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Individual Updates (Most Recent First): Adverse ATO Advice on Super Buy/Sell Cover Partnership and Trust Loan Accounts Effect of Debt Reduction Cover on Buy/Sell Cover Tax Treatment of Self-Ownership Agreements Vested and Indefeasible Interest Simplifying the Valuation Issue Simple or Complete Succession?
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Gross or Net Value of the Business?
One of the most common errors made by Advisers with respect to Business Succession and Buy/Sell Insurance relates to the value of the Business and the amount of the Sale Price that each Life Insured or Vendor will receive upon the occurrence of a claim. Clover Law frequently comes across situations where the Adviser has insured each Life Insured for the Gross Value of their Equity, instead of the Net Value.
Gross vs. Net Value of the Business The Gross Value of a Business normally represents the market value of all of the Assets of the Business. This value can often be found in the balance sheet of the Business. The only qualification is that many balance sheets omit any substantive Goodwill value of the Business. Therefore, if you use the balance sheet to determine the gross value of the Business, then it might be necessary to add the total market value of the Assets and the Goodwill, in order to arrive at the total Gross Value of the Business. A balance sheet is not only a source of information about the Assets of the Business. It contains information about the Liabilities of the Business as well. The Net Asset Value of a Business is the Gross Value less the Liabilities. Therefore, in order to arrive at the Net Value of the Business, you must deduct the Liabilities from the Gross Value of the Assets.
Determining the Sale Price Many Advisers miscalculate the amount of the Buy/Sell Insurance, because they misunderstand the method of determining the Sale Price of the Equity in the Business. In effect, they misunderstand what they are insuring. The best way to understand the issues is to consider an example. Let's look at a Company with two equal 50% Shareholders. The only asset of the Company is a Building worth $1M. However, the Company still owes the Bank $500K with respect to the original Loan required to purchase the Building. Many Advisers and Clients think the Shares in this Company are worth $1M, because it holds an asset worth $1M. One reason they fall into this trap is that they correctly assume that, if the Company sold the Building, it would sell it for a Price of $1M. However, when the Company received the Sale Price, it would have to turn around and repay the $500K Loan to the Bank. Thus, net of Debt, the Company would end up with $500K. The Net Value or Net Sale Proceeds determines the value of the Company and therefore the value of the Shares in the Company. Thus, if one Shareholder wanted to sell their Shares to the other Shareholder, they would expect a Sale Price of $250K (i.e., half of $500K). When determining the amount of the Buy/Sell Cover for each Life Insured, it is the half-share of the Net Value of the Business that needs to be insured.
Start-Up Businesses The contrast is even greater when you consider the value of the Company at start-up stage. Assume the Company recently bought the Building for $1M and borrowed the whole of the Purchase Price from the Bank. Many Advisers and Clients would think the Shareholders had a $1M Asset (i.e., $500K each). The Company might legally own a $1M Asset. However, the Shareholders do not. At the point of start-up, the Net Asset Value of the Company is Nil ($1M Asset Value less $1M Liabilities = Nil). The Shares in the Company are therefore worth nothing or a nominal amount of $1 per Share. This is the appropriate amount of the Buy/Sell Cover (Blue Cover). If the Lives Insured required Insurance Cover to fund Living Expenses, they would need additional Personal Cover (Green Cover).
Relationship with Debt Reduction Cover Another reason that Advisers misunderstand the valuation process is that they might wish to repay some of the Debt with Debt Reduction Cover. In the case of the Start-Up Company, they might want to repay half of the Debt (i.e., half of $1M = $500K) with Insurance Proceeds. It is easy to think that, if you insure the Lives Insured for Buy/Sell Cover of $500K each, then upon their Death, they can sell their Shares and repay $500K of Debt out of the Sale Proceeds. Because they have used their Sale Price to repay the Loan, they will end up with no Net Sale Proceeds. This strategy achieves exactly the same Net Sale Price as if each Life Insured sold their Equity for Nil or a nominal value of $1 per share. However, there is a better way to achieve this outcome. Preferred Strategy The preferred strategy is to structure the Cover, so that there is:
Using the One Policy Strategy, there would still be one Policy with a total Sum Insured of $500K. Capital Gains Tax Implications The difference in the strategies relates to the CGT that might be payable with respect to the Sale of the Shares. If the Shares are worth $1each and they are sold for $1each, then there is no Capital Gain and therefore no CGT payable. However, if they are sold for $500K, then there would be a Capital Gain of $500K. At a worst case tax rate of approximately 25%, this would result in a CGT liability of $125K. This liability would arise solely because the Insurance Cover had been structured inappropriately by the Adviser.
