company, the Life Insured is not the sole shareholder of the company;
• if the Related Entity Owner is a unit trust, the Life Insured is not the sole owner of all units in the unit trust; or
• if the Related Entity Owner is a discretionary trust, the Life Insured is not the sole named beneficiary of the trust.

In these circumstances the Life Insured may become liable to pay compensation to any person who had an interest in the Related Entity Owner as the law imposes a fiduciary duty on Company Directors and Trustees to act in the best interests of the shareholders/beneficiaries. The Life Insured would likely have breached that duty by causing the Related Entity Owner to enter into a Buy/Sell Option Agreement pursuant to which the Related Entity Owner become bound to dispose of its equity in the business in circumstances where only the Life Insured would receive a benefit from the Self Owned insurance policy.

The Seller will be liable for CGT despite not received payment

Despite the insurance proceeds not being received by the Related Entity Owner, that entity will be bound to transfer its equity in the business to the continuing owners pursuant to the Buy/Sell Option Agreement . That disposal of the equity in the business for no consideration will result in a CGT liability for the Related Entity Owner assessed on the market value of the equity disposed of.

As a result of the purchase price/insurance proceeds being paid to the Life Insured, the Related Entity Owner may not have access to funds to pay the CGT liability arising from the disposal or to discharge any loan secured over the equity to be disposed of.

Risk of Deemed Dividend and tax at Life Insured’ individual marginal rate

There is a risk that the payment to the Life Insured would be regarded as a “Deemed Dividend” under Section 109C of the Income Tax Assessment Act 1936 as a result of which Income Tax may be payable by the Life Insured on the full amount of the insurance proceeds at the Life Insured’s marginal rate of tax. In addition to the personal tax, the Related Entity Owner will still be liable for CGT on the market value of the equity disposed of. The net result will be that a greater amount of tax overall will be paid. This is because the personal Income Tax will be assessed on the whole of the sale proceeds, whereas, if the sale proceeds were paid to the Related Entity Owner, only the net proceeds after payment of the CGT would be available for distribution to the Life Insured.

Loss of Opportunity to implement Tax Minimisation Strategies

The ability to apply tax minimisation strategies to the insurance proceeds will be lost. For example, had the purchase price been received by the Related Entity Owner, income tax on the eventual payment of the proceeds to the Life Insured and/or his family could be been minimised by the timely payment of dividends to shareholders or discretionary distributions to beneficiaries of a family trust.

Sale Proceeds may be affected by a Family Provision Order against Life Insured’s Estate

If the Life Insured has died and the insurance proceeds become part of their Estate, the monies would be susceptible to a Family Provision Order by the Court. A Family Provision Order is an Order as a result of the Life Insured’s Will being challenged by an ex-spouse, estranged child or other “eligible person“. If a Family Provision Order is made in respect of the Life Insured’S Estate the insurance proceeds might come to be distributed to parties that the Life Insured had not intended to benefit when making the business succession planning arrangements.

Similarly, if the Life Insured died without a Will the insurance proceeds would be distributed in accordance with the Rules of Intestacy which might result in a distribution that the Life Insured had not intended for the sale proceeds at the time of the making of the business succession planning arrangements.

Difficulty Enforcing Debt Reduction

If the insurance includes cover intended to be used for debt reduction purposes for the business, in the absence of existing contractual obligation, the business may encounter difficulty if the Life Insured or their Executor does not co-operate in applying the appropriate portion of the insurance proceeds to reduce the debt of the business.

Cross Ownership refers to the ownership of an insurance policy in respect of the Life Insured by all owners of the business other than the Life Insured. Cross Ownership also includes circumstances where the business itself may own a policy in respect of the Life Insured, for example where there is an agreement to apply the proceeds towards debt reduction or to fund the buyback of shares in the company.

Cross Ownership is sometimes preferred to ensure that the insurance proceeds are received by the continuing owners who can then control the application of those monies, which would usually include:

• the payment of the purchase price for the outgoing owner’s interest in the business; and
• if part of the Business Succession Plan, payment of monies to reduce debt of the business.

Cross Ownership will result in a CGT liability in the case of Non-Death Benefits (such as Total and Permanent Disablement and/or Trauma Benefits) paid following a claim. As such, unless the amount insured for Non-Death Benefit cover is increased to anticipate the CGT liability, Cross Ownership will result in an avoidable CGT liability.

