Business owners reference guide

Transcription

1 Business owners reference guide Issued October 2012

2 Contents Introduction 1 Key person insurance 3 Who is a key person? 3 What is key person insurance? 3 Why is key person insurance needed? 4 Replacing the loss of a key person 4 Realise personal funds/assets of the business owners 4 Realise business assets 4 Use business cash flow 4 Borrow cash 4 Self-insure 4 Use insurance 4 What insurance products are used? 4 Valuing a key person 5 How is the sum insured determined? 5 Multiple of salary 5 Multiple of gross/net revenue 6 Cost of replacing the key person 6 Considerations when selecting a policy 6 Default policyowner 7 Policy ownership 7 Business entity owns the key person insurance 7 Business owners own the key person insurance 8 Key person owns the key person insurance 8 Lender owns the key person insurance 8 Tax treatment of key person insurance 9 Revenue purpose 9 Capital purpose 9 Cost base for CGT 10 One-person businesses 10 Split purpose policies 10 Change in purpose 11 Substantiation of purpose 11 Guarantor protection (debt reduction) insurance 11 Key person process 15 Key person flowchart 16 B

3 Business succession planning 19 Why is a business succession plan needed? 19 The transfer (buy/sell) agreement 20 Trigger Events 21 Types of buy/sell agreements 21 The funding mechanism 22 How does a business succession plan work in practice? 23 What insurance products are used? 23 Sole Trader 23 Partnership 24 Company 24 Trust 24 How is the sum insured determined? 25 Policy ownership 26 Self-ownership 27 Cross-ownership 28 Trust ownership 28 Discretionary trust ownership 30 Partnership ownership 31 Corporate ownership (within a corporate entity redemption agreement) 33 Superannuation fund trustee ownership 33 Payment of insurance premiums 35 Tax implications of buy/sell arrangements 35 The CGT discount 37 CGT small business concessions 38 Business succession process 40 Business succession flowchart 40 Business expenses insurance 41 Working together 43 Business insurance case study 44 Business owners reference guide i

4 ii Business owners reference guide

5 Introduction Introduction This guide to business insurance is designed to give you a comprehensive and practical reference to business insurance. This can help you to design insurance packages that protect business owners and their families now and into the future. There are two main areas that a business owner needs to consider: insuring key people in the business (key person insurance) continuity of business ownership (business succession). The aim of this guide is to provide you with the tools and information to guide you and your clients through the complexity of business insurance. We provide a technical analysis of the implications of using insurance: to protect a business in the event of the loss, via death, disablement or trauma, of a key person, and to protect business owners and effect the transfer of a business share in the event of the loss of one of the owners. Key person insurance is different to buy/sell (succession planning) insurance. Key person insurance is designed to protect the business in the event that it loses a key person. The insured party may not be the business owner(s), rather it may be a key individual vital to the business. In contrast, buy/sell insurance is designed to protect the business owners. The insurance provides the proceeds to buy out the deceased/disabled person s interest in the business. In this instance, it is generally the business owners lives that are insured. However, the key purpose of both types of business insurance is to ensure the business remains robust and viable. Business owners reference guide 1

6 2 Business owners reference guide

7 Key person insurance Statistics 4 million people in Australia (18.5%) reported having a disability in The disability rate for year olds was 6.6%, and for year olds was 22%, in 2009.* Research by the Centre for Business, Work and Ageing found that 30% of Australian workers leave the workforce after age 45 through incapacity from illness or injury. Types of business structures in Australia, 2007 Sole Proprietor 465,802 (29.2%) Partnership 340,839 (16.0%) Company 702,342 (32.9%) Trust 365,802 (21.8%) Total 1,974,785 million 89.5% of all Australian businesses are classified as small businesses (that is, they employ less than 20 employees). Of the 2,073,793 businesses operating in June 2007, 60.4% were still operating in June Source: Australian Bureau of Statistics (Jun Jun 2011), Counts of Australian Businesses,Cat.no , Canberra: ABS, p.6. Figures are rounded. Includes both agricultural and non-agricultural firms. Something to note: 1 in 3 people will be disabled for at least 3 months before age 65 Alarmingly, only 9% of small businesses with multiple owners have buy/sell insurance in place (Cameron Research Group 2008). Who is a key person? A key person is a business owner or employee who is critical to the ongoing revenue and profitability of the business, or provides capital to the business. Key people can hold all sorts of positions in a business organisation and are often identified by their level of remuneration. They can be in decision making roles, have direct responsibility for carrying out management directives, be a source of revenue for the business, or have a unique talent that is valuable to the business. The biggest asset of most small to medium- sized businesses is the skills, experience and ideas of its people. A key person is someone who: possesses unique business/leadership skills has specialist skills and experience has good business connections is vital to the reputation/goodwill of the business is responsible for significant productivity and/or earnings, or is a guarantor for business loans. Some questions that assist in identifying a key person What financial impact to the business would the recruitment and/or training or replacement of the person have? Does the person have contacts that bring in significant amounts of business or help ensure the smooth running of the business? Does the person generate ideas of value to the company (research & development)? Would the loss of the person affect the business financially? Does the person bring in money to the business? Does the person save the business money? How would the loss of the person affect profitability until a replacement is found? Would the loss of the person affect the business' access to credit? Would the loss of the person have an adverse effect on goodwill? What is key person insurance? Key person insurance protects businesses from the loss of a key person whose capital, knowledge, client base or experience are vital to the company. For example, a company director, an employee with specialised skills, a salesperson who is responsible for providing a large portion of business revenue or a key supplier. Key person insurance proceeds are used (amongst other things) to: support the business financially until a replacement is found train other staff to fulfill the key person s role assist with any costs associated with retraining, advertising or hiring a new employee, or repay debt. Hence, key person insurance assists with protecting the financial stability of a business and reduces business risk. Key person insurance *ABS Survey of Disability, Aging and Barers (SDAC) 16 December 2010 * Cancer in australia 2001, Cancer Series no. 28, AIHW Business owners reference guide 3

