A guide to business protection insurance

Business protection insurance will guard your client and his or her partners against the worst-case scenario, writes Jeffrey Scott.

A business generally depends on a few people to produce the profits, provide the capital or manage the business. If one of those people die and there is no viable succession plan, there may be significant financial hardship for the remaining business owners and family members.

There are four core business insurance concepts to consider.

1. Buy-sell insurance

This form of protection provides the outgoing owner (or their nominee) with sufficient cash for the transfer of equity to the continuing owners if a business owner dies or becomes disabled.

Buy-sell insurance is managed via a buy-sell agreement.

This involves the business owners entering into a written agreement to plan what they will do with their respective interests in the business should one of the owners die, become disabled, suffer a traumatic or terminal illness, resign or retire.

The agreement should provide a mechanism whereby the terminating business owner (or their estate) can sell their interest in the business to the continuing owners, and the continuing owners can purchase the terminating owner’s interest in the business.

Generally, the agreement also recognises the means of funding the buy-sell obligations of the respective owners.

2. Which insurance products can be used?

The choice of insurance solution depends on which trigger events are being provided for.

Total and permanent disability (TPD) and death can usually be readily insured against, by way of TPD and life insurance in the buy-sell agreement.

Trauma can also be used but some complex issues must be considered.

Resignation and retirement cannot specifically be insured against and therefore cannot be funded with insurance proceeds. However, a sinking fund can help by providing a cash amount that can be used as a ‘deposit’ against any buy-out obligation at the time of retirement or resignation.

3. Key person insurance

Capital

Key person capital insurance exists to provide the business with sufficient cash to preserve its asset base (ie, to repay or reduce debts, free up cash flow and maintain credit standing) if a business owner dies or becomes disabled.

Key person insurance proceeds can be applied to maintain the capital value and stabilise the business. The capital value of a business following the loss of a key person could be reduced through:

• credit standing;
• goodwill;
• business debts;
• loan accounts; and
• guarantor protection.

The capital value of the business is often determined by profitability and may include a goodwill component. If profitability or goodwill is reduced by a certain percentage, this would be one measure of the potential capital loss to the business.

Financiers usually secure business loans by obtaining guarantees signed by principals, and most will insist on the joint liability of business owners in relation to the loans or overdraft facilities.

Capital purpose insurance premiums are not tax deductible to the business, and the death benefit proceeds are not taxable if received by the beneficial owner.

The proceeds of TPD and trauma insurance are subject to capital gains tax (CGT) if received by a company or trust, and are not taxable if received by the life insured, a spouse (including de facto and same-sex) or a defined relative.

Revenue

Key person revenue insurance provides the business with sufficient cash to compensate for the loss of revenue and replacement costs if a business owner or key employee dies or becomes disabled.

The loss of a key person can cause revenue to decrease and business costs to increase. Key person insurance proceeds can be used to replace the revenue the key person would have generated and fund the extra costs the business would have in finding a suitable replacement.

It is unlikely that a business will have excess profits or non-income producing assets that could be readily liquidated. It is also unlikely that a financial institution would provide credit to fund a loss of profits and key person replacement costs.

Therefore, the most logical and cost-effective solution is life insurance in the form of life, TPD and trauma cover as the funding vehicle.

In order for a corporate entity to claim a tax deduction on insurance premiums paid for key person cover, there are six key requirements that must be met:

• The policy must be owned by the corporate entity (ie, the business);
• Proceeds must be used to cover expenses or loss of revenue (ie, revenue purpose);
• There must be risk only insurance cover in place (no investment component);
• The loss of a key person must result in a significant loss of profits to the corporate entity;
• The corporate entity must continue even with the loss of the key person; and
• The sum insured must be a reasonable estimate of the loss to the corporate entity.

However, any insurance proceeds for revenue purposes will be assessable as income to the business.

Since it is the business that is being protected against the loss of a key person, to obtain a tax deduction the entity (company, partnership, trust or individual) should own the policy and pay the premium.

4. Business overheads cover

Business overheads cover provides for 100% of fixed business expenses if the business owner becomes totally disabled due to sickness or injury.

Business overheads cover is specifically designed for self-employed individuals or members of a small business who need to cover their fixed business expenses if they cannot work due to sickness or injury.

It is vital for sole proprietors, who are generally responsible for the 100 per cent of the fixed expenses of the business. It is equally important for small partnerships to ensure that each partner is covered for his or her share of business expenses.

Jeffrey Scott is executive manager for business growth services at CommInsure.