Trust Ownership pursuant to a Trust Owned Insurance Agreement will:

• overcome the limitations referred to above for Self Ownership where the real owner is a related entity of the life Insured (such as a Company or Family Trust);
• preserve the CGT exemptions for both Death and Non-Death Benefits;
• enable the insurance proceeds to be distributed to a number of different parties (for example, the Related Entity Owner and a Bank or other Creditor and not just the Life Insured and their Estate);
• allow the owners to maintain a single policy of insurance relating to both business and personal cover for a Life Insured; and
• allow the parties to vary the agreed directions relating to the distribution of any future insurance proceeds as their circumstances change without the need to change numerous different policies through their insurer (for example, where business debt is paid down Debt Reduction Cover could instead be directed to be paid towards any increase in the value of the owner’s equity in the business and/or to the Life Insured personally as top-up personal cover).

Trust Ownership means that a Trustee is the legal owner of the policy on behalf of the Life Insured. As the Life Insured will still be the “beneficial owner” of the policy, Death Benefits paid under a trust owned policy will still be exempt from CGT where the Trustee is bound to pay the Death Benefit to or at the direction of the Life Insured. Similarly, where the Trustee receives a Non-Death Benefit on behalf of the Life Insured in circumstances where it is bound to pay that benefit to or at the direction of the Life Insured, Trust Ownership will preserve the CGT exemption for that Non-Death Benefit.

To achieve these exemptions, and the broader intentions of the business succession planning arrangements, the Trustee and all relevant parties must enter into an agreement (“Trust Owned Insurance Agreement“) setting out, among other things:

• the parties’ respective obligations in relation to the maintenance of policies on behalf of the Life Insureds (the ‘beneficial owners’);
• those beneficial owners pre-determined directions to the Trustee in connection with the payment of the insurance proceeds.

These pre-agreed directions ensure that the true Related Entity Owners receive the sale proceeds for their equity in the business and that any intended part be paid to reduce debt of the business. As such a Trust Owned Insurance Agreement can facilitate the maintenance of a single policy in respect of a Life Insured covering amounts required to:

• perform the continuing owners’ obligations under a Buy/Sell Option Agreement, namely to pay the market value or purchase price for the outgoing owner’s equity;
• reduce business debt proportionate to the outgoing owner’s equity in the business to ensure the release of any personal guarantees of the corresponding Life Insured and their Estate; and
• cover the personal insurance needs relevant to the individual Life Insured, for example for the purpose of paying out a mortgage over the Life Insured’s home.

Too often business owners use Self Ownership or Cross Ownership structures to hold polices of insurance in respect of each other without formalising their intentions pursuant to a written Buy/Sell Option Agreement. The maintenance of insurance policies overcomes a funding problem only, however, does not address the usual problems that can arise in the absence of a written agreement.

The following are some of the implications of not formalising a Buy/Sell Option Agreement in relation to a Business Succession Planning Strategy:

• Disputes may arise in relation to the enforceability and/or terms of the agreement, including:
  • the method of calculating the price for an outgoing owner’s equity,
  • the obligation to accept the insured amount in lieu of the market value, or
  • when and how the price is to be paid.
• If a dispute arises and Self Ownership has been the preferred strategy for structuring ownership, the dispute will be occurring at a time when the Life Insured (or their Estate) has or will receive the insurance proceeds directly without any ability for the continuing owners to control the application of those proceeds.
• In the absence of an agreement in relation to the existence of terms of a Buy/Sell Option Agreement, litigation may result in the Court making an order determining that the continuing owners have a beneficial interest in the policy pursuant to a verbal Business Succession Plan evidenced by previous discussions, correspondence and the parties’ conduct in taking out personal insurance. The potential effect of such a finding may be that the Death Benefit loses its CGT exempt status in the hands of the Life Insured (or their Estate) due to the insurance proceeds being received by a party who the Court has determined was not the sole “beneficial owner” of the policy.

It has been suggested that approximately 90% of all Business Succession Planning Cover is maintained without any written Buy/Sell Option Agreement in place. If you fall within this group it is not too late to act. Call us today to discuss your Business Succession Plan.