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Overview:

Business Succession Agreements

 

Types of Agreement:

Types of Agreement

Cross Ownership:

Cross Ownership

Self Ownership:

Self Ownership

Related Party Vendors

Deemed Dividends

Risks If No Agreement

Trust Ownership:

Trust Ownership

Tax Implications

"Business Family Will"

Changing Needs

Benefits

Choice of Trustee

Super Buy/Sell

 

Drafting Issues:

Put Options

Call Options

Put and Call Options

Conditions Precedent

Put and Call Options vs. Conditions Precedent

 

Other Issues:

Pre-Agreed Purchase Price

Inadequate Insurance Proceeds

Trauma Buy/Sell Strategy

Simultaneous Deaths

 

Debt Reduction Agreement:

Debt Reduction Agreement

 

 

 

 

Related Party Vendors

 

Many Businesses are not simply owned by the actual people who are regarded as the Proprietors in a broad sense (in the insurance context, the "Lives Insured").

Use of Third Parties to Own Equity

Many Business People avoid owning business assets in their own name, so that they can:

  • split taxable income between a number of taxpayers; and

  • minimise their personal exposure to creditors of the Business, litigation and the risk of bankruptcy.

In these cases, some or all of the Equity in the Business might be owned by a Third Party such as a Spouse, Company or Family Trust.

Aggregation of Separate Family Interests

In other cases, different members of the same Family own Equity in the Business in their own right.

In other words, they don't own the Equity for and on behalf of the Life Insured.

They own it for their own economic benefit.

However, as far as the other Proprietors are concerned, the Family interests might represent one parcel of Equity, all of which would need to be sold upon the occurrence of an Insured Event with respect to the Life Insured.

"Related Party Vendors"

The Third Parties are described as "Related Party Vendors", because the Business Succession Agreement must ensure that they sell their Equity in the Business upon the occurrence of the Insured Event.

In other words, the Related Party Vendors must sign and be a party to the Business Succession Agreement, so that they can formally agree to transfer their Equity to the Purchasers.

This means that the interests of the Related Party Vendors must be taken into account, so that they will sign the Agreement.

Receiving the Purchase Price

Normally, in an arm's length transaction, you would expect the Vendor of the Equity to receive the Purchase Price of their Equity.

In the context of Buy/Sell Insurance, this might not be the case, if Self-Ownership of the Buy/Sell Cover is used.

This raises the question of whether Self-Ownership of the Buy/Sell Cover is in the interests of all of the parties who must form part of the Succession Plan and to whom an Adviser owes a duty of care.

 

The Adviser's Duty of Care

Advisers must recognise that, in the context of Business Insurance, they do not just owe a duty of care to the Life Insured.

Their duty is not just to arrange for Insurance Proceeds to be paid to the Life Insured (or their Estate).

They owe a duty to care to:

  • the Business (which is protected by the Succession Plan and might fund the Premiums);

  • the Vendors (i.e., the parties who should be legally entitled to receive the Purchase Price); and

  • the Purchasers (i.e., the parties who should be legally entitled to a transfer of the Equity in return for payment of the Purchase Price).

It is important that Advisers be aware of the issues that affect their duty of care and have processes in place that address the issues from an advice, professional indemnity and compliance point of view.

 

Assumption of Risks by Clients

Self-Ownership in cases where Related Party Vendors own Equity in the Business involves some level of risk.

All relevant parties are entitled to take the risks, as long as:

  • they are advised of the risks;

  • they understand the nature and extent of the risks; and

  • they elect to take the risks.

 

Assumption of Risks by Advisers

The need for advice imposes a duty of care on Advisers who recommend Self-Ownership of Buy/Sell Cover in these circumstances.

This is particularly important where an Adviser recommends Self-Ownership of Buy/Sell Cover as a matter of standard practice, whether or not the Business has sought (or intends to seek) the advice of a Succession Planning Lawyer.

Where the Adviser recommends the method of Policy Ownership before a Lawyer is involved and has had an opportunity to accept P.I. responsibility for the Policy Ownership Advice, the Adviser must accept that they are responsible for the advice.

This analysis attempts to identify some of the issues that Clients are entitled to know.