8 Why is key person insurance needed? The purpose of key person insurance is to ensure the business can continue at the same level of operations/ profitability as it would normally had the death, disability or critical illness to a key person not occurred. The death, disablement or critical illness of a key person could have some serious implications for the business, including: pressure to sell or wind up an otherwise viable business necessity to repay loans foreign and hostile involvement in the control and operation of the business creditors demanding payment financial lenders withdrawing credit customers going elsewhere goodwill suffering the need to hire a replacement employee. The first step in counteracting any problems is to identify key people. The second step is to develop strategies that minimise the risk, such as: people retention strategies succession planning insurance strategies. Key person insurance compensates the business for any financial loss that may arise from the death, disability or trauma of a key person. A financial loss may include: reduction in profits costs to replace the key person loss of ability to access business loans, and costs of unfinished projects. Replacing the loss of a key person To cover the cost of replacing a key person, a business may: realise personal funds/assets of the business owners realise business assets use business cash flow borrow cash self-insure, or use insurance. Realise personal funds/assets of the business owners Many business owners may not have available funds or assets that can be sold. Business owners tend to re-invest any spare cash back into the business and have sold assets for the capital necessary to set up the business in the first place. Realise business assets Selling business assets may jeopardise the future viability of the business. A forced sale may not realise fair value for the assets. Use business cash flow The loss of a key person often means a significant reduction in cash flow. Therefore there may not be sufficient cash to cover the day to day operations, let alone the cost of recruiting and replacing the key person. Borrow cash The business may be able to borrow the funds. However a lender may not be willing to lend due to the perceived risk to the business of the loss of the key person. As mentioned previously, cash flow may be reduced which will limit the ability to repay a large debt. Also, if a loan can be obtained, this may be costly to the business. Self-insure The business could self-insure by using a sinking fund to accumulate funds over time. However, a key person may die or become disabled prematurely when there are insufficient funds in the sinking fund to cover the cost of replacing the key person. Use insurance This will be discussed in the next section. What insurance products are used? The insurance needs of the business must be evaluated before selecting an insurance policy. Insurance requirements vary considerably depending on the type of business being operated. 4 Business owners reference guide

9 Key persons do not exist in all business circumstances. For instance, a sole trader can not generally insure himself or herself as a key person because the business would most likely cease upon their death or disability. Personal insurance and/or business expenses insurance should be considered in these cases. Key persons can be insured for: death permanent incapacity (total and permanent disability), and/or critical illness (trauma). Valuing a key person There is no set formula for the calculation of the monetary value of a key person to the business. The sum insured of an insurance policy should be an amount sufficient to offset the estimated loss a business would suffer as a result of a key person s death or disablement. Thus a cost/benefit analysis relating to the financial contribution or effect the key person has to the business, could be conducted. This requires the business to place a value on a human asset. In doing so, the business should consider: whether a particular borrowing or other finance facility needs to be repaid or replaced on the departure of the key person whether a particular client or contract will be lost to the business on the departure of the key person the amount of loan accounts and other amounts which would need to be paid by the business to the key person or their estate in the event of cessation of service the amount of working capital required by the business to enable it to continue operations until a suitable replacement is found direct and indirect costs associated with locating, training and establishing a suitable replacement, and the likely loss of profits, particularly in the short term, which would be consequent upon the disruption and reorganisation of the business caused by the loss of the key person. How is the sum insured determined? The amount of insurance cover required depends on many factors including: the size of the business the level of current and expected future profits the effect on profitability if the key person dies or becomes disabled the cost of recruitment, training and replacement and the loss of profitability during this period loans that could come due, and loss of goodwill if the keyperson dies or becomes disabled. There are a variety of methods that can be used to calculate the level of key person cover required. Common methods used are: multiple of salary multiple of gross/net revenue, and/or cost associated with replacing the key person. Any one of the above methods could be used in isolation, or in combination with each other. However, consideration should be given to what is most appropriate for each business. Some factors that may influence what method(s) to use include: if the business is newly formed or established and/or whether the business is currently profitable. If the business is newly formed, a sum insured based on projections of future profit may be appropriate. If the business is in a mature phase, historical revenue or profit data may be appropriate as a basis for calculating the sum insured. Multiple of salary How much is the key person worth? A reflection of an employee s worth is their remuneration. Therefore a good measure of how much their death, disability or critical illness will impact the business is a multiple of their salary. Under this approach the key person s salary is multiplied by a factor between five and ten. Generally a key person will have a larger impact upon their departure if the business is small. If the business is small, 10 x salary may be appropriate, whilst with a large business, 5 x salary may be more realistic. This approach may not be accurate because salary on its own does not always reflect the total cost of employment which includes bonuses, superannuation and fringe benefits. Nor does it reflect the person s true value to the business. To calculate the full cost of the person to the business, it is necessary to factor in the total cost of that person to the business. Key person insurance Business owners reference guide 5

