In our previous Winter/Spring edition we highlighted the very real issue of underinsurance in Australia particularly in regards to personal insurances’ such as Death, Total and Permanent Disability, Income Protection and Trauma Insurance. Whilst this continues to be an ongoing issue, our focus in this article is on the importance of Business Insurance and in particular the need to insure key people and have business succession plans in place. There are essentially two forms of business insurance – ‘Key Person Insurance’ and insurance to fund ‘Buy/Sell Agreements’. Both these insurances have quite separate and distinct purposes, however they are both equally important in ensuring a business is well equipped to deal with an unforseen event. Below we provide a summary of some of the characteristics of these insurances.

Key Person Insurance

Many businesses have at least one individual who is the key person of the business. A key person is someone who affects the revenue and/or capital of the business. They may include anyone who creates cost savings; generates revenue; adds goodwill; provides access to credit; and/or has relationships with customers. These people are ‘key persons’ and like any other asset of the business, they should be insured.

Why Insure a Key Person?

The main reason for key person insurance is to help protect and maintain the financial stability of the business should the key person no longer. be able to work. By insuring a key person for unforeseeable events such as death, total and permanent disability (TPD) or critical illness, the business will receive a payment which will help mitigate significant disruptions and keep the business running as smoothly as possible. In the event the policy is triggered, a benefit payment will be received, which the business may then use to pay ongoing bills, replace lost revenue, repay debt, inject capital into the business and assist in financing a suitable replacement or train other staff to fill the missing key persons position.

Ownership of the Policy

The ownership of the insurance policy, which in most instances will be on the life or health of the employee who is deemed a key person, will usually depend on what impact the key person has on the business and whether it is of a ‘capital’ or ‘revenue’ nature.
A key person may be insured for a ‘capital’ purpose where they affect the goodwill of the business, have loaned money to the business, or where they have provided access to credit (agreed to be a guarantor on a loan). In these instances the business itself will generally own the policy as it is the business that needs to receive the proceeds in the event of losing the key person.
On the other hand, a key person may be insured for a ‘revenue’ purpose if, as a result of losing the key person, sales revenue is likely to reduce, the business would have to pay someone else higher salary or wages, or if the business has to pay recruitment and/or training costs. In these instances the ownership of the policy is not as simple and will depend on the circumstances and any potential legal arrangements in place.

Taxation Implications

The tax treatment of key person insurance can become very complex and will depend on a number of factors relevant to the circumstance i.e. the type of policy cover (death, trauma etc), whether the policy cover is of a capital or revenue nature and also for what and how the underling benefit is ultimately used as the original purpose may vary over time. These details should be well documented at commencement of the policy and each yearafter to ensure the purpose of the cover remains appropriate. In general however, where the insurance is for a ‘revenue’ purpose, premiums will be deductible and the proceeds will be taxable as assessable income. Capital Gains Tax (CGT) is not likely to be payable. Where the insurance is for a ‘capital’ purpose, premiums will not be deductible, nor will the proceeds be taxable as assessable income. CGT may apply depending on the type of insurance proceeds received i.e. whether they be death, TPD or trauma proceeds.

Buy/Sell Agreement

Where a business has more than one owner or partner, there should be a sound business succession plan in place. Such a succession plan will allow the business to deal with the departure of an owner or partner and how the remaining owners will fund the departure. The succession plan will involve the business creatinga legal ‘buy/sell agreement’ and provide funding for the departure of an owner/partner.

What is a buy/sell agreement?

A buy/sell agreement is a legal contract entered into between business owners, which specifies the exact terms and conditions under which the remaining owners are bound to buy out the other owner’s interest in the business, should
a specific event be triggered. Specific trigger events can include but are not limited to death, divorce, long-term disability, retirement or bankruptcy.
The legal agreement, which should be drafted by a solicitor or legal adviser, will generally force the owner/partner to leave the business should a trigger event occur. It will then force the remaining owners to buy the departing owner’s share in the business and the departing owner to sell their share of the business. It may also provide provision that will enable the business to purchase outstanding shares from the estate of a deceased owner.
Without a buy/sell agreement in place significant problems may occur between the departing owner (or their estate) and the surviving business owners which could destabilise the business and ultimately affect it’s survival.

Funding a buy/sell agreement

The buy/sell agreement will often include specification regarding the type and amount of the insurance the business will carry to ensure funds are available to buy out the departing owner.
The most common and feasible way to fund a departure is to have life insurance on each business owner. However not all trigger events can be insured for. Certainly death, TPD and trauma may be insured for, however for trigger events such as retirement the business may need to use savings, or business or personal assets, or it could even consider borrowing monies to fund the departure. Each business should address these issues and incorporate their preferred options within their succession plans.
Ownership of the Policy In terms of a life policy to fund a buy/sell agreement there are a number of different ownership options. Each option has its pros and cons and the most appropriate option needs to be considered in light of the individual and business’ circumstances. Possible options for ownership include, self, cross, business, superannuation and bare trusts.

Taxation Implications

The tax treatment applicable to buy/sell agreements, similar to key person insurance, can become complex and will vary depending on a number of factors and the particular circumstance and payment type. In general, where life insurance is taken out to fund an agreement, it is considered to be of a ‘capital’ nature and therefore premiums are not deductible. Similar to key person insurance, CGT may apply depending on the type of insurance proceeds received.
Whilst the above is only a brief summary of the two main forms of business insurance available, being key person and buy/sell insurance, it hopefully highlights the importance and need for insurance planning within your business. Effective business insurance planning is a responsible way to help protect the family members of each business owner, as well as help maintain the best interest of the company and all surviving owners. As mentioned, business insurance can become very complex with various factors to be considered. For more detail on business insurance contact your Moore Stephens Adviser who will be able to assist.

Tax disclaimer
The taxation treatment described in this article is general in nature and should only be used as a guide. It does not constitute tax advice and is based on current tax law and our interpretation. The individual circumstances of each client will differ and as such they should seek professional tax advice.


Contact

Tara Jones
T +61 3 8635 1800
tjones@moorestephens.com.au

www.moorestephens.com.au