Independent Advice

Parties who are adversely affected by the strategy should have an opportunity to obtain independent advice before they are able to consent to the strategy.

It should not be asumed that all parties (including likely Beneficiaries of Trusts and Estates) will acquiesce in the wishes of the Life Insured.

IGS Business Insurance Trust Agreement

In contrast, for a comparable cost, the IGS Business Insurance Trust Agreement is designed to eliminate these risks by distributing the Purchase Price to the appropriate Vendors (i.e., by paying "the right money to the right people").

At the same time, it obtains the same CGT exemptions that Self-Ownership is intended to qualify for.

Only it achieves the exemptions without requiring the Policy Ownership and Business Succession Agreement to be structured in an overtly non-arm's length manner.

IGS Self-Ownership Business Succession Agreement

Where the Adviser recommends Self-Ownership and the parties accept their advice, IGS also supplies a Self-Ownership Agreement, similar to the Buy/Sell Agreements offered by other Lawyers.

 

Purchase Price Not Paid to Actual Owner

So...what is the primary issue?

Ultimately, it boils down to: who receives the Purchase Price and How?

Self-Ownership requires the Life Insured to own the Buy/Sell Insurance Policy.

Therefore, the Insurance Proceeds attributable to the Purchase Price must be paid to the Life Insured (or their Estate), even if the Equity in the Business is owned by a Third Party (such as a Spouse, Company or Family Trust).

Thus, Self-Ownership can result in the Purchase Price being paid to the wrong party, in order to obtain a CGT exemption with respect to the Insurance Proceeds.

The motivation for this strategy is the desire to avoid CGT on the Insurance Proceeds attributable to the Purchase Price.

However, the strategy requires the Life Insured to benefit themselves at the expense of the parties who should and would normally have been entitled to the Purchase Price.

The justification for this strategy is that "near enough is good enough", as long as CGT on the Insurance Proceeds is avoided.

This strategy overlooks, ignores or discounts the legal, commercial and CGT implications of:

  • the failure to pay the Insurance Proceeds attributable to the Purchase Price to the appropriate Recipients (i.e., the Vendors); and

  • any subsequent transaction pursuant to which the Purchase Price might ultimately be paid by the Estate to the Vendors (assuming this is intended to occur).

 

Actual Owner is Spouse

If a Spouse owns some or all of the Life Insured's Equity in the Business, then ideally they should receive their share of the Sale Price by way of the Business Succession Agreement.

Death of Life Insured

If the Life Insured dies, then the Insurance Proceeds attributable to the Sale Price will be paid to the Estate.

If the Spouse is the sole Beneficiary of the Estate, then this might not cause any material problems.

The Spouse will receive the Sale Proceeds as a gift pursuant to the terms of the Life Insured's Will.

Either way, the Spouse ends up with the Sale Proceeds that they are entitled to.

On the other hand, if the Spouse is not the sole Beneficiary, then some or all of the Sale Price might be distributed to parties other than the Spouse.

Similarly, if the Will is challenged by an ex-Spouse or disgruntled Beneficiary or the Life Insured dies intestate (i.e., without a valid Will), then again some or all of the Sale Price might be distributed to other parties.

Disability of Life Insured

If the Life Insured is disabled, then their Will will not be able to distribute the Sale Price to the Spouse, because it can only take effect on the Death of the Life Insured.

If the Spouse wished to receive the Sale Price, presumably the Life Insured (or their Attorney) would simply distribute the funds to them without any formal legal arrangements or CGT implications.

This assumes that there is no dispute between the Life Insured and their Spouse.

It also assumes that the Attorney would be prepared to transfer the funds to the Spouse (assuming the Attorney is not the Spouse).

If the Life Insured or their Attorney is not prepared to transfer the funds to the Spouse, then the strategy would have wrongly deprived the Spouse of their funds.

 

Actual Owner is Family Company

If the actual Owner is a Company, then ideally it should receive its share of the Sale Price.

Life Insured is Sole Shareholder

If the Life Insured is the sole Shareholder of the Company, then it is arguable that there is no substantive difference in the outcome.

Payment to the Life Insured (or their Estate) results in payment to the ultimate Shareholder.

The only issue is whether circumventing the Company results in any CGT or Income Tax liabilities.