10 Multiple of gross/net revenue The most straightforward method to calculate how much key person cover is required is the multiple of net revenue (profit) approach. This approach is designed to give an indication of the revenue which may be lost due to the death or disability of the key person. This method is far more accurate and takes into account the key person s salary, annual revenue and the amount of time it would take to replace the key person. It is common practice to use an estimate of 5 x net revenue, or 2 3 x gross revenue. An alternative method is to look at how much income would be generated by investing the assets of the business and taking that figure away from the average profits over the last number of years. This value would represent the amount of profit directly attributable to the active management of the business, over and above passively derived income. A percentage of this would directly relate to the key person s efforts. It is important with this approach to account for future increase in profits and ensure that this is factored into the sum insured for a more accurate figure. Cost of replacing the key person The cost of recruitment and training a replacement employee can be factored in to the total amount of cover. Considerations when selecting a policy Level v. stepped premiums Insurance can provide cover for death, disablement, and critical illness (trauma). The cost of cover is relatively cheap but can increase as the life insured gets older. Stepped premiums may be suitable if the cover is only required for a fixed period, for example, to cover any personal guarantees of a principal for a loan until the loan is repaid. If the cover is required for a much longer term, or for life, then stepped premiums can get quite expensive in later years and may cause cash flow problems. A level premium structure could be considered in these circumstances as the cost remains the same every year regardless of age. Underwriting issues Besides the usual medical underwriting issues, key person insurance has a number of unique financial underwriting requirements. The underwriter must consider factors such as: the appropriate method to value the key person the purpose for which the insurance is sought. They nust be comfortable that the level of cover proposed reflects the value of the key person to the business, and the business is not placed in a better financial position by the death or disability of the key person after the pay out of an insurance claim. The underwriter, therefore, needs more information than required with personal/family situations. Most life offices have developed detailed financial questionnaires to assist in this area. Much of the information will need to be supplied by the client s accountant or solicitor and if it is not readily available, this may cause problems or delays. Purpose of key person insurance The loss of a key person may affect the income or expenses of the business (revenue purpose) or the liabilities or proprietorship of the business (capital purpose). Revenue purpose key person insurance is taken out when the loss of the key person will have an impact on revenue or expenses of the business. This will directly impact the operating statement (profit and loss statement) of the business. A key person will be insured for a revenue purpose if their absence may result in either: lost sales or income recruitment expenses additional salary for a replacement person, or training costs. Capital purpose key person insurance is taken out when the loss of the key person affects the proprietorship or loans of the business. This will directly impact the statement of financial position (balance sheet). A key person will be insured for a capital purpose if their absence may result in a loss to the business of: goodwill access to credit a loan from the key person, or ability to repay loans. The purpose of the key person insurance may affect policy ownership. 6 Business owners reference guide

11 Policy ownership As key person insurance is taken out to protect the business, the business is usually the policy owner (especially for revenue purposes). However, depending on circumstances the policy owner could be the life insured, business owner, lender or trust. The preferred policy owner is the business or employer on the life of the key person(s). The decision will depend on who needs to receive the money but also consideration to policy control and taxation implications. Revenue purpose Revenue purpose Key person insurance Default policyowner Business entity Capital purpose Repay debt/release guarantee Compensate for lost business value Life insured* Lender The business entity* or owners* * Can be held directly or through a bare trust. The section below highlights some advantages and disadvantages of each policy ownership option. Business entity owns the key person insurance The business entity is the default ownership option for revenue purpose (affecting business profitability) key person insurance and an option for capital purpose (affecting the business value) key person insurance. Control The entity that requires the insurance proceeds is in control of the policy. The proceeds are paid directly to the business and the business can decide whether to use the proceeds for the original purpose (to cover a loss incurred from the death or disability of a key person) or another purpose. Therefore, in the case of guarantor insurance (see page 11), the business is not compelled to pay out the loan when it receives the insurance proceeds (unless a legal agreement is in place). However, the lender will usually look to recoup the outstanding loan from the business before the guarantor. The business can also maintain the insurance policy after the key person ceases to be associated with the business this can be a concern to the key person. Change in ownership If business owners change, this will not require a change in ownership of the insurance policy as it is owned by a separate entity the business itself. Business owners reference guide 7

