Business assurance and key person insurance can be used to ensure the ongoing sustainability of a business in the event of death or disability. Both these tools are available to business owners who wish to proactively reduce or mitigate risks, provide liquidity and ensure smooth succession with the least amount of disruption to their business.
One of the main aims of buy-and-sell insurance is to create sustainable business continuity in the event of death disability of any of the owners or shareholders. The structuring of a buy-and-sell policy can be complex as it needs to take into account the company’s memorandum of incorporation and/or shareholder’s agreement and needs to be supported by a well-drafted buy-and-sell agreement. It is also imperative that the owners, payers and lives-insured are correctly set up to ensure validity and enforceability of the policies, and to minimise tax liabilities.
Where a business has more than one owner or shareholder, correctly structured buy-and-sell insurance can provide certainty for the other shareholders and liquidity in the business to ensure smooth succession. The buy & sell insurance policy needs to underpinned by a buy-and-sell agreement. This agreement sets out the details of what should happen if one of the owners/shareholders was to die or become permanently disabled. It is important to ensure that the buy-and-sell agreement clearly sets out what events will trigger a buy-out of the remaining shareholders, what proportion and class of shares they would be entitled to, how the shares should be valued and how the share purchase will be funded. It is often not ideal for the deceased shareholder’s shares to pass onto his heirs, specifically if they do not have the skills nor inclination to work in the business, and the buy-and-sell agreement works well to protect the business against this type of inadequate succession – providing shareholders with certainty that family members or other outsiders will not inadvertently gain shares in the business. Similarly, the buy-and-sell agreement also protects the estate and dependants of the deceased shareholder by ensuring that fair value is received for his business interests.
When putting buy-and-sell cover in place, bear in mind that the nature of the business entity (e.g. sole proprietorship, close corporation, partnership or private company) will have an impact on the type and structure of the insurance required. Incorrect policy structuring can have far-reaching estate planning, CGT and tax consequences and should be done correctly at the outset. Also, keep in mind that no other agreement can supersede the memorandum of incorporation of shareholders’ agreement, and the buy-and-sell agreement therefore needs to be fully aligned.
Example: Sharon and Liz each hold 50% shares in ABC (Pty) Ltd, with the company being valued at R5 million. The shareholder’s agreement states that if either Sharon or Liz die or become permanently disabled, the other shareholder should purchase their shares. However, neither Sharon nor Liz have R2.5 million available to buy the shares if such an event was to occur. They therefore decide to take out buy-and-sell insurance on each other’s lives. Sharon will therefore own a policy on Liz’s life which would provide life cover and capital disability of R2.5 million respectively. Similarly, Liz would own a policy on Sharon’s life providing R2.5 million life and capital disability cover. If Sharon dies, the insurer would pay Liz an amount of R2.5 million which she would use to purchase Sharon’s 50% share of the business.
Key person insurance
Key person insurance is designed to protect a business against the loss of a staff member, owner of shareholder who is pivotal to the business, and upon who the business relies heavily for its future success. If a person is identified by the business as a ‘key person’, the business can take out an insurance policy on the life of that person with the aim being to receive financial compensation if that person were to die or becomes disabled through injury or illness. In calculating the level of cover on the life of the key person, the company would give consideration to the key person’s income, the impact of his absence on the revenue of the business, how quickly his position could be filled, any training he might need and the costs of recruitment.
In terms of the Income Tax Act, a company may be able to claim certain insurance premiums paid on the life of a key person as a deduction provided that certain conditions are met, and it is therefore imperative that your policy is structured correctly.
It is never ideal for a business to be too heavily reliant on one individual within the organisation, and reducing such dependency should form part of the business’s strategy.
Key person insurance is an effective tool to reduce risk while the business grows its internal know-how and creates knowledge depth in the organisation. Taking the business’s timeline into account, your financial adviser will be able to guide on term versus whole life insurance, how to structure your premiums appropriately and finding the most cost-effective solutions.
Example: Sharon and Liz employ a software developer, Dan, who develops customised software for their business. They pay Dan an income of R100 000 per month. The business becomes heavily dependent on this software and Dan’s expertise, and the owners decide to take out key person insurance on his life. In order to ensure that the company has the cashflow to find a replacement software developer, cover the recruitment costs and pay for any training, they take out life and capital disability cover on Dan’s life of R1 million. The policy is owned and paid for by the business, while Dan is the life-insured. In the event of Dan’s death, the insurer would pay out the claim the company, and proceeds of the policy will be included in the company’s taxable income. However, any part of the proceeds used to pay the salary of the new employee could still be claimed as a deduction.