BUY/SELL PROTECTION
When an owner of a business dies, or becomes disabled, injured or ill, or chooses to leave the business, the surviving business partner/s will often desire ownership and control of the business, and the Estate will want funds to maintain their lifestyle. Buy/sell insurance arrangements can provide the money to fund some of these needs. It allows the surviving business partner/s of a business to buy out the deceased or disabled owner’s interest in the business.
Most business owners don’t leave their tangible assets (buildings, plant, equipment and stock) uninsured for a single day. Yet it is not their tangible assets, but themselves, their business partners and their key people, who make the business successful.
What is a buy/sell agreement?
A buy/sell agreement involves the owners of a business entering into a written agreement to plan for:
the voluntary exit of a business owner e.g. retirement (insurance cannot be used to fund the transfer), and
the involuntary exit of a business owner e.g. death, total and permanent disablement (insurance can be used to fund the transfer).
A documented buy/sell agreement will set out how:
the transfer of ownership interest would occur, and to whom
the value of the business will be determined, and
the purchase of the ownership interest being transferred will be funded.
Generally the agreement is structured in such a way that it does not matter what business structure has been used to own the business i.e. family trust, company or partnership.
Careful structuring of the buy/sell agreement as well as the application of the small business CGT concessions will assist in reducing potential taxes.
The buy/sell agreement should cover such issues as:
the events that will trigger the transfer of the business interest e.g. death, permanent incapacity, and/or serious illness,
the value (or formula for determining the value) at which the business interest will be transferred,
who will receive the outgoing owner’s business interest e.g. remaining shareholders, partner(s) in
partnership etc,
how often the arrangement will be reviewed to ensure the value of the business is accurately reflected in the agreement,
how the transfer will be funded e.g. using insurance, own funds, borrowed funds etc, and
if funding is via insurance:
– who will own the insurance policy(ies)
– who will pay the insurance premiums
The table below outlines the roles of the various professionals
– who will receive the proceeds
– how often the level of cover should be reviewed
Structure of a buy/sell agreement
You can structure a buy/sell agreement in several ways, including: a mandatory agreement to buy/sell, or
an agreement to use put/call options (non-mandatory). Mandatory buy/sell
The business owners can enter into a legally binding agreement specifying that upon the occurrence of an event covered in the agreement (e.g. permanent disablement or death of a business owner), the agreement compels the outgoing owner to sell their business interest and compels the other party(ies) to buy this interest.
Put/call options
Under a put/call option agreement, following the occurrence of an event specified in the agreement, a put option arises to the outgoing owner, giving them the right to sell the interest in the business. Simultaneously, a call option arises to the remaining business owner(s) providing them with the right to buy the outgoing owner’s share in the business.
Like all options, they do not have to be exercised, however should one party exercise their legal right to sell (put option) or buy (call option), the other party(ies) must transact with them i.e. buy/sell as per their agreement.
This gives the remaining business party(ies) the first option at purchasing the other share of the business.
Advice specialists
A business must obtain advice from a number of specialist advisers when establishing a buy/sell arrangement, including legal, accounting/tax advice and financial planning advice.
The table below outlines the roles of the various professionals
Financial Adviser
- Coordinator/facilitator
- Advice about insurance funding
Tax Adviser
- Business valuation
- Tax planning
- Financial statements
Legal Adviser
- Drafting buy/sell agreements
- Drafting or updating Wills
In the drafting of the buy/sell agreement an accountant/tax adviser would also need to be consulted on the potential CGT liabilities of any arrangements. Once a trigger event has arisen, the exercising of either a put (the right to sell the ownership interest) or call (the right to buy the ownership interest) option will result in the transfer of the business ownership interest.
Funding for this can occur through bank loans, self-insurance, or through the purchase of term life (including total and permanent disablement) insurance.
Insurance policy ownership
Buy/sell insurance policies are generally owned and paid for by the business owners. There are a number of different methods for owning buy/sell insurance policies including:
self ownership
cross-ownership
entity ownership
policy holding trust ownership
superannuation ownership
It is important to note that there is no single correct way to structure buy/sell agreements and policy ownership. This will come down to your individual circumstances.
It is extremely important that you seek advice on the suggested insurance policy ownership requirements:
from your financial adviser
from your legal adviser drafting the buy/sell agreement, and
from your tax adviser
Incorrect policy ownership may lead to unnecessary payment of tax.
Scenario
Cathy, Bill and Sandy are directors and partners in a small company; they each have an equal shareholding in the business that has an annual turnover in excess of $5m, and an estimated value of $6m. All of the three are married with children.
What would happen if Bill were to die? Cathy and Sandy have a number of options:
They could bring Bill’s spouse into the business as a director – after all, as Bill’s beneficiary, she now owns 33% of a successful business.
They could buy out her shareholding, but would need $2m to do so.
They could offer a financial arrangement with Bill’s spouse to pay her some form of income – but in order to continue with the business development plans, would also need to employ someone to take Bill’s place.
Here we have a small business dilemma. Cathy and Sandy do not want to work with Bill’s spouse – she is untrained and unskilled in this field of work – but she has in fact inherited a one-third ownership of the business. The business cannot afford to borrow $2m to buy the spouse’s share of the business. Cathy and Sandy are trapped, and Bill’s family has few options and no income.
If Cathy, Bill and Sandy had put in place a buy/sell agreement and used life insurance proceeds held on the life of Bill to fund the purchase then they would not be in this position. The life insurance proceeds would be used to fund the purchase of the business from Bill’s spouse. This will result in Sandy and Cathy owning 100% of the business and Bill’s spouse receiving $2m in return.
A buy/sell agreement is a process that involves a number of steps. In simple terms:
The business owners take out insurance policies on each other to cover an agreed amount. A legally-binding agreement is signed by each business owner whereby, in the event of their death or permanent incapacitation, the proceeds from the insurance policy would be passed on to the partner’s family in return for their shareholding in the company.
In this way, the business can continue without undue disruption and the family of the deceased person gets adequate financial compensation.
This is a simple summary of a process that can be very demanding. However, when you consider the alternatives outlined in the scenario above, the process could well be worth every minute spent on it.
