The best way to understand the impact of adequate, or in the unfortunate event of inadequate cover, is by way of past experiences. In 2012, I was contracted by a small business, with two shareholders, (let’s call them Suzie en Mark) for a review of their risk portfolio and business agreements. The two partners had life and disability cover in place and had entered into agreements with each other that stipulate the agreed terms in case something unexpected happened to one of them.
Their agreements required a few small amendments but the cover that they had in place was sufficient (based on up-to-date business valuations on their two businesses from their auditor). Company X, was a manufacturing business and company Y, a holding company for a few select investment properties. Company Y was also exposed to various credit facilities at certain banks.
When you undertake these types of assessments and then have the related discussions with partners, one might be excused for experiencing it as a very theoretical exercise. I have been involved in many assessments where the outcomes have been unexpectedly concerning to partners, with a surprising delay in implementation of the proposed corrective steps. Sometimes it is viewed as a theoretical exercise with all kinds of legalese, policies and definitions in areas that are beyond the scope of business owners’ normal areas of expertise. Or is it just theoretical?
Unfortunately for the two partners in companies X and Y, it became very real.
In 2014, Suzie’s husband Cliff was diagnosed with Alzheimer’s. As can be expected, it was a very traumatic time for the family and could have had a severe impact on the business if the necessary cover had not been in place. Both Suzie and Mark were intricately involved in the business, and both had key roles with daily deliverables. Fortunately, Suzie’s husband had the foresight to put personal disability cover in place. The cover paid out and provided the family and the business the time to adjust to their new challenges.
This is not where the story ends though. In 2018, Suzie herself was diagnosed with dementia. This obviously had a dramatic effect on the day-to-day deliverables and the future of the business. The cover that the partners had put in place was as follows:
- Life and disability cover for the partners in the manufacturing business and a buy-and-sell agreement governing the terms, should a benefit under one of the policies pay out.
- Contingent liability cover for the partners in the property company to cover the liabilities attached to these properties.
- Key-person cover for both partners as they were instrumental in the daily deliverables.
On diagnosis of her illness by a neurologist, the necessary claim documents were submitted to the insurance companies. The disability benefit on all three policies on Suzie’s life paid out, which provided the necessary liquidity for Mark to buy her shares in the manufacturing business, invest funds in the manufacturing business to ensure continuation and succession and lastly provided the required liquidity to settle all outstanding bonds in the property company.
The contingent liability agreement stipulated that a new valuation should be conducted on the company once the bonds had been settled, as this will have a material effect on the valuation.
What could have gone wrong?
Below are a few common mistakes that we’ve come across where cover and agreements did not fulfil the initial intentions of the partners:
Shares are held in trust, but the Buy-and-Sell agreement was drawn up and signed between the shareholders in their personal capacities and not by the authorised representatives of the trust. There would be no obligation by the trustees to honour the agreement if they were not signatories to it with the necessary resolution in place.
- The cover amounts were never reviewed and a few years down the line, the value of a successful business would have increased. The cover that was provided by the policies would have been insufficient to fund the obligations of the remaining partner.
- Ownership in the business might have changed and the agreements were not amended.
- Values of the loan accounts were not included in the cover amounts, which could again also have caused a shortfall in liquid assets.
- Payment of premiums was paid from the wrong account. The Estate Duty Act is very clear on how premiums should be paid to allow for the estate duty exemption.
- There could have been a contradiction between the Memorandum of Incorporation (MOI) and the Buy-and-Sell agreement. The terms of the MOI prevail over the Buy-and-Sell agreement.
2. Contingent liability:
- No contingent liability agreement was signed. The surety agreements with credit providers will typically be worded in their favour and do not require them to first recover outstanding amounts from the business. The partners will generally be jointly and severable liable, which means the bank can hold any of the parties liable. If no contingent liability agreement was signed there is no obligation on the business to use the proceeds to settle debt. This could expose the estate of the deceased to liability.
- Ensure that surety agreements are cancelled when all outstanding amounts have been settled and the facility is no longer required. You have to prevent a situation where businesses are sold, subsequently default on debt and the signatories are held liable for the debts even though they are no longer shareholders.
- When facilities are increased with the institutions it is very important to update the cover amounts as again a liquidity shortfall could be the result.
- The cover that was applied for did not include disability events or the cover definitions applied for were incorrect. It gets technical here, but a review of the policies will very quickly highlight these shortfalls.
- Life policies are a deemed asset in the estate of the life assured. Sars expressed a view that contingent liability cover would probably not qualify for the estate duty exemption. Cover amounts should therefore include possible estate duty on the policy.
- The policy could have been structured incorrectly. Ownership, payer, beneficiaries, life assured, benefits, and cover value all must be structured correctly to achieve the desired result.
3. Key individual plan:
- The revenue loss caused by the passing of a key individual in the business could have been underestimated. Typically, the direct loss of revenue, cost of replacing the employee and cost of training the replacement should be calculated and included in the cover amount.
- Premiums were deducted from tax. Deductions of premiums are possible in terms of Section 11(W)(ii) of the Estate Duty Act if all three of the following conditions are met:
- The policy must insure the employer for loss of revenue in case of death, disability, or critical illness of an employee;
- The policy must be a pure risk policy (it can therefore not be a policy that builds up a maturity value);
- The employer must be the owner of the policy at the time of paying the premiums;
- If all three of the conditions are met, the employer can decide whether to claim the deduction. If premiums were claimed for a deduction from tax, the proceeds are taxable. This could cause a shortfall and jeopardise the successful continuation of the business.
- Section 3(3)(a)ii of the Estate Duty Act provides for the exemption of the policy proceeds from estate duty if all of the following conditions are met:
- The policy was not put in place by the deceased;
- No premiums were paid by the deceased;
- No portion of the proceeds of the policy will be paid into the estate of the deceased;
- No amount due will be utilised for the benefit of a.) any relative of the deceased or any person who was wholly or partly dependent for their maintenance upon the deceased and b.) a company that was at the time a “family company” in relation to the deceased.
- If any of these conditions cannot be met, allowance in the cover amount must be made for the estate duty liability.
Legal mistakes, such as inadequately negotiating the most appropriate and relevant terms and thereby creating unenforceable agreements, can cost you significant amounts of money in the future.
Ensure that your Buy-and-Sell agreement makes sense for your unique business or personal situation and is continuously updated.