How to fund business succession with buy & sell insurance

As a business shareholder, safeguarding the continuity and profitability of your company in the face of unforeseen events is likely a key concern for you and your co-shareholders. Many shareholders use buy-sell insurance as a strategic funding tool to facilitate the seamless transfer of shares should a shareholder pass away, become disabled, or suffer a critical illness. This article delves into how buy-sell insurance serves as an effective funding mechanism, ensuring smooth transitions in business ownership and securing a workable succession plan for all involved.
The purpose of buy and sell insurance
Different from key person insurance, buy-sell assurance is long-term insurance taken out by business partners on each other’s lives to cover risks such as death, disability, or critical illness, depending on which set of circumstances they wish to insure against. Should a shareholder pass away, the remaining shareholders will likely need access to capital to purchase the deceased partner’s shares which is where buy-sell insurance becomes invaluable. Without this funding, surviving shareholders may struggle to finance the purchase, leading to the deceased’s shares devolving to heirs through the estate, which can complicate ownership and control. 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 structuring 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-and-sell event to occur, it is best to include the basis for valuing the business in the buy-and-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, should two shareholders, Mr T and Mrs 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:
Mr T would take out a policy on Mrs Y’s life to the value of R5 million, being the value of Mrs Y’s 50% share. Mrs Y is the life insured while Mr T is the premium payer and the policy owner. Similarly, Mrs Y would take out a policy on Mr T’s life for the same value and would be the policy owner and payer. In the event of Mr T’s death, the proceeds of the policy would be paid to Mrs Y which she, in turn, would use to purchase Mr T’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.
Tax
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.
Estate planning
The correct structuring of the buy & sell policies is critical to ensure that they function 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.
In conclusion, buy-sell insurance can be a vital tool for funding business succession, providing financial security and ensuring a smooth transition of ownership. By setting up these policies, business partners can protect their interests, maintain control, and support the families of deceased shareholders. However, it is imperative that you seek advice from an independent advisor with experience in structuring such policies.
Have a fantastic day.
Sue