Equity Loans vs. Business Debt There are situations where it is appropriate to repay a Debt out of the Sale Price of the Equity. They largely concern situations where the Life Insured borrowed funds to purchase the Equity. Clover Law describes this type of Loan as an Equity Loan (i.e., a Loan obtained by the Proprietor in order to fund the Purchase Price of the Proprietor's Equity in the Business). This type of Debt is different to a Loan obtained by the Business itself to purchase an Asset or fund its working capital. Returning to the first example of a Company whose Net Value is $500K, assume that one Life Insured has bought the Shares of a previous Shareholder for their market value of $250K. In order to do so, they borrowed $250K from the Bank. Option 1 One option would be to obtain $500K of Cover structured as follows:
Upon repayment of the Equity Loan, this strategy would leave the Life Insured with $250K net of Debt. Thus, the Net Sale Proceeds would contribute to the amount required to fund the Living Expenses of their Family. Option 2 An alternative option would be to obtain a total of $250K of Buy/Sell Cover. The Business Succession Agreement could require the Sale Proceeds to be paid to the Bank. This legal obligation would be particularly important, if the Continuing Proprietor had cross-collateralised the security for the Equity Loan (i.e., they had each guaranteed the other's Equity Loan). The contractual obligation to repay the Equity Loan would give the Continuing Proprietor comfort that their Guarantee would be released at the time of claim. It should also be remembered that the Bank might require payment of the Equity Loan, before it surrenders any Security over the Equity provided by the Vendor. Thus, repayment of the Equity Loan will often be a condition of passing good title to the Equity to the Purchasers. Upon repayment of the Equity Loan, this strategy would leave the Life Insured with no Net Insurance Proceeds. If they required Insurance Cover to fund Living Expenses, they would need additional Personal Cover.
Impact of Debt Reduction Cover on Sale Price Another common approach is to take the amount of the Debt Reduction Cover into account in determining the Sale Price and therefore the amount of the Buy/Sell Cover.The goal is to give the Vendor a financial benefit equivalent to their share of the reduced Debt. This is an understandable approach. It is not strictly speaking an error, although it does have adverse consequences and the same goal can be achieved more tax-effectively by an alternative approach. Again, consider the example of the Start-Up Company. A typical strategy would be to obtain the following Cover:
Using the One Policy Strategy, there would be one Policy with a total Sum Insured of $500K. If the Lives Insured required Insurance Cover to fund Living Expenses, they would need additional Personal Cover. However, the question is whether the repayment of the Debt should increase the amount of the Buy/Sell Cover.
Reduction of Debt Normally Increases Net Asset Value Some Advisers and Clients consider that, because the Business Debt would be reduced by $500K, the Sale Price and Buy/Sell Cover should be determined on the basis that the Net Asset Value of the Business has increased by $500K. As a result, the Sale Price payable to the Vendor should be increased by their share of the Debt that has been repaid (i.e., half of $500K = $250K). This would mean that the above strategy would be altered in order to obtain the following Cover:
This approach would increase the total Cover from $500K to $750K.
Complete Succession Approach Clover Law does not normally adopt this approach for a number of reasons. "Insuring Insurance" A preliminary concern is that the fact that the Clients have one type of Cover (i.e., Debt Reduction Cover) means that they have to increase the amount of another type of Cover (i.e., Buy/Sell Cover). This means that the amount of the Sale Price and Buy/Sell Cover would differ according to whether they had Debt Reduction Cover. It also means that, to the extent that they have to increase the Buy/Sell Cover, they are effectively "insuring insurance". Time for Determination of Value and Sale Price Clover Law's general approach is that the value of the Business and the amount of the Sale Price should be determined as at the day before the Death or Insured Event. This means that:
In a sense, if the Business has never been worth the higher amount before the Insured Event, why increase the Sale Price as a result of the Insured Event? Adverse CGT Implications If there is a Capital Gains Tax liability with respect to the Sale, any increase in the Sale Price as a result of the Debt Reduction Cover would increase the Capital Gain and therefore the amount of the CGT liability. Thus, up to 25% of the increase would be payable in tax. Substitute Loan Accounts The Clover Law Business Insurance Trust Agreement effectively repays the external Debt by establishing Substitute Loan Accounts between the Continuing Proprietors and the Business. Instead of the Business owing the Debt to the external Creditor, it now owes an equivalent amount to the Continuing Proprietors. Thus, while the external Creditor has been repaid (in order to obtain a Release of any Personal Guarantee or other Security provided by the Life Insured), there has been no reduction of the overall Liabilities of the Business. As a result, the Net Asset Value of the Business remains the same as it was before the Insured Event. Thus, there is no need to increase the Sale Price and Buy/Sell Cover. Alternative Method of Obtaining Comparable Benefit for Outgoing Proprietor As mentioned above, the justification for Debt Reduction Cover from the point of view of the Life Insured (or Outgoing Proprietor) is to obtain a Release of any Personal Security for the Business Debt. However, this commercial goal is achieved by enriching the Continuing Proprietors by the amount of the Debt Reduction Cover. Thus:
Some Advisers and Clients feel that the Outgoing Proprietor should obtain a financial benefit equivalent to their share of the Debt Reduction Cover. For example, if the Debt was reduced by $500K, one view is that the Outgoing Proprietor should obtain an additional $250K in Cover. Alternatively, some go as far as to say that, because the Continuing Proprietor might have received a financial benefit of $500K from the Debt Reduction Cover, the Outgoing Proprietor should obtain an additional $500K in Cover. Clover Law has reservations about the appropriateness of this approach, although it will document the strategy if the Clients require it. Where additional Cover is required, Clover Law recommends that it be categorised as Personal Cover (because it will be tax-free).
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