12 Tax If the business entity owns a revenue purpose key person insurance policy, the premiums will be deductible and the proceeds will be assessable to the business. If the business owns a capital purpose key person insurance policy, there are potential capital gains tax (CGT) issues. This will generally arise when a key person is permanently disabled (TPD) or suffers a critical illness (trauma). This is because a CGT liability will arise on insurance proceeds paid from a TPD or trauma policy when the proceeds are paid to someone other than the insured or their relative a business entity can never be one of these as it is not an individual. Business owners own the key person insurance The business owners are an option for ownership of capital purpose key person insurance (not generally considered for revenue purpose key person insurance). Control If a business is not performing, the business owners may put their individual interests before the interests of the business. There is nothing compelling the business owners to transfer the insurance proceeds to the business (unless a legal agreement is in place). In addition, the business must rely on the business owners maintaining premium payments so that the insurance does not lapse. The business owners can also maintain the insurance policy after the key person ceases to be associated with the business this can be a concern to the key person. Change in ownership If there is a change in business owners, this will require a new insurance policy to be taken out for the new business owner (assignment of the policy may have tax implications see below). Also, the departing business owner could continue the insurance policy on the key person even though they are no longer part of the business. Tax There may be CGT implications if TPD or trauma insurance proceeds are paid to the business owners. The exception is where a business owner is the key person or a business owner is a relative (or spouse of a relative) of a key person. If a term life policy is transferred to a new business owner and the departing business owner is paid some consideration for the transfer, CGT may apply. Key person owns the key person insurance The key person is an option for ownership of capital purpose key person insurance (not generally considered for revenue purpose key person insurance). Control The business must rely on the key person maintaining premium payments. If the key person leaves the business, they are able to keep the policy and use it for a personal purpose. If the key person is a guarantor, they can ensure that the guarantee is extinguished by paying out the loan from the insurance proceeds. However, because the lender will generally try to recoup the outstanding loan from the business before the guarantor, the guarantor may choose to use the proceeds for another purpose. Change in ownership There is no requirement for a change in ownership. Tax Payment of TPD or trauma insurance proceeds will not create a CGT liability. Lender owns the key person insurance Control The business must rely on the lender maintaining premium payments. If insurance proceeds are paid, the lender is not compelled to extinguish the loan / guarantee (unless a legal agreement is in place). The lender can also maintain the insurance policy after the key person ceases to be associated with the business this can be a concern to the key person. Change in ownership There is no requirement for a change in ownership. Tax As with business ownership, the lender will never be the insured or their relative as the lender is not an individual. Therefore there may be a CGT liability when TPD or trauma insurance proceeds are paid. 8 Business owners reference guide

13 Tax treatment of key person insurance The tax treatment of key person insurance depends on whether the key person insurance is for a revenue or capital purpose. Anything that affects the value of the business i.e. the statement of financial position (balance sheet) will be considered cover for a capital purpose. Anything that affects business profitability i.e. the operating statement (profit and loss statement) will be considered cover for a revenue purpose. The purpose of the cover has implications for tax. The table below summarises what items generally result in a revenue/capital purpose. Business revenue generated by key person Capital purpose Y Revenue purpose U Recruitment costs Y U Training costs Y U Loss of goodwill U Y Repay debts U Y Revenue purpose Deductibility of premiums If a key person is insured for a revenue purpose, the premiums are tax deductible. Any expense that is incurred in producing assessable income of a business is tax deductible. Income tax and CGT Proceeds are subject to income tax and included as assessable income of the business as the cover is taken out for a revenue purpose. Tax will be applied at the company rate (30%). There is no capital gains tax liability as the proceeds are treated as assessable income and are not a capital item. Regardless of whether the insurance is life, TPD or trauma, if it is for a revenue purpose, the premiums are always tax deductible and the proceeds are always included in, and taxed as, assessable income. Capital purpose Deductibility of premiums If insurance cover is for a capital purpose, the premiums are not tax deductible because the expense is not incurred in producing assessable income of the business. Income tax and CGT Proceeds may be subject to CGT as the cover is taken for a capital purpose. The application of CGT is determined by the type of underlying insurance and who receives the proceeds. If CGT applies, the capital gain will form part of the insurance owner s assessable income and be taxed at their applicable company or marginal tax rate. Life insurance and terminal illness Generally, there is no CGT payable on life insurance or terminal illness cover. Example: terminal illness Dominic was the original beneficial owner of a life insurance policy which provided a terminal illness benefit if required. Dominic was diagnosed with a terminal illness and advised by his doctor that he could only expect to live for 10 months. One month after receiving this diagnosis, Dominic received a payment under his insurance policy. The capital gain is disregarded because the payment was made on the happening of an event that was contingent on the duration of Dominic's life. The event was the professionally diagnosed expectation of his death within a 12-month period. However, if life or terminal illness insurance proceeds are paid to someone other than the original beneficial owner and the policy was transferred for some consideration, capital gains tax will apply. To avoid potential CGT issues, it may be prudent to cancel the original policy and reissue the new policy under the new owner rather than transfer or assign it. Consideration may include money or any goods/ services that can be seen as compensation to the original policy owner for the transfer of the policy. However, the mere payment of premiums is not deemed consideration for the policy (TD 94/34). Key person insurance Business owners reference guide 9

