The rights created by the arrangement require the parties to either buy or sell defined business interest and property of another party. These interests often include company share (if the business is a corporate entity), partnership interests and land.

The defined events commonly referred to in the plan are:-

The death of any party

Total and Permanent Disability (TPD) of any of the parties

Trauma which occurs if any of the parties contracts a major disease or condition as identified in a policy of trauma insurance

Retirement of a party

A business succession plan has several benefits, some of which include the following:- 

• Ensure that a business continues to exit following the retirement, death, TPD and trauma of a key employee of principal of the business.
• Gives the remaining parties involved in a business the peace of mind of knowing who will be involved in the business in the future.
• Gives each party and his/her family the security of knowing that they will have the financial means to support themselves when a defined event occurs.
• Helps the business continue smoothly and with the latest disruption upon an event occurring.

There are three basic protection needs that typically apply to businesses:

• Asset Protection

• Revenue Protection

The most important asset to a business is not the obvious physical assets but the key person or persons. In the event of a key person’s death or disablement, a business may be forced to sell assets to maintain cash flow – particularly if creditors press for payment or debtors hold back payment. Similarly, customers and suppliers may not feel confident in the trading capacity of the business, and its credit rating could fall if lenders are not prepared to extend credit. Outstanding loans owed by the business to the owners (or their beneficiaries) may also be called up for immediate repayment.

Asset protection can provide your business with enough cash to preserve its asset base so it can repay debts, free up cash flow and maintain its credit standing if a business owner or loan guarantor dies or becomes disabled. It can also release personal guarantees secured by the business owner’s assets (such as the family home).

Asset Protection (or capital purpose debt protection) poses a complex set of taxation issues. In addition to the CGT provisions that apply to all life and disability cover, the commercial debt forgiveness rules and the taxation of company profits as dividends must also be considered. Generally, whilst the CGT provisions and the taxation of company profits favours individual beneficial ownership of cover, the commercial debt forgiveness rules tend to favour ownership of cover by the debtor (often the business).

While it is our understanding that the original purpose of the commercial debt forgiveness provision was not to catch transactions such as those above, the definition of “forgiveness” in the Income Tax Assessment Act 1997 states “a debt is forgiven if the debtor’s obligation to pay the debt is released or waived, or is otherwise extinguished”. This could include, for example, insurance benefits received by a guarantor or business principal that are then paid directly to a company’s lender or bank. Assuming that the relevant provisions apply, the impact of the commercial debt forgiveness provisions is to apply the “net forgiven amount” as follows: 

• To reduce revenue losses of the debtor in the years of Income before the forgiveness year of income;

• Then any balance remaining of the net forgiven amount is applied to reduce the deductible net capital losses of the debtor in respect of years of Income before the forgiveness year of income;

• Then any balance remaining of the net forgiven amount is applied to reduce the deductible expenditure of the debtor in the years of Income before the forgiveness year of income;

• Then any balance remaining of the net forgiven amount is applied to reduce the cost base of the assets of the debtor as the beginning of the forgiveness year of income. If there still remains a balance of the net forgiven amount at this point, it is disregarded.

Business Principals must therefore balance their concerns to 

• ensure that their personal guarantees provided to lenders are released;

• The need to ensure that the business itself does not suffer adversely from the operation of the commercial debt forgiveness rules;

• Their desire to ensure that ties with the terminating principal and/or their family or estate are severed and;

• The need to ensure that the continuing principals and proprietors do not incur additional tax liabilities unnecessarily.

As the priorities for various business principals will vary, Asset Protection ownership solutions for each business is also likely to vary.

A drop in revenue is often inevitable when a key person is no longer there. Losses may also result, while finding and training a suitable replacement, from demand that can’t be met, errors of judgement by a less experienced replacement, or through the reduced morale of employees. If there isn’t a suitable replacement within the business it may be a costly process and take substantial time and financial inducement to find and train a successor.

Revenue protection can provide your business with cash to compensate for the loss of revenue and costs of replacing a key employee or business owner should they die or become disabled.

Policies which are taken for the purpose of protecting revenue, are considered as being tax deductible to the business and the proceeds on payment are assessable income to the business. Deductibility of revenue protection premiums is contingent upon the purpose for cover and how the sum insured was calculated being clearly minuted at the time the cover was taken out and at every review. It is therefore prudent for you to prepare a minute which explains the purpose of the policy (ie to protect revenue) and the treatment of premiums and proceeds. This is required for auditing and taxation purposes.

Arrangements should be in place so that: 

• Each business owner or their estate agree on the value of the business and;
• Can get the full value of their equity in the business at the time of their departure or death, or;
• To facilitate the continuing business owners financing a buy-out of that share of the business.

There are two main issues that need to be addressed when planning for business succession in your estate plan.

• The legal transfer of control and ownership of the business.
• The way that the transfer of the business will be funded.

The above can be achieved via a Buy Sell Agreement. A properly funded Buy Sell Agreement can be thought of as estate planning for your business – think of the Buy Sell Agreement as a ‘business will’ and the insurance proceeds as the assets of this will.

The transfer agreement is entered into by the principals of a business to provide for the transfer of business interests in certain defined events. The agreement – which can be a part of or separate to a broader Business Succession Agreement can cover: voluntary events (such as retirement of a principal) as well as 

• involuntary, insurable events (such as death, TPD or critical illness of a proprietor)

• involuntary, non-insurable events (such as bankruptcy of a proprietor or death, TPD or critical illness of a proprietor when adequate cover cannot be obtained for them)

The transfer agreement is traditionally a mandatory contract for sale and purchase of the outgoing proprietor’s business interest (sale contract). More recently it involves put and call options under which the remaining proprietors have the right to acquire the business interests of an outgoing proprietor (call option). The outgoing proprietor (or their estate) has the right to sell the interests of the outgoing proprietor to the remaining proprietors (put option).

The funding agreement is critical to Buy Sell Agreements because it obliges the proprietor to take out insurance cover for the contingency that each proprietor may die (or become disabled) during the existence of the business. The insurance policies provide the funding to support the ultimate transfer of the business interests when, and if, it occurs. Insurance is generally the most cost-effective funding mechanism for transfer of business interests arising from death, TPD or critical illness of a proprietor as the alternatives, such as self-funding or borrowing may not be possible or are unpalatable to business owners. 

The funding agreement should outline alternative funding mechanisms to cater for:

• succession events that cannot be insured

• business proprietors that cannot be insured and

• situations where the insurance proceeds may not be adequate to compensate the exiting proprietor for the transfer of their interest in the business.

There are a number of options available with respect to the ownership of an insurance policy used to fund a Buy Sell Agreement. Funding a Buy Sell Agreement through self ownership or superannuation ownership of life insurance policies will offer you both flexibility in holding and managing the life insurance policy as well as significant practical and taxation advantages over cross ownership or business ownership of the policies.Some of the major considerations when determining ownership options have been outlined below: 

Insurance Owner	Advantages	Disadvantages
Self	Simple:- Proceeds from Life, TPD and /or Critical Illness are generally paid tax free	Premium costs are likely to differ however compensation can be made via an altered salary package. Effectiveness is dependant on a correctly worded Buy/Sell agreement
Cross	Simple	Capital gain tax liability may arise. Premium costs are  likely to differ however compensation can be made via an altered salary package in the event of a change of owners it may be difficult to change the insurance policy
Business	Simple:- A change of ownership of the business will not result in change of ownership of the insurance	Capital gain tax liability may arise.

Self ownership provides a simple means of funding where new owners enter or existing owners leave the business without affecting other owner’s entitlements to insurance policy proceeds and without giving rise to any unnecessary tax implications.