Business succession insurance ownership Fact Sheet - October 2014

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1 Business succession insurance ownership Fact Sheet - October 2014 When creating a life insurance solution for clients there needs to be a recommendation of the correct amount and type of insurance cover. Also, a decision needs to be made as to who should own the policy to ensure benefits get to the right person. This is especially true when insurance is used for business succession planning. The default for policy ownership (other than where there are loans) is the individual or entity that needs the money when someone dies, becomes disabled or suffers a critical illness. An insurance policy can be owned by the life insured or another person/entity. If the policy is owned by another person/entity as part of a buy/sell agreement, the recipient can use the proceeds to buy the life insured s share of the business. If owned by the life insured, the buy/sell agreement may specify that proceeds received by that person (or estate) represent payment for their share in the business. The decision on policy ownership should include consideration of: purpose for the policy potential changes to business ownership how premium costs will be shared/paid by business owners, including mechanisms to avoid policy lapses for non-payment taxation implications, including capital gains tax (CGT), and clear documentation especially if insurance is part of the buy/sell agreement. It is generally the structure of the business that dictates the guidelines for insurance policy ownership. 1. Self-ownership 2. Cross-ownership 3. Bare trust ownership 4. Corporate ownership 5. Superannuation trustee ownership 6. Discretionary trust ownership 7. Partnership ownership The most appropriate means of owning an insurance policy in any buy/sell arrangement depends on: who the parties are; and the circumstances of those parties to the arrangement. Asteron Life 1

2 Each approach to ownership has its advantages and disadvantages. Since one size doesn t fit all it is important to review each case on its own merits. Self-ownership Under this option, each person owns the insurance policy on their own life. When an insurable trigger event occurs for one of the owners the insurance proceeds are paid to that person or their estate. A separate buy/sell agreement must be created. If the agreement is not made or is incorrectly executed, the departing owner of their estate could potentially end up with the insurance proceeds and the interest in the business. The buy/sell agreement can be structured so that the life insured (or estate) accepts the insurance proceeds as payment for their share of the business. Business ownership then transfers to the remaining owner(s). This should be clearly documented in the buy/sell agreement. This option may suit businesses with larger numbers of owners, or where business ownership may change. This is a simple option and gives the life insured control over their own policy. It also removes the need to assign policies if business ownership changes which means there are no CGT issues for life (or TPD and trauma) cover. This potentially makes self-ownership a suitable ownership option for both life and disability policies. Self ownership It is simple to understand and put in place. Unlike cross-owned policies, there is no need to assign policies with changing business owners. Accordingly there should be no CGT implications. from trauma and TPD policies should not be subject to CGT as the life insured is the owner of the policy. If the succession planning documentation is not adequately completed, the estate of the departing owner or their estate may unintentionally receive both the policy proceeds and the business interest. There may be a disproportionate cost of premiums on the policies held by each principal, particularly where a large age gap exists. (The interest holders may, however, agree to pool the premium payments). An illustration of self ownership is provided below. Other business owners (no CGT) CGT on transfer of business share Cross-ownership Under this option, an insurance policy is set up for each business owner and owned by the other business owner(s). Upon death or occurrence of the insured event, the proceeds are paid to the other business owner(s) and can be used under a buy/sell agreement to purchase the departing owner s share of the business. The proceeds would be used to purchase the deceased s interest in the business from their estate. This is a simple option which may suit a small business that is unlikely to change its ownership. Life insurance proceeds generally do not incur CGT if paid to any of the original owner(s). However, if the policy is assigned or transferred to a new owner for some consideration, CGT may apply to that person s share of the payment. CGT may also apply to a TPD or trauma payment paid to someone other than the life insured or close relative. Therefore, crossownership may not be an effective ownership option for TPD or trauma policies. Asteron Life 2