14 TPD and critical illness (trauma) If TPD or critical illness insurance proceeds are paid to someone other than the insured or their relative* (or spouse of their relative), and the insurance is used for a capital purpose, CGT may apply (ITAA 1997 section ). * A relative is defined under ITAA 1997 section 995 as: a) the person s spouse; or b) the parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendent or adopted child of that person, or of that person s spouse; or c) the spouse of a person referred to in paragraph (b). Taxation of key person insurance is summarised in the table below: Key person insurance Purpose Deductible premiums Income tax Capital gains tax Revenue Yes Yes No Capital No No Yes* * Life insurance and terminal illness if the proceeds are paid to someone other than the original beneficial owner and the policy was transferred for some consideration TPD and trauma if the proceeds are paid to someone other than the insured or their relative (or spouse of their relative) Cost base for CGT The amount of capital gain is equal to the proceeds less the premiums paid. Whether the total accumulated premiums or just the annual premium is used will depend on whether a direct and substantial link can be shown between the payment of premiums and the right to collect the insurance proceeds. This is clearly demonstrated from the time when the policy commences in the case of life and TPD insurance. However, in the case of trauma, the ATO s view is that a direct and substantial link does not exist between the payment of premiums in previous years (before diagnosis) and the right to collect trauma insurance proceeds for the particular illness that the individual suffers. Therefore for trauma insurance, only the premiums for the period following diagnosis will be part of the cost base. One-person businesses Deductibility of premiums for revenue purpose insurance The Australian Tax Office s view of whether a single employee of a company can be seen as a key person of the business is expressed in IT 155. IT 155 states that premiums are only deductible when they relate to a key person of the business. In the Australian Tax Office s view, the purpose of key person insurance is to ensure that the business continues in the event of permanent disability, critical illness or death of the key person. In the normal case of a one-person business where the owner is also the employee, this would result in the termination of the business. In ATO ID 2002/174, the Federal Court stated that a deduction would not be denied merely because a business had ceased, nor because the expense was incurred in a year later than the income was incurred. That is, if the expense could be associated with the production of assessable income, that expense would be deductible. However as the insurance premiums cannot be associated with the production of income (because of the cessation of business), they are not deductible. Split purpose policies When there are both revenue and capital purposes to be covered, there are two options on how the policies can be structured: 1) One policy for both purposes accurate records must be kept to demonstrate which portion is for a revenue purpose and which for a capital purpose (usually done through a trust). 2) Separate policy for each purpose easier to administer but may be more expensive. 10 Business owners reference guide

15 Change in purpose If key person insurance proceeds are used for a different purpose than originally stated, the tax office will look at how the proceeds are actually used, rather than the original intention. The business may need to revise their tax returns because of the change in purpose. Example purpose changes from a capital to revenue Capital purpose key person cover is taken out by Penguin Toys Ltd on the life of Selwyn, a guarantor of the business loan. Selwyn dies five years later and the insurance is paid to Penguin Toys. By this time, the debt has already been repaid and therefore the insurance proceeds are used to increase staff salaries. As the insurance proceeds were actually used for a revenue purpose and not the original capital purpose, the proceeds will be fully assessable at the company rate of 30%. Key person insurance When the purpose changes from a capital to a revenue purpose, the insurance proceeds may be assessable upon receipt. When the purpose changes from a revenue to a capital purpose, tax returns where deductions were claimed previously may need to be amended. Substantiation of purpose Keeping records relating to the purpose for which a business insurance policy is taken out is recommended. These records will provide evidence to determine the purpose, but the ATO may also look at how the funds themselves were used. Tax Ruling IT 155 provides authority on these issues and examines the ATO s viewpoint regarding documentation and the effect of a change in purpose. It is possible for one policy to support both a capital and revenue purpose. In this circumstance, an apportionment is made based on the facts, but care must be taken to substantiate the purpose and split. Often the use of separate policies may provide a more appropriate solution. It is recommended that when the insurance policy commences, the purpose is recorded in: minutes as a book entry, or a letter to the insurance company or file note (sole trader). Records should be updated when policy is renewed eg. annually. IT 155 states information about the taxpayer s minutes or book entries would be of some value but should not necessarily be regarded as conclusive. Guarantor protection (debt reduction) insurance A business owner may either: take out a loan personally for a business purpose, or give their personal guarantee on the repayment of a business loan. The second option is where the business owner becomes the guarantor for the loan. If the business fails to repay the loan, the lender will generally try to recoup their losses from the business first. However, if this is not possible, they can seek repayment from the guarantor who may be forced to liquidate their personal assets. If the guarantor no longer wants to or is unable to provide the guarantee on the loan due to death, disablement or critical illness, the lender may call in the loan. The business can protect itself by taking out guarantor protection (debt reduction) insurance. Guarantor protection insurance ensures that: 1) the business has adequate funds to pay out the loan, and 2) the guarantee is extinguished and the guarantor or their estate no longer have a liability. Business owners reference guide 11