Life Insured is Not Sole Shareholder

If some or all of the Shareholders are parties other than the Life Insured, then arguably they should be beneficially entitled to the Sale Price.

To the extent that they do not ultimately receive any of the Sale Price, then they have been deprived of their entitlement.

However, if the other Shareholder was the Life Insured's Spouse, then similar issues would apply to the situation where the Spouse is the direct Owner of the Equity.

Deemed Dividend

It is arguable that the payment to the Life Insured would constitute a deemed dividend under section 109C of the Income Tax Assessment Act 1936.

Section 109C provides as follows:

"A private company is taken to pay a dividend to an entity at the end of the private company's year of income if the private company pays an amount to the entity during the year and either:

(a) the payment is made when the entity is a shareholder in the private company or an associate of such a shareholder; or

(b) a reasonable person would conclude (having regard to all the circumstances) that the payment is made because the entity has been such a shareholder or associate at some time."

Commissioner of Taxation v Rozman

In Commissioner of Taxation v Rozman [2010] FCA 324 (1 April 2010), Perram J. of the Federal Court held that the word "payment" includes a payment by another party at the direction of the Company.

Thus, it is not necessary that the Company itself directly make the payment to the Shareholder or Associate of the Shareholder.

Application of Section 109C to Buy/Sell Situations

In a Buy/Sell situation, the Company would normally be expected to receive the Sale Price as the consideration for the Equity it owns and must transfer to the Purchasers under the Business Succession Agreement.

Self-Ownership is simply a strategy to avoid the Capital Gains Tax that would be payable in some circumstances, if the Purchasers owned the Buy/Sell Cover.

Self-Ownership effectively requires the Insurance Proceeds attributable to the Sale Price to be paid directly to the Life Insured (rather than the Company Vendor).

it is arguable that the payment is made to the Life Insured by the Insurance Company:

  • at the direction of the company; or

  • in accordance with an arrangement pursuant to which the Life Insured (rather than the Company itself) effectively receives the Insurance Proceeds as consideration for the transfer of the Equity held by the Company .

Thus, it is arguable that there would be a deemed dividend and income tax payable with respect to the deemed dividend at the Life Insured's marginal tax rates.

This income tax liability would be additional to any Capital Gains Tax liability as a result of the sale of the Equity by the Related Party Vendor.

Comparison with Payment to Related Party Vendor under Trust Ownership

Trust Ownership is designed to pay the Insurance Proceeds attributable to the Sale Price to the appropriate Related Party Vendor.

If the Sale Proceeds were paid to the appropriate Vendor, it would be responsible for payment of the CGT liability.

The amount of Capital Gains Tax would be the the same as would be deemed to be payable under Self-Ownership as a result of the Market Value Substitution Rules.

However, in the case of Trust Ownership, the Vendor's CGT liability would reduce the amount of the Net Sale Proceeds available for distribution as a dividend.

In other words, the amount available for distribution as a dividend would be the Net Sale Price after payment of the CGT liability.

If there was no CGT liability, then the amount of the dividend (and therefore the income tax liability) would be potentially higher, because the whole of the Sale Price would be available for distribution.

However, in the case of Self-Ownership of the Buy/Sell Cover, the whole of the Insurance Proceeds attributable to the Sale Price will always be paid to the Life Insured by the Insurance Company (subject to the availability of adequate Cover).

Therefore, the deemed dividend will always be equivalent to the gross amount of the Sale Price.

There would be no deduction for any CGT liability payable by the Related Party Vendor (subject to any allowance under section 109Y).

In fact, if there was a CGT liability, the Vendor would have to pay it out of funds other than the Insurance Proceeds.

As a result, in cases where there is a CGT liability with respect to the sale of the Equity, Self-Ownership will result in a higher tax liability than would have applied under Trust Ownership.

 

Actual Owner is Family Trust

This situation will partly depend on the identity of the Trustee.

If the Trustee is a Company, in many cases the Life Insured might be the sole Shareholder of the Company Trustee.

Subject to any fiduciary duties towards Beneficiaries and Creditors (see below), the Life Insured is effectively in control of the Trust and therefore able to make decisions to divert funds away from the Trust and into their own hands (or their Estate).

