Buy/Sell Agreements for business continuity
A buy/sell agreement deals with the involuntary transfer of a proprietor’s business equity where a “trigger event” such as the death or total and permanent disability of a proprietor. However careful consideration needs to be given to the funding and tax implications to avoid unexpected CGT assessments.
In small business, planning for the unexpected is essential where the sudden loss or incapacity of a business partner can create uncertainty and risk for both the business and the families involved. That’s why buy/sell agreements are an important tool business succession planning.
What is a Buy/Sell Agreement
A buy/sell agreement is a legally binding contract that outlines what happens to a business owner’s share if they leave the business involuntarily, typically due to death or total and permanent disability (TPD). The agreement is designed to cover:
Business Continuity: Remaining owners can continue running the business without interference from the departing owner’s estate or family; and
Fair Compensation: The exiting owner or their estate receives proper payment for their share of the business.
Without such an agreement, disputes may arise, or the business is frozen while the deceased estate is administered, potentially harming the business’s value and operations.
Buy/Sell Insurance
A key feature of buy/sell agreements is the funding mechanism for buying out the departing owner’s equity.
Insurance policies such as life and TPD insurance are commonly used, and there are several ownership structures to consider:
1 - Self Ownership
Each owner holds a policy on their own life
Proceeds go to the owner’s estate and are used to fund the buyout
Generally, insurance proceeds are exempt from Capital Gains Tax (CGT) if certain conditions are met.
The buy/sell agreement can provide mechanisms for how the short-fall should be met including the timing and any required interest payments on the shortfall.
If the insurance proceeds are greater than the value of the exiting proprietor’s share of equity, it is common for buy/sell agreements to state that such proceeds are to be paid into the deceased’s estate with the deceased’s equity being transferred to the remaining proprietors in full.
2 - Cross Ownership
Cross-owned insurance policies are policies where each of the business proprietors hold policies on each other. On the death or TPD of a business proprietor, the proceeds are payable to the surviving proprietors and the proceeds would be used to purchase the deceased’s equity in the business.
A significant disadvantage of having cross-ownership is the CGT implications arising from payments of TPD insurance proceeds.
Owners hold policies on each other
Proceeds go directly to surviving owners to fund the buyout
Life insurance proceeds are usually CGT exempt, but TPD proceeds may not be, making this structure less tax-effective for TPD cover
3 - Trust Ownership
Trust-owned insurance policies involve the establishment of a special purpose insurance trust, where the trustee holds the policies on behalf of all of the owners. If a business proprietor suffers death/TPD, the proceeds will be paid to the trustee as the owner of the policy, and the trustee is to divide the policy proceeds under the terms of the insurance trust deed.
Under the terms of the insurance trust deed, the beneficiaries of the trust would be the business proprietors themselves and provided the insurance proceeds received is as a result of an injury of one of the proprietors, the proceeds should be CGT exempt.
Further, life insurance proceeds paid to the trustee as the “original owner” of the life insurance policy are also exempt from CGT.
A trust holds policies for all owners
Proceeds are distributed according to the trust deed
This centralizes policy management and can provide CGT exemptions for both life and TPD insurance proceeds.
4 - Superannuation Ownership
Insurance policy premiums are generally not deductible making it an expensive outgoing to fund. However, the trustee of a superannuation fund is allowed to claim deductions for insurance premiums on death or TPD policies. It is therefore common for individuals to hold life and TPD insurance in superannuation given the deductibility of premiums and potentially cheaper premiums through superannuation.
Nevertheless, in the self-managed superannuation fund (SMSF) context, the ATO has is of the opinion that buy/sell insurance obtained through an SMSF is in breach of superannuation law and would cause a member’s fund to become non-compliant with consequent penalties and higher taxes applying.
Policies are held within a superannuation fund, offering deductible premiums
However, using self-managed super funds (SMSFs) for buy/sell insurance can breach superannuation laws and is generally not recommended
Tax Considerations
Transferring a departing owner’s equity under a buy/sell agreement is normally a CGT event A1. To calculate any taxable capital gain, the value of the asset at the date of the buy/sell agreement is used, even though a trigger event might occur in the distant future.
it is important that the buy/sell agreement be drafted such that the deemed transfer provisions are contingent on certain conditions precedent occurring. A condition precedent would be the happening of a trigger event, being the death/TPD of a particular business owner and the insurance company paying out the insurance proceeds.
Another issue arising out of the transfer of equity in the business is the potential for the parties to be deemed to be paying market value consideration and receiving market value proceeds where they are considered not to have transacted with each other on arm’s length terms under the ATO’s market value substitution rules. To overcome this, the buy/sell agreement needs to include terms to have the business (and thus the exiting proprietor’s equity) valued by an independent third party valuer on the trigger date.
To minimise tax and cash flow issues:
Ensure the agreement makes transfers contingent on the actual trigger event (death or TPD), not just the signing of the contract
Use independent valuations to determine fair market value at the time of transfer
Explore available CGT concessions:
the 50% discount under Division 115 of the ITAA 1997 (prior to 1 July) for assets held over 12 months and small business CGT concessions, to reduce tax liabilities for the departing owner’s estate; and
the Small Business CGT Concessions under Div 152 of the ITAA 1997 as the equity in the business subject of the transfer is very likely to be considered an “active asset”.
Note also that, s 152-80 of the ITAA 1997 provides that if the CGT asset forms part of the estate of a deceased individual, the legal personal representatives (for example, executors) or the beneficiaries can access the CGT concessions
Final Thoughts
Proactive succession planning protects both your business and your family’s interests.
Buy/sell agreements, backed by the right insurance and structured with tax efficiency in mind, provide peace of mind and ensure your business can weather any storm.
If you’d like to discuss how a tailored buy/sell agreement can safeguard your business, contact our team today.
