If you are a shareholder in a business, ensuring the ongoing profitability and sustainability of your business in the event of an unforeseeable event will no doubt be a priority for you and your fellow shareholders. Most company shareholders use what is known as buy & sell insurance as a funding mechanism to ensure the smooth transfer of shareholding in the event of the death, disability, or severe illness of one of the shareholders. In this article, we explore how buy & sell insurance can provide an excellent funding mechanism for business succession planning.
The purpose of buy and sell insurance
Not to be confused with key person assurance, buy & sell assurance is long-term insurance cover taken out by business partners on each other’s lives in the event of death, disability and/or critical illness depending on which set of circumstances they want to insure against. If a shareholder was to die, the other shareholders would no doubt want to ensure that they have sufficient capital available to buy the deceased’s shareholders shares, and this is where buy & sell insurance comes into play. If the surviving shareholders cannot finance the purchase of the deceased partner’s shares, those shares could fall into the deceased estate and devolve on the deceased shareholder’s heirs, which is not an ideal situation. To prevent this from happening, shareholders take out buy & sell insurance on each other’s life which will pay out in the event of a pre-determined event, with the proceeds providing the surviving shareholders with the appropriate amount of capital to purchase the deceased’s shares. In putting such a mechanism in place, financial protection is also provided to the deceased’s loved ones.
The buy & sell agreement
Over and above the correct structing of the buy & sell policies, it is just as important to ensure that the policies are supported by a well-drafted buy & sell agreement. With this in mind it is important to remember that, in terms of the Companies Act 2008, no agreement entered into may supersede the shareholders’ agreement or the Memorandum of Incorporation, which means that the terms and conditions included in the buy & sell agreement must fully align with these founding documents. Important aspects to consider when setting up the agreement include the method of valuing the business, the timeframe for the transfer of shares, and which events will be considered a buy & sell trigger. The buy & sell agreement should also specify exactly which shares the surviving shareholders are entitled to purchase and in what proportions.
The value of the business
The quantum of buy & sell insurance taken out will be based on the value of the business and the actual market value of the shares or member’s interest being purchased. Further, if a shareholder has a loan account with the business, in the event of his death the executor of the deceased’s estate will request that the value of the loan be paid into the estate. As such, shareholders may want to insure the value of any loan accounts as well. Rather than waiting for a buy & sell event to occur, it is best to include the basis for valuing the business in the buy & sell agreement so as to avoid any potential disputes later on. It is also imperative to maintain accurate records in respect of any loan accounts that exist.
Determining a buy & sell event
It is up to the shareholders to decide what type of events would trigger a sale of shares. Generally speaking, buy & sell cover is taken out in the event of the death or disability of a shareholder. However, depending on the nature and needs of the business, cover can be extended to include severe illness or even insolvency of a shareholder.
Buy & sell policies
For the sake of simplicity, if two shareholders, X and Y, each own 50% of a business with a total value of R10 million, the buy & sell policies would need to be structured as follows:
X would take out a policy on Y’s life to the value of R5 million, being the value of Y’s 50% share. Y is the life insured while X is the premium payer and the policy owner. Similarly, Y would take out a policy on X’s life for the same value, and would be the policy owner and payer. In the event of X’s death, the proceeds of the policy would be paid to Y which he, in turn, would use to purchase X’s shares. While this is a fairly simplistic example, bear in mind that business shareholding and structuring can be particularly complex and, if the buy & sell policies are not correctly set up in terms of the life assured, payer and policy owner, it may not be deemed a buy & sell policy for tax purposes if and when an event is triggered.
If the buy & sell policy is correctly structured as a non-conforming policy, the premiums will not be tax deductible, although the proceeds paid from the policy will not be subject to tax meaning that the surviving shareholder will have the full amount available with which to purchase the deceased’s shares.
The correct structuring of the buy & sell policies is critical to ensure that it functions optimally as an estate planning tool. Generally speaking, the proceeds from life insurance policies are considered deemed property in a deceased estate and are therefore subject to estate duty. However, the proceeds of correctly structured buy & sell agreements are not considered deemed property in the estate of the deceased shareholder and are not estate dutiable. In order to qualify for this exemption, the policy must be taken out on the life of a business partner who is a shareholder at the time of his death. It must also be evident that the policy was taken out with the specific purchase of buying the deceased’s business interests, and that the deceased did not pay the policy premiums.
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