16 Ownership of the policy As guarantor protection insurance is normally taken out to protect the business, the business is usually the policy owner. However, depending on circumstances the policy owner could also be the business owner(s), the guarantor or lender. The decision will depend on who needs to receive the money but also consideration needs to be given to policy control and taxation implications. If the initial recipient of the proceeds is not the intended final recipient, the flow of money can be determined through a legal agreement. Legal advice should be sought on this matter. The following table highlights some advantages and disadvantages of different guarantor protection policy ownership options. Policy owner (and payer of premium) Advantages Disadvantages to the business Disadvantages to the guarantor Business Business has control of policy and will receive proceeds Business can choose how to use proceeds Minimises problems with changes in business owners Receipt of TPD or trauma proceeds may be subject to capital gains tax Business is under no compulsion to repay the debt unless a legal agreement exists. The guarantee could remain in force after death or disability occurs If the guarantor leaves business, they cannot force the policy to revert to them for personal protection Business could stop paying the premiums and policy could lapse Guarantor does not have control of the policy and cannot make any changes to it Business owner(s) No capital gains tax payable on TPD or trauma policies if proceeds are paid to the guarantor or the guarantor's relative Business owner(s) are under no compulsion to repay the debt unless a legal agreement exists. This may depend on how well the business is running and the individual interests of each business owner Receipt of TPD or trauma proceeds subject to capital gains tax if proceeds are not paid to the guarantor of the guarantor's relative Business owner(s) could stop paying the premiums and policy could lapse Business owner(s) are under no compulsion to repay the debt unless a legal agreement exists. The guarantee could remain in force after death or disability occurs If the guarantor leaves business, they cannot take the policy with them for personal protection Business owner(s) could stop paying the premiums and policy could lapse Guarantor does not have control of the policy and cannot make any changes to it 12 Business owners reference guide

17 Policy owner (and payer of premium) Guarantor Advantages Disadvantages to the business Disadvantages to the guarantor Guarantor has control of policy and will receive proceeds No capital gains tax payable on TPD and trauma proceeds If purpose changes, guarantor could elect to continue the policy for personal protection Upon death, proceeds may form part of the estate. There is no compulsion for the estate to repay the debt unless a legal agreement exists Guarantor may keep the proceeds for another use instead of repaying the loan. The lender will usually seek to recoup money from the business first Business does not have control of the policy and cannot make any changes to it Key person insurance Lender If relevant provision is in loan contract, receipt of the policy proceeds will reduce the debt owing Lender could stop paying the premiums and policy could lapse Receipt of TPD or trauma proceeds subject to capital gains tax Business does not have control of the policy and cannot make any changes to it If the guarantor leaves the business, they cannot take the policy with them for personal protection Even after the loan is fully repaid, the lender can still hold the policy on the guarantor If the lender agrees to transfer the policy to the guarantor, there may be capital gains tax implications upon death Guarantor does not have control of the policy and cannot make any changes to it Example: Guarantor insurance Andrew and Bruce run the company ABC Pty Ltd. Andrew has provided personal guarantees for the business s loans. ABC Pty Ltd has taken out a life and TPD insurance policy on Andrew s life so that if he died or became permanently disabled the business would be able to repay the debt guaranteed by him. ABC Pty Ltd owns the insurance policy and pays the premiums, which are not claimed as a tax deduction. A year later, Andrew has an accident that leaves him permanently disabled and ABC Pty Ltd receives the proceeds of the TPD insurance policy. From the facts that have been disclosed it appears that the TPD insurance policy was taken out for capital purposes. Therefore it would not be assessable as income. However, as the proceeds were received by someone (ABC Pty Ltd) other than the life insured or a defined relative of the life insured or a spouse of a defined relative of the life insured, the proceeds of the TPD insurance policy (less the cost base) will be subject to CGT at the company tax rate of 30 per cent. Unless Andrew has separately contracted with ABC Pty Ltd, there is no compulsion on the business to use the insurance proceeds to repay the debt. The bank could still hold Andrew accountable for his guarantee. The legal protection available from a correctly worded document can prove invaluable. In this circumstance such a document would reduce Andrew s exposure and provide greater peace of mind. Business owners reference guide 13

