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The death or disability of a business co-owner can have serious consequences for your business’s ongoing operational ability, making business succession planning an essential component of any company’s future planning.
In this article, we provide comprehensive answers to often-asked questions about buy-and-sell agreements.
What is business assurance?
Buy-and-sell insurance is cover taken out by business owners on each other’s lives to ensure business continuation in the event of a co-owner’s death. In the event that one business owner dies, the proceeds of the policy will provide the other business owners with sufficient capital to buy the deceased’s shares.
Business assurance cover can be extended to cover business owners in the event of disability, although this will largely depend on the intention of the shareholders.
Importantly, buy-and-sell assurance must be supported by an agreement between the shareholders which creates the respective obligations and provides details on how the transaction will work in the event of a shareholder’s death or disability.
What risks do shareholders face without buy-and-sell cover?
For many business owners, the value of their business interests forms a sizeable portion of the overall asset base and, as such, needs to be protected against unforeseeable risks.
Should a shareholder die or becomes permanently disabled and unable to continue working, they could face a situation where the other shareholders do not have sufficient capital to buy out that person’s shares which, in turn, would affect the value of the deceased’s estate and the financial legacy they intended to leave to their heirs.
In the absence of buy-and-sell cover, both the remaining shareholders and the deceased’s estate could be left with a lack of clarity as to how the deceased’s shares should be dealt with. Further, if the business needs to access its own capital to buy out the deceased’s shares, this could impact the business’s ability to continue operating.
With these risks in mind, buy-and-sell insurance is something that co-owners of a business should definitely consider.
How does buy-and-sell insurance work?
Buy-and-sell assurance works as follows: The company’s shareholders enter into an agreement which stipulates that, on the death of a shareholder, the other shareholders will buy the deceased’s shares at a set price. To fund the purchase, the shareholders take out life cover on each other’s lives, and the proceeds are used to purchase the shares of the deceased.
What are the benefits for the shareholders?
There are several benefits that a buy-and-sell agreement can provide for co-owners of a business, with peace of mind being the most obvious one.
Business co-owners will no doubt want certainty that the business can continue to operate in the event that one partner dies or becomes disabled, and buy-and-sell assurance can be an effective succession planning tool in the event of a tragedy.
One of the aims of the agreement is to create an obligation to sell on the part of the deceased shareholder, and a corresponding obligation on the part of the surviving co-owners to purchase the shares.
These concomitant obligations mean that external parties, including the deceased’s heirs, cannot interfere in the shareholding of the business.
Being funded by a life policy that pays out on the death of a shareholder means that the funds will be readily available to conclude the share sale transaction quickly.
How does it impact one’s estate planning?
In terms of the Estate Duty Act, the proceeds of all domestic policies paid to a deceased estate will be considered deemed property and therefore subject to estate duty. However, legislation provides several exceptions to this general rule, including the treatment of proceeds paid out in terms of a buy-and-sell policy.
In terms of Section 3(3) of the Estate Duty Act, proceeds from a buy-and-sell policy will not be included for estate duty purposes provided that the policy was taken out by a person who, together with the deceased, was a co-owner – and with the express purpose of funding a share purchase on the death of the shareholder.
Further, the policy premiums must not have been paid by the deceased on their own life.
What are the benefits to your dependants?
One of the most significant benefits to your dependants is that a buy-and-sell agreement provides them with peace of mind that your estate will receive fair value for your share of the business should you die. In the event of your death, your dependants will receive a lump sum amount which they can invest to provide for future income.
What should be included in the agreement?
Although a verbal agreement is still valid, it is always advisable for a company’s shareholders to sign a buy-and-sell agreement as there are several important details that should be incorporated into the document.
Firstly, the agreement should create an obligation on the remaining shareholders to purchase the deceased’s shares in the business, together with an obligation on the deceased to sell their shares to the surviving shareholders.
Further, the agreement should set out either the value of the business or the method to be used in valuing the business so that there is no disagreement as to the value of the deceased’s shares when the time arises.
In addition, the agreement should provide detail on the funding mechanism for the purchase of the shares and how the transaction should take place.
Ideally, the contract should also deal with eventualities such as the resignation of a shareholder or the simultaneous death of two or more shareholders.
What benefits should be included in the policy?
Generally speaking, buy-and-sell assurance can be funded through a whole life policy on the life of each shareholder, with the quantum of cover being linked to the value of their shareholding.
Depending on the intentions of the shareholders, the policy can include just life cover, or life and capital disability cover which would then provide funding if a shareholder becomes permanently disabled.
In such circumstances, life and disability cover would be structured as accelerated benefits, meaning that the policy would pay out on either the death or disability of the insured shareholder.
What are the tax implications?
It is important that the policyholders pay the premiums on the policies in order for the buy-and-sell assurance to be valid, keeping in mind that these premiums are not tax-deductible.
On the death or disability of a shareholder, the proceeds will be paid tax-free to the policyholder, who needs to use the proceeds to purchase the deceased’s share in the business.
The sale of the shares will however attract potential capital gains tax in the estate of the deceased/disabled shareholder.