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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

 

 

 

 

 

 

 

Pre-Agreed Purchase Price and Distributions of Total Sum Insured

 

Unlike most other Business Succession Agreements, the standard IGS Business Insurance Trust Agreement and Business Succession Agreement allows the parties to pre-agree or “lock in” a specific Purchase Price (and any other distributions out of the total Sum Insured), until the Agreement is subsequently varied.

 

"Hedge and Wedge" Strategy

By insuring the Purchase Price, you are protecting yourself or "hedging" against the risk that the Purchasers might not be prepared (or able to afford) to pay the Purchase Price of your Equity.

By pre-agreeing the Purchase Price, you are ensuring that the Owner of the Equity will receive a guaranteed minimum Purchase Price.

In effect, over time, you are "wedging" the Purchase Price of the Equity at a fixed position on the growth curve that represents its value over time.

When you combine these two strategies, you have a "Hedge and Wedge Strategy".

By insuring a Pre-agreed Purchase Price, you are therefore putting in place a "Capital Guarantee" with respect to your Equity in the Business.

In a sense, you have converted your Equity into a form of "Protected Equity".

 

Simplifying the Valuation Issue

Many business people do not know the value of their Business or find it difficult to reach agreement on the value of their Equity in the Business for insurance purposes.

You can imagine that if it is difficult to reach agreement now, it would be even worse after one Proprietor has died or become disabled.

The One Policy Strategy can help simplify the valuation issue.

Example

Assume that three Proprietors don't know whether their Equity is worth $300K or $500K.

A $200K difference at the time of a death could be quite an emotive and expensive dispute.

However, when a Proprietor is trying to fund a capital sum of $1 million (so that, invested at 5% per annum, it generates living expenses of $50,00 per annum), the issue becomes a choice between:

  • a Purchase Price of $300K and Personal Cover of $700K; and

  • a Purchase Price of $500K and Personal Cover of $500K.

Either way, the total Sum Insured is $1 million. There would be no difference in Premium cost if one option was chosen over the other.

Capital Gains Tax

In practice, there is a difference in the tax treatment of the Purchase Price and the Personal Cover.

The Purchase Price might be subject to capital gains tax (up to 25% of the capital gain), while the Personal Cover will be tax-free.

Thus, most Proprietors minimise the Purchase Price and maximise the Personal Cover.

In the above example, they might chose the option of a $300K Purchase Price and $700K Personal Cover.

Market Value

It is important that the Purchase Price still be within market parameters acceptable to the ATO.

If the Price is unrealistically low, the ATO might seek to apply the "market value substitution rules".

The rules enable the ATO to impose CGT on the basis of the market value, regardless of whether the Vendor received this amount of money.

If the ATO commissioned a valuation, it is likely that both the Vendors and the Purchasers would also want to obtain independent valuations to protect their interests.

Thus, there would end up being a three-way valuation dispute.

Pre-agreement of the Purchase Price results in a sensible value that is not too inflated to concern an underwriter or too low to concern the ATO.

The Type of Valuation

One implication of this strategy is that the Business need not obtain an expensive valuation in order to determine the value of the Equity in the Business.

If a valuation is desired, it need only be a simple valuation necessary to satisfy the requirements of the insurance company's underwriter.

This reduces the upfront cost of the Succession Plan and prioritises the affordability of the Premium.

 

Best Opportunity to Review Purchase Price and Insurance Policy

Insurance Policies are an annually renewable contract with the Insurance Company.

An annual review is a convenient opportunity to review the Purchase Price and the level of insurance cover attributable to it.

The easiest time to renegotiate the Purchase Price is when all of the Lives Insured are alive.

If you wait for a death or insurable event to occur, then the dynamics of the negotiations are radically different:

  • One Life Insured is no longer alive or representing themselves;

  • One party is now a Vendor that wants to increase the Purchase Price;

  • The other Parties are now Purchasers who want to reduce the Purchase Price (or at least maintain it at the level of the Insurance Proceeds);

  • All Parties are acting in good faith for the ultimate benefit of their own families;

  • Litigation lawyers just love principle-based disputes.

In contrast, if you negotiate the Purchase Price when all Parties are alive, then nobody knows whether they will be "the first to die or the first to buy".