3 Cross ownership Documentation is usually simple and easy to follow. The remaining business owner(s) have control of the funds. This structure works well when there are only a small number of owners or stakeholders and there are unlikely to be any changes to the ownership. Policies are normally assigned when an existing owner leaves (ie. a departing business owner assigns their policy to the new business owner). If it is deemed that there is consideration in respect of the change of owner on a life policy, CGT may apply in the event of a payout. CGT may apply to the proceeds of a TPD or trauma policy where the recipient of the proceeds is not the insured or a relative of the insured. Cross-ownership generally results in CGT on the insurance proceeds in the case of TPD or trauma. Different cost of premiums for individuals, especially where there is an age gap (the interest holders may, however, agree to pool the premium payments, ie. pay equal amounts). An illustration of cross ownership is provided below. Business owner (CGT on TPD/ trauma and possibly on death) CGT on transfer of business share Bare trust ownership Under this option the trust should be set up as an absolute entitlement (bare) trust. The trustee owns the policies on behalf of all the business owners. Insurance proceeds are paid to the trust and can then be distributed to the life insured s estate in exchange for transfer of the business ownership to the continuing owner(s) under a buy/sell agreement. This option may be more complicated and more expensive, due to the costs to establish and maintain a trust. This option may suit businesses with a large number of owners or where business ownership is likely to change as policies do not have to be assigned to new owners. This structure can therefore avoid CGT implications on life policies provided the beneficiary is considered the beneficial owner (Tax Determination TD 94/31). CGT may be avoided on a TPD or trauma proceeds provided they are paid from the (bare) trust to the life insured (absolute entitlement). An ATO opinion should be sought on the trust structure. As the owner of the policy is the trust, entry of new owners into the business will not create any re-assignment of policy, so they may avoid CGT implications on life policy proceeds. This method of ownership is particularly appropriate when there are a large number of shareholders and new business owners are likely to be admitted. There are, however, extra costs in establishing and administering a trust. It is difficult to discuss the effect of trust ownership on life insurance proceeds as the type and circumstances of each trust could vary significantly, and will have a major impact on the ownership structure. For example, the trustee of a discretionary trust owns term life policies on behalf of all business owners and on the death of a business owner, the proceeds are paid to the trust and may be distributed to the continuing owners. The continuing owners can then use the money to purchase the deceased s business share. Other types of trusts would provide different results. Asteron Life 3

4 Bare trust ownership There is no need to assign policies with changing business ownership and accordingly there should be no CGT implications on life policies (policies are indirectly self owned, therefore the beneficial owner is the life insured and the proceeds are exempt from CGT). This method is appropriate where there are a large number of interest holders (partners, shareholders, unit holders) and where new interest holders are likely to be admitted. Costs in establishing and administering a trust. Trust ownership may be more complicated than other types of ownership. The trust must be a bare trust under which the beneficiaries are absolutely entitled to the trust assets, otherwise CGT may be payable on trauma and TPD proceeds. An illustration of bare trust ownership is provided below. Trust (no CGT) Other business owners CG T on transfer of business share Corporate ownership (within a corporate entity redemption agreement) Under this option, the company operating the business owns the insurance policies on the life of each business owner. Insurance proceeds are paid to the company. If a triggering event such as death occurs, the business buys back the interest in the business from the deceased s family and the shares are cancelled (or units in a unit trust are redeemed). Under a buy/sell agreement, the departing owner s (ie. life insured) shareholding can be repurchased by the company using the insurance proceeds and that person s shares are then cancelled. This effectively distributes full ownership of the business across the remaining shareholder(s). This option may suit businesses with a large number of owners or where business ownership is likely to change as policies do not have to be assigned to new owners. Corporate ownership Simple to understand. Original policy holder is not altered by a principal entering or exiting the business. Corporate entity owns and pays for the policy, the after-tax cost of the premium may be reduced due to the tax rate differentials. There may be significant taxation consequences to the departing interest holder (ie. the remaining principals are effectively acquiring more equity but not getting an increased CGT cost base. They would therefore be subject to unnecessary tax upon final disposal of their shares. Whenever a share buy-back occurs with a private company, the company needs to ensure that no breach of the capital streaming or share streaming occurs. These provisions are breached when one shareholder is provided with an advantage or opportunity (ie. share buy-back) that is not provided to other shareholders. If a breach occurs, adverse taxation consequences may apply to either the shareholder or the operating entity, or both. It is often difficult to place a value or determine the cost base of the shares if they are not widely held or publicly traded (ie. private company). This may lead to confusion when any share buy-back occurs, as the share buy-back offer may be less than anticipated by the original shareholder. Asteron Life 4