18 How much debt reduction cover is required? The amount of cover required may depend on who the policy owner is and if a capital gains tax liabilty is likely to occur. Some policy owners may choose to only cover part of the debt and capital gain tax liability with insurance (partly self-insure) while some will choose to cover the entire amount required to repay the loan in full. If the insured amount covers the entire amount of the loan, it can be grossed up by the capital gains tax payable. The capital gains tax will differ according to who or which entity owns the policy. Capital gains tax will be payable if: life insurance proceeds are paid to someone other than the original beneficial owner and the policy was transferred for some consideration (less likely to happen), or TPD or trauma proceeds are paid to someone other than the insured, their relative* or spouse of their relative (more likely to happen). *A relative is defined under ITAA 1997 section 995 as: (a) the person s spouse; or (b) the parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendent or adopted child of that person, or of that person s spouse; or (c) the spouse of a person referred to in paragraph (b). Activity Andrew has recently purchased a pub business, although he doesn t hold a liquor licence and doesn t intend to get one. Jane, a current employee, is the leading salesperson in the business and holds a current liquor licence. Jane has worked in the business for the previous 10 years and has established a large network of customers and suppliers as well as goodwill in the community. 1) Is Jane classified as a key person in the business? 2) What financial costs could Andrew incur if Jane has to leave the business due to disability? 3) What insurance, if any, would you recommend that the business takes out to cover any financial costs if something happened to Jane? Answer 1) It is highly likely that Jane would be classified as a key person in the business, and Andrew may wish to insure against her death, TPD or critical illness. 2) Financial costs that Andrew may incur if Jane leaves the business include: Loss of profits Loss of goodwill Recruitment and training costs Meet the viability concerns of staff, customers and creditors Cost of obtaining a liquor licence. 3) It would be prudent to recommend that the business takes out key person insurance for Jane for death, TPD and trauma. 14 Business owners reference guide

19 Key person process The business identifies key person(s) The business estimates the value of the key person(s) of the business Key person insurance Sum insured amount is determined Insurance ownership is determined Arrange purchase of insurance Insurance owner commences paying premiums Regularly review insurance and level of cover Upon trigger event, claim submitted and insurance proceeds paid Business owners reference guide 15

20 Key person flowchart This flowchart shows how, in five easy steps, key person insurance can be implemented and how it fits into a client s overall insurance plan. 5 steps to keep a business running Step 1: Purpose Keep business running Succession planning (see page 21) Protect person and family Guarantor cover Key Person cover Business expenses (see page 39) Buy/sell arrangements Personal insurance Step 2: Who needs the money? Who is life insured? Who needs the money? Who needs the money will depend on how it will be used The key person Rapay debt (Capital purpose) Replace lost value (Capital purpose) Cover expenes or replace profits (Revenue purpose) Step 3: Policy ownership (Ownership default is entity who needs money modify if megative tax or control issues arise) For debt repayment, start with the borrower as default policy owner. Guarantor^ (if life inured) Lender Business owners^ or business entity Business entity* Step 4: Transfer agreements (only needed if final recipient of money is not the policy owner check CGT implications**) Step 5: Tax implications Premiums NOT deductible Premiums ARE deductible Proceeds: Income tax no CGT** no, unless not original owner and some consideration paid Proceeds: Income tax no CGT** yes: trauma or TPD and not life insured or relative, or death or terminal illness and not original owner and some consideration paid. Proceeds: Income tax yes CGT no ^ Can be held directly or through a trust. If held througha trust, CGT may not apply for disability policies if the life is beneficially entitled to, and receives the proceeds. The Government announced in the 2012/13 Federal Budget that legislation will be introduced to ensure the same CGT outcome is achieved for an individual; regardless of whether insurance proceeds are received directly, or indirectly through a trust. A consultation paper was issued in June 2012 in regard to this. For business expenses, policy owner may need to be life insured (ie: business owner) ** If there is a legal agreement to pay the money from the policy owner to another entity/individual or to create a contractual obligation, that agreement may also create a CGT event. Tax advice and/or ruling from ATO should be sought 16 Business owners reference guide

