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How to protect your business from insolvency risk due to a loan account

The most cost-effective way to avoid liquidity and insolvency risk is to apply for a life policy on the life of the owner/lender.

New business ventures require startup capital to purchase assets and necessary equipment that is crucial to start and run the business and to cover important expenses to ensure its success. Often business owners will loan their own funds to the company to cover these startup and running costs. This is because owners either do not want any external stakeholders involved in the business or go to the bank for a loan where they would need to stand surety and pay interest on the loan.

These loans are reflected as long-term liabilities of the business and the repayment of these loans to be done at an indefinable future date. In the event of the untimely death of the owner/lender, the executor of the deceased estate will call up the loan. The risk that the business presents itself in the event of the owner’s death is that there may be liquidity issues when the business needs to repay the loan, or the business simply cannot repay the loan and therefore be forced to potentially sell income-generating assets or risk insolvency.

What can be done to avoid this risk?

The most cost-effective way to avoid liquidity and insolvency risk in the event of the loan being called up is to apply for a life policy on the life of the owner/lender. The business will own and pay the premiums of this policy and receive the proceeds in the event of death. An agreement should be put in place between the lender/owner and the business to ensure that the proceeds are used to settle any debt. The policy can also make provision for permanent disability and critical illness in terms of settling the debt.

Another alternative for the business to settle the loan is to start an investment for the owner whereby repayment of the loan can be made either as a lumpsum or on a regular basis overtime. This can assist the lender with lowering the stress of not being able to retire with enough retirement savings.

Tax and policy proceeds considerations.

In terms of Section 11(w)(ii) the premiums of this policy cannot be tax deductible for the business because the policyholder is not insuring the owner/lender against any operating or income loss but rather the purpose is the repayment of capital. It therefore does not comply with the requirements of Section 11(w)(ii) and the premiums are not tax deductible. Because the premiums were not tax deductible the policy proceeds will not be taxable, and the full amount of the policy proceeds will be payable. In addition, because the payment to the lender by the business was repayment of a capital amount the lender will also not be taxed on the amount repaid.

For estate duty purposes the policy will be a deemed asset in the deceased estate as it cannot be argued that the policy was not taken out to protect the estate of the deceased or that the deceased did not have any role in taking out the policy. Because of this inclusion it is advisable to gross up the sum assured by 20% or 25% depending on the size of the estate to cover for estate duty payable.

Loan accounts and Buy and Sells

One consideration to better structure the loan account policies is to look at including the loan account in the buy and sell agreement. The benefit of doing this, where the value of the shares and the loan account is included, is that upon one of the shareholders death the remaining shareholder will receive the shares in the business as well as the loan thereby not affecting the balance sheet of the business as only the lender changes as the liability will now be seen as settled.

Another benefit of this is that now the remaining shareholder can allow for capital extraction without incurring any income tax liability. By including the loan account in the buy and sell agreement the proceeds can now potentially be exempt from Estate Duty if all requirements in Section 3[3][a] [iA] are met. By doing this you have mitigated liquidity risks within the business and saved in estate duty.

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Michael Haldane

Global & Local The Investment Experts

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