5 An illustration of corporate ownership is provided below. Increased value of shares (no adjust to cost base) Other business owners (CGT on TPD/ trauma and possibly on death) Company CG T on transfer of business share Buy back and cancel shares Superannuation fund trustee ownership Under this option, the trustee of the life insured s superannuation fund owns the insurance policy. Insurance proceeds are paid to the trustee and then form part of the life insured s superannuation benefits. Insurance premiums are paid using superannuation contributions made on behalf of the life insured. If contributions are tax deductible, this can reduce the effective cost of premiums. CGT will not apply to the insurance proceeds, but proceeds will be subject to the taxation rules applying to superannuation benefits. This option suits businesses that wish to claim a tax deduction for premiums and are not concerned about possible taxation on payouts or superannuation preservation rules. Under a buy/sell agreement, the departing owner s (ie. life insured) business share can be relinquished upon payment of the insurance proceeds to their superannuation fund. Full ownership of the business then reverts to the remaining owner(s) without any further purchase costs. Superannuation fund ownership Original policy holder is not affected by a principal entering or exiting the business. may be cheaper, and possibly less stringent underwriting requirements will apply. are generally partially or wholly tax deductible to the super fund (except for trauma insurance). Death benefits are received tax free when paid to a tax dependant. Terminal illness benefits are received tax free (regardless of age). Contributions made into the super fund to cover the cost of insurance may be tax deductible if contributed by a person who is eligible to make tax deductible contributions to super. Can be substantial tax payable if a death benefit is received by a nontax dependant. Need to ensure that a binding nomination is used and that it is kept up to date. Where the nomination is not binding or not up-to-date the death benefit may be paid to someone other than the intended recipient. There may also be tax payable on TPD and trauma benefits depending on the age and tax-free component of the benefit. Must meet the SIS conditions of release to receive TPD or trauma benefits. The super fund needs to ensure that it meets the sole purpose test under the SIS Act. It may not be suitable for trauma insurance to be held within superannuation. Although the policy proceeds may be paid, a condition of release will not necessarily be met, and therefore proceeds may be trapped in the super fund. If the succession planning documentation is not adequately completed, the departing owner or their estate may unintentionally receive both the policy proceeds and the business interest. As a consequence, offsetting arrangements need to be carefully drafted into the agreement. If inadequate provision has been made for a beneficiary in the Will of the deceased, they may be able to challenge the distribution and claw back the benefit (binding death benefit nominations do not solve this dilemma). Asteron Life 5

6 An illustration of superannuation fund ownership is provided below. (partially or wholly tax-deductible for death and TPD) Superfund (no CGT) Contributions Other business owners Super lump sum (lump sum tax) CGT on transfer of business share Discretionary trust ownership Depending on the insurance provider, it may be possible to hold life and TPD insurance within a discretionary trust. Where this is the case, the discretionary trust owns the policy with an individual person as the life insured. Life insurance proceeds Life insurance benefits are exempt from capital gains tax (CGT), if the recipient of the insurance proceeds is a person or entity that: - is the original beneficial owner of the policy, or - did not give any consideration for the acquisition of the policy. The Trustee of a discretionary trust holds the trust assets on behalf of the beneficiaries. However, because the Trustee has discretion with regard to the distribution of trust assets, the beneficiaries do not have a fixed interest in the trust assets. In this situation, the law considers that: - none of the discretionary beneficiaries is a beneficial owner of the trust assets, and - the Trustee is the sole beneficial owner of the trust assets. Therefore, it would appear the Trustee would be deemed to be the beneficial owner of the policy for the purposes of the tax act. TPD and trauma proceeds Non-death benefits (eg TPD and trauma benefits) are only exempt from CGT, if the recipient of the insurance proceeds is the insured person or a defined relative. With trust ownership of insurance, CGT may be payable unless the beneficiary is absolutely entitled to the proceeds from the trust and the beneficiary is the life insured or a defined relative of the life insured. If the purpose of the cover is to fund the payment of a capital amount (such as a loan), the insurance proceeds will not be assessable income. In addition, the premium will not be tax-deductible. Income protection Depending on the insurance provider, it may be possible to hold an income protection policy within a discretionary trust. Where this is the case, the discretionary trust owns the policy with an individual person as the life insured. Paying premiums and receiving the benefit If a discretionary trust owns an income protection policy on behalf of a life insured, the trust can make premium payments to the insurance provider. If the insured person is temporarily disabled and makes a claim on the policy, the insured benefit is paid directly to the trust. If it is a discretionary trust, the trustee can distribute the benefit to some or all of the beneficiaries as it likes. Asteron Life 6

