If correctly structured, insurance policies can be used effectively to protect your business against future risks. If death, disability, or critical illness strikes a key person or shareholder of a business, the profitability and future sustainability of a company can be jeopardised, and in such circumstances, long-term insurance can play an important role in mitigating risk. In this article, we explore the use of key person and buy-and-sell insurance as funding mechanisms for succession.
Key person insurance: Protecting against the loss of human capital
In general, a key person is someone whose absence will have a materially detrimental effect on the future of your organisation. When determining whether someone qualifies as a key person in your organisation, consider:
- Does he/she have a unique or specialist skill that is critical to the future success of your business?
- Does he/she impact positively on the reputation and good standing of the organisation?
- Is he/she critical to client and staff confidence?
- Will his/her absence from the business, whether permanent or temporary, have a materially adverse effect on the business?
- Does the organisation rely heavily on the person for business growth and development?
- Will that person’s absence interrupt the day-to-day running of the business?
- Will that person’s absence potentially result in loss of clients or suppliers?
- In his/her absence, will the organisation have difficulty raising capital or attracting new investments?
Key person insurance is typically a policy taken out on the life of the key person in order to minimise financial risk to the business if that person died prematurely or became disabled. The company that owns the policy is responsible for paying the premiums and is the nominated beneficiary on the policy. If structured this way, the company can elect for the premiums to be tax deductible and the proceeds subject to tax. Alternatively, the option for the premiums to not be tax deductible would mean a tax-free payment of the proceeds of the policy. If the key person dies, becomes disabled, or suffers from a critical illness, the proceeds of the policy will be paid directly to the business. The proceeds effectively provide the company with cash flow to enable the business to continue operations until a replacement is found. Key person insurance can be structured to cover the death, temporary disability, permanent disability, or critical illness of the insured.
There is no formula or set of rules when determining how much key person cover to take out. Every organisation is different, and each key person presents a different set of skills and expertise. However, factors that can be taken into account when considering the appropriate level of cover include:
- The time it would take to find a suitable replacement;
- The number of months or years it would take for the new person to achieve the same level as the key person;
- The cost and time of recruiting and training one or more suitable replacements;
- The key person’s worth in terms of net profit generated for the business;
- The current salary of the key person;
- The current financial position of the organisation;
- The costs of any training the replacement person would need to undergo.
Buy-and-sell assurance: A funding mechanism for succession
Business assurance – also known as buy & sell insurance – is cover taken out by business owners on each other’s lives to ensure business succession in the event of the death of a shareholder. If one business owner dies, the proceeds of the policy will provide the other business owners with sufficient capital to buy the deceased shareholder’s shares – bearing in mind that business assurance cover can be extended to cover the business owners in the event of disability. Note, however, that if the insured’s life is covered in respect of disability as well as death, it is important that the definition of disability as it stands in the policy matches the definition of disability as set out in the buy & sell agreement.
Business assurance protection is a useful mechanism available to business owners to have a significant portion of their wealth invested in their business and where their business interests are intended as a source of retirement capital or to provide their family with income in the event of tragedy. If a business owner dies or becomes permanently disabled, he/she would naturally want to ensure that the remaining shareholders have enough capital to buy his shares from his deceased estate. Depending on the value of the business, the surviving shareholders may struggle to raise enough capital to buy these shares, thus giving rise to the need for buy & sell cover.
The reality is that many shareholder’s agreements or Memorandums of Incorporation (MOI) do not deal with the practical details of ownership transfer to new parties. As such, a buy & sell agreement is designed to set out the details of what will happen with a partner’s share in the business should he die or become disabled. A properly drafted agreement should ensure business continuity in the event of tragedy together with a timeframe in which the transfer should take place. It should also address the funding mechanism to be used to purchase the deceased’s share which in most cases is a buy & sell policy, being less risky and more cost-effective. Very importantly, bear in mind no agreement can supersede a shareholder’s agreement and it is therefore imperative for the buy & sell agreement to be wholly aligned with the shareholder’s agreement (or MOI).
That said, it is important to note that the efficacy of a business policy is wholly dependent on being underpinned by a correctly worded buy & sell agreement. To be fully effective, business assurance must include (a) a correctly structured insurance policy on the life of the shareholder and (b) a meticulously worded, written agreement between the shareholders to pay the proceeds of that policy to the buyer. To demonstrate this, we use the example of Thando and Rachel who each own 50% of a pharmaceutical packing business valued at R20 million. In the event of Rachel’s death, their buy-and-sell agreement makes provision for Thando to buy Rachel’s shares which are valued at R10 million. But, Thando does not have access to that type of capital and, as such, takes out buy-and-sell cover on Rachel’s life to the value of her shares as a funding mechanism. The policy is structured so that, while Rachel is the life insured, Thando is the premium payer and the nominated beneficiary on the policy. In the event of Rachel’s death, the proceeds of the buy-and-sell policy will pay directly to Thando who will then have sufficient capital to buy Rachel’s shares.
In respect of a typical, non-conforming business assurance policy, the premiums are not tax deductible. However, the proceeds paid from the policy will then not be taxed and the buyer will have access to the full amount required to purchase the shares. As insurance policies are considered deemed property in the estate of the deceased shareholder for estate duty purposes, it is important that the buy & sell policy is correctly structured in order to avoid unintended estate taxes. To qualify for an exemption from estate duty, the buy & sell policy must be taken out by a person who is a co-owner of a business with the deceased at the time of his death. Further, the policy must be taken out with the specific purpose of purchasing the deceased shareholder’s business interests, with the added proviso that the premiums must not be paid, or have ever previously been paid for, by the insured.
In general, the amount of buy & sell cover needed is dependent on the value of the shares and whether the shareholder has a loan account with the business. To avoid potential disputes in the future, it is vital that the buy & sell agreement provides a basis for valuing the business interest. There are numerous ways of determining the value of the business and, to ensure that each shareholder receives fair value for his business interests, an equitable method of valuation needs to be accepted by all parties to the agreement.
If you and your business partners want to protect your business interests and the succession of your business, our advice is to have a comprehensive business assurance plan developed in conjunction with an experienced advisor.
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