John Ciacciarelli looks at buy/sell business succession arrangements in order to facilitate the transfer of business interests following the departure of an owner.
Following a steady stream of business surveys, it has become clear that a significant number of small business owners do not have an up-to-date succession plan in place to facilitate the transfer of their business interests following their departure, whether it is a planned exit such as retirement, or an unplanned exit like death, disability, or critical illness.
When it comes to buy/sell business succession arrangements specifically designed to facilitate a transfer of the business interest following an unplanned exit, there could be a number of reasons why they are not more readily adopted.
And it is likely that this is at least in part due to the plethora of options available to business owners. Business owners might, for example, be grappling with whether or not to use an insurance policy to fund the arrangement.
If a business owner decides to establish an insurance policy to fund the business transfer, one of the primary considerations is to ensure that the insurance proceeds are received without incurring any unnecessary income or capital gains tax (CGT).
The ability to achieve this will depend on how the arrangement has been structured, while different types of cover will also introduce different tax considerations.
Some of the arrangements that are available include:
- Self-ownership: Business owners hold a policy on their own life;
- Cross ownership: Business owners hold a policy on the life of their business partner(s);
- Ownership through the entity running the business; and
- Ownership through a purpose built trust structure.
While there is no universally accepted way to structure a buy/sell arrangement, an increasingly common method involves funding using an insurance policy tied to a transfer agreement with the policy self-owned by the business owner.
Self-ownership of insurance
A self-ownership buy/sell insurance arrangement is relatively straightforward, especially where the business owner directly holds the interest in the business (eg, an individual partner in a partnership).
Under a self-ownership arrangement, the business owner will generally own an appropriate insurance policy(s) on their own life, equivalent to the value of their interest in the business.
Following the occurrence of an insured event such as death, the insurance proceeds are paid directly to the departing owner (or their estate), which effectively represents the gross consideration for the sale of the business. Under this type of arrangement, the insurance proceeds are generally income tax and CGT free.
Another benefit of self-ownership is that business owners can take their policies with them if they leave the business. This removes the need to change the policy ownership, which in itself can create subsequent CGT issues.
Insurance through superannuation
Superannuation ownership, including ownership through a self-managed superannuation fund, is a variation of self-ownership arrangements.
While many additional considerations come into play, a major attraction of holding this insurance in superannuation is the potential to make tax-deductible contributions in order to fund the insurance premiums.
In addition to the fact that these superannuation contributions may be tax deductible, the superannuation fund trustee is also generally able to claim a tax deduction within the fund for the cost of life and total and permanent disability (TPD) insurance premiums.
This ensures, no contribution tax is payable on the amount of the contribution that is used to fund these premiums.
As the policy is owned by the superannuation fund, contribution cap issues will need to be considered and, in the event of a claim, the insurance proceeds will be paid into the fund.
While no taxation implications should arise for the trustee, the potential benefit payment issues include:
- Preservation: In the event of TPD or trauma, the proceeds may not be immediately accessible if the member cannot satisfy a condition of release; and
- Superannuation benefits tax: Depending on the reason the superannuation benefits are paid out (eg, permanent incapacity or death), who the benefits are paid to, and the type of benefit paid (lump sum or pension), the proceeds may be subject to tax.
Due to these preservation and tax issues, it may also be appropriate to consider holding the life insurance policy within a superannuation fund, while holding any TPD and/or trauma policies outside superannuation.
Tax considerations
Premiums relating to buy/sell insurance policies that are self-owned outside superannuation will not attract a tax deduction, as the purpose of the insurance cover is to fund the purchase of a business interest, which is capital in nature.
Similarly, the insurance proceeds should not attract income tax or CGT, which represents another attraction of self-ownership buy/sell arrangements over other forms of ownership where, in certain circumstances, CGT may apply.
As insurance proceeds received under a buy/sell arrangement will be capital in nature, they should only be subject to CGT in limited situations as set out in table 1.
In summary, when business owners are planning how they will exit their business unexpectedly due to death, permanent incapacity or serious illness a buy/sell agreement will formalise the transfer of the departing owner’s interest to the remaining owner(s) and any insurance cover required.
Caution must be exercised though as tax considerations arise on both the insurance proceeds and the transfer of the business interest.
John Ciacciarelli is technical services manager at AMP.