7 Tax treatment Income protection premiums are generally tax deductible. Income tax applies to income protection proceeds when paid to an individual. When paid to a trust, income tax is payable on the distributions made to each beneficiary. Potentially, this may reduce the amount of tax paid on the income protection benefits. Example: income protection held in a discretionary trust John and Mary Smith are married and have three children aged 18, 22 and 25. They set up a discretionary family trust called the Smith Family trust. John, Mary and the children are all beneficiaries of the trust. John is self-employed earning 150,000 per annum. He takes out an income protection policy and is insured for a monthly benefit of 9,375 (75% of his usual income). The Smith Family trust is the owner of John s policy and pays the annual premium of 3,710. On 1 July 2013, John has an accident and is totally and temporarily disabled for 12 months. The insurance provider pays the monthly benefit of 9,375 directly to the trust. The trust then distributes the benefit in the form of income distributions to John, Mary and the three children equally. As John does not work for 12 months, the income distributions are his only source of income for the 2013/14 financial year. He includes 22,500 of assessable income in his tax return. Mary and the three children are not working and therefore not receiving any other income, so they also include 22,500 of assessable income in their annual tax returns for 2013/14. They each pay approximately 710 in income tax. Issues to consider Before advising the client, check with the insurance provider to see if they allow a trust to own the policy. Trusts can be expensive to set up and maintain. Clients should be mindful of the costs involved with setting up and holding a trust. Clients should also be careful when setting up this type of arrangement as they potentially lose control of their monthly benefit. As the benefit is paid directly to the trust and distributed to beneficiaries, they will not directly receive full benefits from their policy. The intention of an income protection policy is to pay a monthly benefit to an individual to replace lost earnings in the event of temporary illness. If a benefit is paid into a trust and then distributed out to several beneficiaries, the real intention of the policy may be lost. Before setting up this type of arrangement, clients must seek individual tax advice, as anti-avoidance tax penalties (Part IVA provisions) may apply. Part IVA provisions apply if an arrangement is entered into for the purpose of avoiding or reducing tax. Trust ownership of insurance may be more complicated than other types of ownership. There are also costs involved in establishing and administering a trust. As the beneficiaries of a discretionary trust are not absolutely entitled to the trust assets, there may be tax penalties upon receipt of insurance proceeds. An illustration of discretionery trust ownership is provided below: Trust (CGT may apply on TPD/trauma) Other business owners CG T on transfer of business share Asteron Life 7

8 Partnership ownership A partnership is known as a flow-through entity as income flows through and is taxable to each partner according to their partnership share. In the case of business insurance, each partner is typically insured for death, total and permanent disability (TPD) and critical illness (trauma) as compensation for their relinquished business share. As the partnership is able to own an insurance policy in its own right, the owner and the insured person will be two different entities (ie: owner = partnership, insured person = partner). Therefore, the proceeds will generally be paid directly to the partnership and then flow through to each partner as per the partnership agreement. If insurance proceeds are distributed in the same proportions as other income/distributions, this may create a capital gains tax (CGT) liability upon receipt of TPD or trauma proceeds for some partners (other than the insured person or a defined relative* of the insured person). * a relative is defined as: person s spouse; or parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendent or adopted child of that person, or of that person s spouse; or spouse of any of these. CGT will generally not be an issue for term life policies (including terminal illness payments) as long as the policy has not been transferred from the original beneficial owner (or if transferred from the original beneficial owner, without payment of some consideration). As partnership-owned insurance is a more complex version of cross-owned* and/or self-owned^ insurance, the pros and cons of partnership-owned insurance should be considered. * If the partnership agreement distributes the insurance proceeds to partners other than the insured person ^ If the partnership agreement distribute the insurance proceeds to the insured person only The advantage of partnership ownership of business insurance is that control is retained by all partners, however a more complex partnership agreement (for example, to allow payment of the insurance proceeds to the insured person only) and/or buy/sell agreement may be required. Payment of insurance premiums For all ownership options, the business owners need to determine how premiums will be paid and an appropriate method for sharing costs. The premium cost for each owner is likely to vary due to age, health and other underwriting requirements. The owner of the policy is responsible for paying premiums. However in practice the business entity often pays the premium as a non-deductible expense. If paid by a company the payment may be deemed to be a dividend or could be deducted from the owners loan accounts. In many cases, owners may agree to combine premiums and each pay a portion of the total cost based on their share of business ownership. An illustration of partnership ownership is provided below: Business owner (CGT on TPD/ trauma and possibly on death) CGT on transfer of business share Asteron Life 8

9 Contact Details Technical Services Suncorp Portfolio Services Limited ABN AFS Licence No For more information on Asteron product solutions, please contact the Sales Manager in your State. NSW/ACT Level Kent Street Sydney NSW 2000 T NSW callers outside Sydney: VIC/TAS Level Collins Street Melbourne VIC 3000 T VIC callers outside Melbourne: QLD Level Wickham Terrace Brisbane QLD 4000 T QLD callers outside Brisbane: SA/NT Level Grenfell Street Adelaide SA 5000 T SA callers outside Adelaide: WA Level William Street Perth WA 6000 T WA callers outside Perth: Important note The information contained in this publication is of a general nature only and is intended for use by financial advisers or other licensed professionals only. it must not be handed to clients for their keeping nor can any copies of sections of this publication be given to clients. The information has been compiled based on regulatory policy at the time of writing. We recommend that your client refer to their professional tax or legal adviser prior to implementing any recommendations you may make based on the information contained in the publication. 10/2014

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