Security for Your Business and Loved Ones – Buy/Sell Life Insurance Agreements

How does a Buy Sell Life Insurance Agreement actually work?

When taking out a buy/sell life insurance agreement, business partners purchase life insurance policies on the lives on each co-owner but not on themselves. In the event of one of the co-owners death, the other co-owners will be paid a lump-sum benefit that is then paid to the deceased’s surviving family members. This payment allows the owners to acquire to share of the co-worker who has passed away while compensating the deceased family members.

What are the key benefits?

Some of the advantages of Buy Sell Life Insurance Agreements include:

• Mutual benefit. Not only does the family of the deceased benefit through this agreement, but the company does not experience any financial loss
• Extends cover to serious illness and injury. Buy-sell life insurance can also be used to cover total permanent disablement or serious medical trauma
• Policies can be owned in various ways. Cover can be owned individually, cross-owned (owned on behalf of the lives of other owners), owned by super fund trustee on behalf of those insured

Why do people have to buy and sell insurance agreements in place?

A buy and sell agreement is an integral part of a business succession planning process. When a partner is unable to continue running the business due to death or disability, a buy and sell life insurance agreement can protect the business, especially for the surviving owners. Buy/sell agreements can also provide cover for events other than death and disability. This can include:

• Divorce or separation (if the owners are married or in a de facto relationship)
• Retirement
• In some cases, bankruptcy

Key components of a buy and sell life insurance agreement

Some of the main inclusions in a typical buy/sell life insurance agreement include:

• Guarantee to buy the owner’s shares: The trigger events for a buy/sell agreement are always mentioned in the agreement and all the owners offer a guarantee that the shares of an owner will be purchased if any of the trigger events occur.
• The purchaser of the owner’s shares: The agreement will also mention who has to buy the shares of the departing owner. The remaining owners may be bound to purchase the shares of the departing owner, or the company itself may be required to effect a buyout of the shares.
• Valuation of the departing owner’s interest in the business: One of the main features of a buy/sell agreement is the valuation of the shares of the departing owner. The interest is typically valued as per the market rate of the shares at the time the trigger event occurred. Since most businesses differ in valuations over the years, the valuation of the shares of the owners is typically reviewed and re-calculated at least once every year.
• How to fund the buyout: The buyout of the shares of the departing owner is typically funded through life insurance policies on the owner’s lives. These policies generally include total and permanent disability and trauma cover in some instances.

How much cover should I obtain for a buy and sell life insurance agreement?

To determine the level of cover that you and your business partner/s may need, consider the value of each owner’s share of the business. This value amount should generally reflect the sum insured on the buy and sell life insurance agreement. It is important that the business owners review this amount on an annual basis to ensure adequate cover is in place.

For example, if the business has two owners and each has an equal share of a business with a value of $2 million, the amount insured on the life of each partner should be $1 million on a buy/sell life insurance agreement that will provide cover for death, TPD and possibly trauma.

Determine the value of your business for the purpose of buy/sell life insurance agreement

There are three types of valuation methods to help determine the value of your business for a buy and sell life insurance agreement:

Current market value

The Australian Taxation Office (ATO) will most likely consider the validity of a business interest transfer under a buy and sell agreement when it occurs at market value. Therefore, it may be reasonable to utilise current market value as the main valuation method and it is essential that this value is up-to-date, at least on an annual basis.

Current market value with indexation

You also nominate the sums insured based on the current market value of the business and keep up with changes of business value amount overtime by having them indexed to inflation or by the anticipated growth rate of the business.

Formula-based valuation

The business owners/partners/executives can also use a different approach by using a formula-based valuation method. This formula should reflect an industry standard and appropriate for the specific business. The value of the business over the years must also be reviewed by using this formula and it is important that the business owner is subjective when assessing whether or not the result (value) is realistic.

In addition, it is essential to have the business accountant conduct an additional assessment on the valuation and provide a confirmation on whether or not it is acceptable on ordinary commercial terms, which may be an underwriting requirement depending on the nominated sums insured.

ownership structures of buy/sell life insurance agreements

When life insurance is utilised to fund a buy and sell agreement, the business owners/partners must consider an ownership structure that is appropriate to their individual situation and objectives. There are five ownership structures for buy/sell life insurance agreements and these include:

1. Self-ownership
2. Cross ownership
3. Corporate ownership
4. Discretionary trust ownership
5. Superannuation ownership

1. Self-ownership

In this ownership structure, business owners hold an insurance policy on their own lives. When a trigger event occurs, the departing owner or their estate is generally required to give up their share of the business to the surviving owners. A modern buy and sell life insurance agreement often uses this type of arrangement, which is also known as a put and call option.

2. Cross ownership

With this type of ownership, each shareholder owns an insurance policy on the other owners of the business. So, in the event that an owner passes away or is permanently disabled, the insurance proceeds can be used by the surviving owners to purchase the departing owner’s share of the business. A buy/sell life insurance agreement with cross ownership structure also places the requirements for the transfer without compromising the liquidity needs of the company.

3. Corporate ownership

In a buy/sell life insurance agreement with corporate ownership structure, the business partners do not own life insurance policies on each other. The corporate entity owns the insurance policies on behalf of the owners of the business. So, in the event of death or permanent disability of one of the owners, the entity will buy out the departing owner’s share of the business using the proceeds from the insurance policy.

A buy and sell agreement with corporate ownership is usually easier to put in place when there are multiple owners of a company. The company only needs to buy an insurance policy on each of the owners, rather than all the owners buying policies on each other.

It is important to note that once the company purchases the interest of the departing owner, it does not mean that the shares of the surviving owners in the business will automatically increase, as they do not buy the shares in their own names. The percentage of ownership of each surviving owner, however, will increase.

4. Discretionary trust ownership

With discretionary trust ownership structure in a buy/sell agreement, an independent trustee of a discretionary trust, also known as bare trust, has been appointed to hold insurance policies on behalf of all of the lives insured. When a trigger event occurs, the trustee will then divide the proceeds of the policy to the continuing owners, which can be used to purchase the departing owner’s interest in the business.

5. Superannuation ownership

This structure can be considered as a variation of self-ownership, as the insurance policies are owned and structured through a superannuation fund, as opposed to under each of the business owners’ names.

Consider the benefits of buy and sell life insurance agreement for your business

Uncertainties, such as death, illness, and injury, can greatly affect the financial well-being of your business. You, including your partners, are exposed to the risk of significant financial loss should the other suddenly die or become disabled. However, with a buy/sell life insurance agreement in place, you can eliminate such risk and ensure the smooth business transition, even in difficult times.

Buy/sell agreement is a convenient and hassle-free solution for business owners and their loved ones while preserving the continuity of the business.

Contact Total Advisory Services and speak with an expert in this field.