Death of Life Insured

To the extent that the Beneficiaries of the Estate might be the same Family Members as the Discretionary Beneficiaries of the Family Trust, this might not result in any material disadvantage.

However, this assumes that there is a valid Will and that it is not challenged by an ex-Spouse or disgruntled Beneficiary.

Payment to the Estate only achieves the Life Insured's wishes, if the Funds end up being distributed to the Beneficiaries nominated by the Life Insured.

Disability of Life Insured

The payment to the Life Insured effectively assumes that the Life Insured would have exercised their discretion as a Trustee (or a Sharehodler of the Trustee Company) to distribute the Trust Funds to themselves.

This might be realistic, given that at the time the Life Insured is disabled and possibly has a greater need for the Funds than the other Discretionary Beneficiaries.

It should be remembered that, if the Funds are paid to the Life Insured, then at the time of their Death, any unexpended Funds will form part of their Estate.

Thus, they could be subject to any dispute with respect to the Will that might otherwise have occurred.

 

Actual Owner is Third Party

This situation will apply where the Buy/Sell Arrangements with respect to the Life Insured are intended to fund the purchase of Equity in the Business that might be owned by an Arm's Length Party.

Examples are:

  • a Sibling or other Relative co-owns the Equity, but wishes to depart the Business, if the Life Insured dies;

  • a Proprietor close to their own Retirement wishes to bring forward their Retirement, if the Life Insured dies; and

  • the Continuing Proprietors wish to buy out the Equity of a Venture Capitalist Shareholder, if any of the Lives Insured die.

In all of these situations, it is more important that the Actual Owners of the Equity receive the Sale Price of their own Equity.

It is not sufficient that the Sale Price be paid to the Life Insured (or their Estate).

 

Asset Stripping

If the Life Insured (or their Estate) retains the Insurance Proceeds attributable to the Purchase Price, the assets of the Related Party Vendor would be denuded by the value of the Equity.

While a Spouse might be prepared to consent to this outcome, it is questionable whether it would be sufficient for a Company or Trustee controlled by the Life Insured to consent to it, if the Shareholders or Beneficiaries include parties other than the Life Insured.

In other words, it is relevant to determine whether all parties are content that the Insurance Proceeds remain with the Life Insured (or the Beneficiaries of their Estate specified in their Will).

 

Intention to Distribute Insurance Proceeds to Appropriate Recipient

Alternatively, it might be their intention that, by some means or other, the Insurance Proceeds will find their way to the appropriate Recipient?

If this is the case, it is important to identify the commercial, legal and tax implications of any mechanism that pays the Insurance Proceeds to the appropriate Recipient.

Is it intended that the Life Insured (or the Beneficiaries of their Estate) will simply "do the right thing" and pass the Insurance Proceeds onto the appropriate Recipients (e.g., as a "gift").

Alternatively, do the parties require greater contractual certainty that the distribution will occur?

Click here for an analysis of the issues that affect Contractual Obligations to Distribute the Insurance Procees to Third Parties.

 

Possible Breach of Fiduciary Duties

In the case of Companies and Trusts, the sale of the Equity for no consideration or inadequate consideration might constitute a breach of fiduciary duty on the part of the Directors of the Company or the Trustee Company.

This could create a liability against the assets of the Estate (including the Sale Proceeds).

 

Possible Breach of Covenants or Obligations to Creditors

The sale of the Equity for no consideration or inadequate consideration might breach a covenant or obligation to a Creditor of the Company or Trust under any Loan Agreement.

 

Inability to Release Security over Equity

If the Equity is subject to a Security in favour of a Creditor or Lender, it might not be possible to obtain a release of the Security, unless the Beneficiaries of the Estate disgorge the Insurance Proceeds and pay them to the Creditor.

Unless the release of Security occurred, the Purchasers might not be able to obtain good title to the Equity.

The repayment of the Creditor would erode the assets of the Beneficiaries who received the Insurance Proceeds under the Life Insured's Will.

Again, if the Beneficiaries complied, there could be adverse CGT and tax implications in the arrangements by which the funds were made available for this purpose.

There would be considerable scope for dispute, delay and expense, while the repayment of the Creditor was arranged.