As a result:

  • Nobody has an interest in inflating the Purchase Price (thinking they will receive it); and

  • Nobody has an interest in artificially defaulting it (thinking they will have to fund it).

 

Avoidance of Valuation Disputes

At the time of a claim, the Pre-agreement Provisions in the initial Agreement and subsequent Variation Agreements therefore avoid expensive valuations, legal and accounting advice, and disputes with respect to the Purchase Price.

 

Monitoring Changes

It is important that the Business monitor the growth in its value and the impact on its Succession Plan (including the insurance arrangements) on a regular basis.

Because the insurance is renewable annually, this is an appropriate time to review both the Need and the amount of the Insurance.

 

No Variation for Three Years

If the parties fail to vary the Pre-agreed Purchase Price for three years, the standard Agreement assumes that the parties have forgotten to vary it.

It also assumes that three years is too long to be bound by a Price that might have become out-of-date.

Therefore, from that point onwards:

  • the Pre-agreement Provisions cease; and

  • the Agreement defaults to the standard Valuation Procedure.

If the Purchase Price exceeds the Insured Purchase Price, the Agreement requires Purchasers to pay the shortfall at the same time as the Insured Purchase Price.

This would effectively require the Purchasers to borow the shortfall.

It is obviously desirable that the parties pre-agree the Purchase Price regularly, so that:

  • there are no potential disputes with respect to the valuation; and

  • any arrangements with respect to the payment of the shortfall can take into account the cash flow implications for both the Vendors and the Purchasers.

Once the Price has been reviewed and pre-agreed, a new three year period commences.

 

Variation of Purchase Price or Other Needs

The Business may vary the Schedules to the Agreement, if there are substantive changes to the Purchase Price or any other Need.

This would normally require a Variation Agreement.

 

Minor Changes

Minor changes do not necessarily require a formal Variation Agreement.

The holistic approach of the One Page, One Policy Strategy minimises the need for minor changes.

By combining the Purchase Price Cover (say $400,000) and Personal Cover (say $600,000) on the one Policy, it focuses attention on the aggregate that will be received by the Life Insured and their Related Parties (say $1,000,000).

If the value of the Equity increased from $400,000 to $430,000, the Business might wish to change the split from [$400,000 Blue plus $600,000 Green] to [$430,000 Blue plus $570,000 Green].

This variation would make no substantive change to the aggregate amount that would be payable to the Life Insured.

However, it would effectively move $30,000 of Tax-free Green Cover to $30,000 of potentially assessable Blue Cover.

Therefore, in the event of a claim, the CGT liability would increase by up to 25% of $30,000 (i.e., $7,500).

In this case, the variation would result in a lower net-after tax payment to the Life Insured.

Ultimately, where there are only minor chnages, the Business could choose to postpone a formal Variation Agreement, until a more substantive variation is required.

 

Dual Role of Personal Cover

Click here to read about how the dual role of Personal Cover and how the inclusion of Personal Cover in a Complete Succession Plan can help avoid disputes with respect to valuations.

 

Default Recipients Where Needs Change Over Time

Normally, where there are material changes, the Parties should enter into a Variation Agreement.

However, sometimes, a claim might occur before the Parties have elected to document the changes.

The standard Agreement contains default provision for some anticipated changes.

Increase in Sum Insured Over Time

If the total Sum Insured has increased as a result of a CPI adjustment, the default Recipient of the Surplus is the Life Insured.

The increase will be deemed to be Personal Cover (which will be tax-free).

Reduction of Debt Over Time

Similarly, if the amount of any Debt reduces before a Variation, the default Recipient of any Excess is the Business.

If this is the intention of the parties, there is no need for a Variation Agreement at the time.

 

Valuation Process

A Business can "switch off" the Pre-agreement Provision in the standard Agreement, if it would prefer a valuation process at the time of a claim.

A valuation process creates scope for the ultimate Purchase Price to exceed the Insurance Proceeds.

In these cases, it would be necessary to substitute provisions with respect to the payment of any shortfall, either at the same time or by way of instalments.

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

The best time to agree the Purchase Price is when all parties are alive, not when one of them has died.

When everybody is alive, "nobody knows whether they will be the first to die or the first to buy".

This way, nobody will try to increase the Price (thinking they will receive it first) or decrease the Price (thinking they will have to pay it first)

See more Adviser Tips

 

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