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Buy sell insurance agreements

Buy sell life insurance agreements help company owners with succession planning should they die or become permanently disabled.

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By

James Martin

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Business partners can purchase life insurance policies for the lives of each co-owner. In the event of the passing of a co-owner, the other owners can receive a lump-sum benefit equivalent to the departing owner's interest in the company.

At the same time, the deceased's family members can be compensated. Let's take a closer look at how buy sell insurance works.

What is a buy and sell insurance agreement?

A buy and sell agreement is an integral part of a business succession planning process. When a partner is unable to continue running the business due to death or disability, a buy and sell life insurance agreement can protect the business, especially for the surviving owners.

Buy/sell agreements can also provide cover for events other than death and disability. This can include:

  • Divorce or separation (if the owners are married or in a de facto relationship)
  • Retirement
  • In some cases, bankruptcy

What are the main benefits of buy-sell life insurance agreements?

  • Mutual benefit. Not only does the family of the deceased benefit through this agreement, but the company does not experience any financial loss.
  • Extends cover to serious illness and injury. Buy-sell life insurance can also be used to cover total permanent disablement or serious medical trauma.
  • Policies can be owned in various ways. Cover can be owned individually, cross-owned (owned on behalf of the lives of other owners), or owned by a super fund trustee on behalf of those insured.

Key components of a buy and sell life insurance agreement

  • Guarantee to buy the owner’s shares. The trigger events for a buy/sell agreement are always mentioned in the agreement and all the owners offer a guarantee that the shares of an owner will be purchased if any of the trigger events occur.
  • Purchaser of the owner’s shares. The agreement will also mention who has to buy the shares of the departing owner. The remaining owners may be bound to purchase the shares of the departing owner, or the company itself may be required to affect a buyout of the shares.
  • Valuation of the departing owner’s interest in the business. One of the main features of a buy/sell agreement is the valuation of the shares of the departing owner. The interest is typically valued as per the market rate of the shares at the time the trigger event occurred.
  • How to fund the buyout. The buyout of the shares of the departing owner is typically funded through life insurance policies on the owner’s lives. These policies generally include total and permanent disability, and trauma cover in some instances.

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5 ownership structures of buy and sell life insurance agreements

When life insurance is utilised to fund a buy and sell agreement, the business owners/partners must consider an ownership structure that is appropriate to their individual situation and objectives. There are 5 ownership structures for buy/sell life insurance agreements and these include:

Single User

Self-ownership

In this ownership structure, business owners hold an insurance policy on their own lives. When a trigger event occurs, the departing owner or their estate is generally required to give up their share of the business to the surviving owners. Pros and cons include:

Pros
Cons
  • Flexibility to change the policy arrangements and alter the arrangement if new partners join or existing owners leave the business.
  • Life, TPD and trauma policies are generally not subject to Consumer Goods Tax (CGT).
  • The buy and sell agreement must be worded carefully to ensure that it meets the desired outcomes of the parties involved.
  • Issues may arise if the individual does not own the business assets in their own name, and instead under a third party, which could be a spouse, a company or a family trust.
  • Business owners may pay different premium rates for their policies, where one is a much higher amount than the other.

Contract

Cross-ownership

With this type of ownership, each shareholder owns an insurance policy on the other owners of the business. Any insurance proceeds can be used by the surviving owners to purchase the departing owner's share of the business. Pros and cons include:

Pros
Cons
  • Easy to implement with simple documentation required
  • No CGT is payable on life policies
  • Issues may arise if the individual does not own the business assets in their own name, and instead under a third party, which could be a spouse, a company or a family trust.
  • If there are multiple owners in the business, the cost of owning multiple policies can be significant.

Wealthy businessman

Corporate ownership

In a buy/sell life insurance agreement with corporate ownership structure, the business partners do not own life insurance policies on each other. The corporate entity owns the insurance policies on behalf of the owners of the business.

So, in the event of death or permanent disability of one of the owners, the entity will buy out the departing owner's share of the business using the proceeds from the insurance policy. Pros and cons include:

Pros
Cons
  • Easy to understand and implement
  • Centralised management and payments, as the company will own all the insurance policies
  • Easier to add and amend insurance policies when there are changes in ownership compared to cross-ownership agreement
  • TPD and trauma insurance proceeds are likely to be subject to Capital Gains Tax (CGT).
  • Insurance policy benefit may increase the business value, which in turn may affect the CGT liability for the surviving owners.
  • There may be some additional tax implications on the benefit payment from the company to the departing owner.

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Discretionary trust ownership

With discretionary trust ownership structure in a buy/sell agreement, an independent trustee of a discretionary trust has been appointed to hold insurance policies on behalf of all of the lives insured.

When a trigger event occurs, the trustee will then divide the proceeds of the policy to the continuing owners, which can be used to purchase the departing owner's interest in the business. Pros and cons include:

Pros
Cons
  • More flexible to accommodate changes in business ownership
  • Tax treatment for trust ownership is generally more complicated and it is recommended to seek professional advice from a tax specialist.
  • CGT may be payable on TPD and trauma policy proceeds.
  • Setting up a trust will require initial and ongoing costs.

Superannuation icon

Superannuation ownership

This structure can be considered as a variation of self-ownership, as the insurance policies are owned and structured through a superannuation fund, as opposed to under each of the business owners' names.

Determine the value of your business for the purpose of a buy and sell insurance agreement

There are 3 types of valuation methods to help determine the value of your business for a buy and sell insurance agreement:

Number 1

Current market value

The Australian Taxation Office (ATO) will most likely consider the validity of a business interest transfer under a buy and sell agreement when it occurs at market value.

Number 2

Current market value with indexation

You also nominate the sums insured based on the current market value of the business, and keep up with changes of business value amount over time by having them indexed to inflation or by the anticipated growth rate of the business.

Number 3

Formula-based valuation

This formula should reflect an industry standard and be appropriate for the specific business. The value of the business over the years must also be reviewed by using this calculation.

Generally, a business accountant will conduct an assessment on the valuation and provide confirmation on whether or not it is acceptable on ordinary commercial terms. This may be an underwriting requirement prior to insurance being offered.

Tax treatment for different buy/sell insurance agreements

Ownership typeAre premiums tax-deductible?Tax on payouts for life insuranceTax on payouts for TPD & TraumaTransfer of ownership
Self/principalNoNo CGT (if the payout is used for the original beneficiary)No CGTAssessable for CGT even though the departing owner does not receive any payment for their share of the business.
CrossNoNo CGT (if the payout is used for the original beneficiary)No CGT (if the benefit payment is received by relatives of the policyholder)Assessable for CGT
Corporate entityYesAssessable for CGTMay be subject to CGTAssessable for CGT
Discretionary trustNoNo CGT (if the payout is used for the original beneficiary)May be subject to CGTAssessable for CGT
Superannuation fundYesCan depend on:
  • Whether or not the beneficiary is a dependent
  • How the benefit is paid – lump sum or income stream
  • Age of the life insured
  • The eligible service date, date of death/cease to work due to a disability, and retirement date
  • Conditions of release for TPD benefit payment
  • The super fund balance of the member
Can depend on:
  • Whether or not the beneficiary is a dependent
  • How the benefit is paid – lump sum or income stream
  • Age of the life insured
  • The eligible service date, date of death/cease to work due to a disability, and retirement date
  • Conditions of release for TPD benefit payment
  • The super fund balance of the member
Assessable for CGT

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