Why should business owners consider business partner insurance?
Taking out sufficient insurance cover is a fundamental step of business planning. From insuring against fire and theft to income protection, there’s a range of covers that are simply a necessity for business owners. It's also important to think about having cover in place in the event that one of the business partners or key employees suffers a serious illness, injury or passes away.
Buy-Sell Life Insurance and Key Person Insurance can provide the means for business succession in the event that a business partner or employee becomes permanently disabled or passes away. This article will provide an overview of how these different types of insurance actually work.
Key person insurance
Key person insurance is a corporate-owned life insurance cover that insurers the employer against the loss or permanent disablement of a key worker in the business. This cover can be taken out on any employee whose loss would impact the companies profitability and result in additional costs including:
- Cost of hiring a temporary worker
- Cost of recruiting successor
- Loss of capacity to conduct business until successor is trained
As well as a business partner, other employees who can be considered a key person in a company include:
- Managing director
- Financial controller
- Computer programmer
- Sales manager
This is far from an exhaustive list, but a person is basically anyone who provides a business with a direct and substantial economic gain.
Tax treatment of key person insurance
When it comes to assessing the tax treatment of key person insurance, you must consider it from both an income tax and a capital gains tax standpoint. The insurance payout is not taxable, but the payment received for the partner’s share of the business will be subject to tax. Subject to how the business is owned, the tax payable may possibly be reduced by small business capital gains tax (CGT) concessions.
However, the exact treatment of your key person insurance will depend on the type of policy you take out and what you use the benefit payment for. The purpose of your insurance can be for either "revenue" or "capital". Revenue purpose insurance includes using the benefits to cover a loss in sales or profit, using them to recruit and train a replacement, or taking care of debts.
Capital purpose insurance, on the other hand, includes payment of debts owed to the key employee or their estate, using the money to cover a loss of goodwill resulting from the loss of a key person, or using the benefits to replace credit lines which were previously guaranteed by the lost employee.
Revenue purpose insurance premiums are tax deductible, capital premiums are not. Revenue purpose claim proceeds are assessable for tax while capital purpose claim proceeds are not.
Buy/sell life insurance agreements
A buy/sell life insurance agreement is a written agreement that business owners enter into that sets out each owner’s obligations concerning the transfer of the business equity in the event one partner passes away. So if one business partner dies or suffers total and permanent disablement, a plan for how to proceed with the business has already been laid out.
Buy/sell agreements are usually made up of a transfer agreement and a funding agreement. The former concerns the transfer of the departing owner’s interest in the business to the remaining owners, while the latter specifies how the departing owner or their estate will be compensated for their share of the business. These agreements are usually linked to life insurance policies for each partner.
What is the value of having an agreement in place?
Buy/sell life insurance agreements ensure the smooth transition of your business should one partner be forced to leave due to death or total and permanent disablement. It means you’re financially protected if something goes wrong, and will help your business survive and continue to thrive.
Not only that, but buy/sell agreements can also stop these sort of situations turning nasty. If the transfer of each partner’s share in the company has already been agreed upon and set in writing, it can prevent any unpleasant disagreements or feuds developing down the line.
In short, buy/sell life insurance agreements are a great way of ensuring your business is prepared in case disaster ever strikes.
Different types of ownership for buy/sell agreements for business partners
If you’re using insurance to fund a buy/sell life agreement for your business, there are several ownership structures to be considered. Each structure has its own tax implications.
- Self ownership. This is the most common ownership structure and is sometimes referred to as a put/call arrangement. Each partner has insurance policies on their own lives and, should death or TPD occur, the owner or their estate is required to give up their business share to the remaining parties. This means the agreement can be easily altered if the need arises. However, put/call arrangements need to be very carefully worded to avoid any later disputes.
- Policies owned through superannuation. This means each owner can structure their own insurance policy through a super fund. One of the benefits of this approach is that the premiums are generally tax-deductible to the super fund. A number of factors can affect how policy benefits are taxed when paid out through a super fund, while using this structure means you’ll also have to be mindful of things like contribution caps.
- Cross ownership. This is when the business owners hold policies on each other’s lives. If death or TPD occurs, the remaining owners are usually required to purchase the departing party’s business share. This approach can often be simpler than self ownership but has the disadvantage that policies must be changed and reassigned when a new owner joins or an existing one departs.
- Corporate ownership. This is when a company or trust owns the insurance policies and receives the proceeds. If death or TPD occurs, the company then buys back the departing owner’s interest in the business and cancels it. This is perhaps the easiest ownership structure to understand, but it can have a number of tax implications.
- Discretionary trust ownership. In this structure, the trustee of a discretionary trust owns insurance policies on each of the business owners. If death or TPD occurs, the trust distributes the proceeds of the policy to the surviving owners, and they can then decide whether they want to use those funds to buy the departing owner’s interest in the business. This flexible arrangement is best for when owners are likely to regularly join and leave the agreement.
Tax treatment of buy/sell agreements
Each ownership structure of bus/sell life insurance agreements also has its own tax implications.
- Self ownership. Although the premiums for life, TPD and trauma cover are not tax deductible, they will generally not be subject to Capital Gains Tax (CGT). The transfer of the departing owner’s share of the business will also be subject to CGT.
- Policies owned through superannuation. Contributions to fund your insurance premiums may be tax deductible. In addition, benefit payments withdrawn from superannuation are sometimes subject to little or no tax – depending on the circumstances.
- Cross ownership. In this type of structure, CGT is more likely to be payable on TPD and trauma payments than with a self-ownership structure. Life policy proceeds, however, will probably not be subject to CGT.
- Corporate ownership. CGT is more likely to be payable on TPD and trauma payments. Life policy proceeds, however, will probably not be subject to CGT. Insurance proceeds may also increase the value of the business, resulting in further possible CGT implications.
- Discretionary trust ownership. Trust ownership makes things more complicated when it comes to tax time. You may need to pay CGT on TPD and Trauma proceeds, and you may need to seek professional advice to understand the pros and cons of the tax treatment of this structure.