21 Business owners reference guide 17

22 18 Business owners reference guide

23 Business succession planning Business succession refers to planning how a business will be managed in the event of death, illness, injury, retirement or departure of one of its owners. Why is a business succession plan needed? Half of all Australians over the age of 30 can expect to be diagnosed with a serious illness, disability or injury at some time during their lives. Where a business is owned by two or more people, the death or permanent disablement of one owner can create financial hardship for the other owner(s). A sound business succession plan is important. If business owners have not implemented plans to safeguard their business, the result may be: the continuing owner(s) may not be able to afford to buy out the outgoing owner s share of the business, the outgoing owner s family may receive less than the market value for his/her share of the business, in the case of death, the estate may insist on immediate and direct involvement in the control and operation of the business, but may not have the expertise to handle this in the case of death, the estate of the deceased business owner may be forced by circumstances to sell his or her interest in the business to an outside buyer at fire sale values in the case of traumatic illness (eg. heart attack), there may be uncertainty over the likelihood of the business owner recovering or ever returning to work the continuing business owners may end up doing all of the work, but splitting the profits with a nonworking owner, or the business may no longer be viable and be forced to wind up. The lack of proper agreements can make negotiations to buy-out or continue running the business difficult. For example: Partnerships under partnership law, the partnership is automatically dissolved upon the death of a partner. The business can only continue if the deceased partner s beneficiaries agree, otherwise the business needs to be liquidated. Company ownership the company continues to exist after the death of a shareholder. However, disputes can arise around the distribution of company profits with both active and inactive owners. Gives peace of mind to the continuing business owners so that they can buy out the departing business owner s share of the business without putting the business or their personal finances in jeopardy. When a business has more than one owner, business succession planning is essential. The death, injury or disablement of a co-owner can cause severe problems for a business and can throw ownership into disarray. All the years and hard work in building a business can be lost if provision for succession is not planned. The interests of the deceased s family or beneficiaries also need to be taken into consideration. The family may need funds urgently, and will want to realise the true value of their interest in the business. The beneficiaries of the deceased may also want to become involved in the business, and this could be a problem for the remaining owners. A business succession plan ensures that the needs of business owners and the beneficiaries/family of a deceased or disabled owner are met, and that the ownership of the business remains consistent with the wishes of the owners. Because there are a number of ways in which business succession can be implemented, and these can have serious tax as well as other financial implications, business owners should seek professional financial advice before embarking on any particular strategy. If a business owner leaves and it is decided by the remaining business owners to continue the business, the departing owner may: transfer their business share to the remaining owners/partners sell their business share to a third party, or transfer their business share to their family member(s). Succession planning can help a business owner(s) to: maximise the value of the business provide an exit strategy safeguard business continuity into the future pass on the business to next generation, and provide peace of mind and certainty to co-owners/ successors. By putting a formal business succession plan in place, business owners can exit on their own terms and ensure that they or their estate receives the full value of their share of the business. Business succession planning Business owners reference guide 19

24 The structure of the business (eg. sole trader, partnership or company), potential buyers (eg. co-owners, third parties) and the level of debt, will determine the type of succession plan needed. Business succession planning requires a solicitor to draft the most appropriate method of passing the business interest to the party or parties in the form of a buy/sell agreement. A buy/sell agreement is also generally used to determine how the change of ownership will be funded. Example: business succession plan in practice Martin and Sarah are partners in a small, successful dental practice. Martin and Sarah had prepared a business succession plan, and had agreed that the business was valued at $2 million. James suffers a fatal heart attack. He is survived by his wife, Jane and two young children. Martin and Sarah had taken out life insurance to fund the purchase of each other s share of the business in the event of one of their deaths. When Martin died, Sarah was able to pay the $1 million from life insurance proceeds to Jane, representing Martin s share of the business. This meant that Sarah was able to continue the business and Martin s wife Jane and the children were provided for. Generally business succession planning has two key components: the transfer (buy/sell) agreement, and the funding mechanism. The transfer (buy/sell) agreement A buy/sell agreement is a written contractual agreement outlining how a business owner s interest is dealt with if a trigger event occurs, eg. they die, become disabled, suffer a trauma or want to resign or retire. If one owner suffers a trigger event, the buy/sell agreement operates to transfer ownership of that person s business interest to the other owner(s) at an agreed price (usually market value). This can have the benefit of minimising disputes and/or interference in the business by the deceased s family or beneficiaries. A buy/sell agreement can provide a business owner(s) with a structured timetable for exit to allow: the purchase of the departing owner s interest in the business, and transfer of that interest to the continuing owner(s). If insurance is used, the proceeds flow to the policy owner or beneficiary. However this may not be the entity that should ultimately receive the money. Since the departing owner of the business share requires compensation for their business share and any CGT liability, it is imperative that the buy/sell agreement is constructed so that they are the ultimate recipient of insurance proceeds (or other funding). A buy/sell agreement is still required when the insurance proceeds are owned by the person who ultimately should receive the insurance proceeds. The buy/sell agreement would simply effect the transfer of the business share. Establishing the buy/sell agreement A solicitor must be briefed to prepare the buy/sell agreement. The agreement will reflect the particular ownership structure of the business, the funding mechanism to transfer the business share and the trigger events, valuation of the business and the obligations of each party to the agreement. It is advisable for the parties to the agreement to estimate any capital gains tax and stamp duty that will be incurred upon transfer of the business share to ensure that the funding mechanism is sufficient. Something to note: buy/sell agreements should include methodology to determine the value of the business. 20 Business owners reference guide