 

CGT Liability of Related Party Vendor

Notwithstanding that the actual Vendor did not receive the Purchase Price, it will be obliged to transfer the Equity to the Purchasers.

If the sale is subject to Capital Gains Tax, there will still be a CGT liability, even though no funds were paid to the Vendor.

The ATO will apply the Market Value Substitution Rules under section 116-30, so that:

  • the Purchasers will be deemed to have paid market value for the Equity; and

  • the Vendors will be deemed to have received the market value.

As a result, the Vendors will incur the appropriate CGT liability with respect to the Disposal.

However, they will not have any funds attributable to the Purchase Price to fund the liability.

If this liability is to be discharged from the Insurance Proceeds paid to the Life Insured (or their Estate), there may be a CGT liability with respect to any transaction by which the funds are channelled to the Vendors.

 

CGT Liability of Related Party Vendor (Discretionary or Family Trust)

The CGT liability with respect to the deemed Disposal can cause significant administrative, commercial and tax problems if the Related Party Vendor is a Discretionary or Family Trust.

The actual Insurance Proceeds attributable to the Purchase Price would normally be paid to the Beneficiaries of the Life Insured's Estate in the case of a death.

These Beneficiaries will not always be the same as the Beneficiaries of the Discretionary Trust.

However, more importantly, the Trustee will have to determine how to deal with the CGT liability with respect to the deemed Disposal by the Trust.

Normally, the CGT liability would attach to the distribution of Trust Income to the Beneficiary.

However, because the CGT liability will arise with respect to a "deemed" Disposal by the Trust, there will be no actual Trust Income to distribute to a Beneficiary of the Trust.

Proportionate Approach

In the absence of an alternative determination by the Trustee, the CGT Liability would normally be payable by the Beneficiaries in proportion to their interest in the Net Income of the Trust in that financial year ("the Proportionate Approach").

This approach might be unfair to one or more Beneficiaries, if they did not actually receive any of the Insurance Proceeds under the Life Insured's Will.

In effect, they would have to fund their CGT liability out of other income or assets.

Capital Beneficiary Approach

Alternatively, the Trustee could determine that one or more Beneficiaries should be deemed to have had a vested and indefeasible interest in the Trust Capital representing the Trust's Capital Gain, as if the deemed Capital Gain was represented by actual Trust Capital distributed to the Beneficiaries ("the Capital Beneficiary Approach").

Again, this approach could be unfair to one or more Beneficiaries, if they did not actually receive any of the Insurance Proceeds under the Life Insured's Will.

Trustee Approach

A third alternative would be for the ATO to assess the Capital Gain in the hands of the Trustee under section 99 or 99A of the ITAA 1936 ("the Trustee Approach").

This could result in a higher tax rate than would apply, if the Capital Gain was assessable in the hands of a Beneficiary.

It would also erode the Trust Capital, to the detriment of the financial interests of all of the Beneficiaries.

This result might apply, if there is no other Trust Income in the financial year and the Trustee fails to make a determination within two months after the end of the financial year.

Exercise of Trustee's Discretion

In these situations, the Trustee has a discretion to allocate the CGT liability to the Beneficiary of its choice.

The arbitrary use or abuse of this discretion could result in significant financial embarrassment and scope for dispute.

 

Disputes with respect to Estate

The inappropriate payment of the Insurance Proceeds to the Estate means that they have to be distributed in accordance with the Life Insured's Will (rather than the terms of the Trust Deed in the case of a Family Trust).

The Life Insured will not always wish to treat the assets of their Family Trust in the same way as the assets of their Estate in the event of their death.

The Insurance Proceeds would also be subject to disputes with respect to the distribution of the Estate by disgruntled Beneficiaries.

 

Insurance Trust Solution

The above issues can be avoided by the use of a Business Insurance Trust Agreement.

The need to pay Insurance Proceeds to the right Recipients is a major reason for the use of a Trust Agreement.

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

Self-Ownership must pay the insurance proceeds to the Life Insured or their Estate.

It cannot pay them to a Related Party that owns some of the Equity in the Business (e.g., a Family Trust or Company) nor can it pay them to a Creditor without adverse tax implications.

 

See more Adviser Tips

 

 

 

 

 

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