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Mutual Will Strategies
Many Advisers and fewer Clients ask about the possibility of using Mutual Wills to document the Buy/Sell Arrangements between the Proprietors of a Business. This is a limited but dangerous Strategy for any Business.
How Do Mutual Wills Work? The best way to understand how a Mutual Wills Strategy is supposed to operate is to use an Example. Let’s assume that Michael and Wendy are equal owners of a Business and that their Equity is worth $400K. Each Proprietor obtains a Self-Owned Insurance Policy for $400K. Although the Sum Insured has regard to the value of the Proprietor’s Equity in the Business, it is actually structured as Personal Cover, not “Buy/Sell Cover”. Upon the Proprietor’s Death, the Insurance Proceeds will be paid to their Estate. The Proprietors don’t enter into a Buy/Sell or Business Succession Agreement that sets out the legal arrangements between them. Instead, there is an “understanding” that each Proprietor will gift their Equity in the Business to the Continuing Proprietor. This means that there is no Sale or Purchase of the Equity.
Implications for Premium Cost of “Buy/Sell” Cover The Mutual Will Strategy has a neutral impact on the Premium Cost. Exactly the same amount of Cover is obtained at exactly the same cost. Thus, premium cost savings cannot be a legitimate motivation or reason for a Mutual Will Strategy.
Death Only Strategy It is crucial to a Mutual Will Strategy that there be an effective Gift of the Equity under the Outgoing Proprietor’s Will. A Will can only make a Gift upon the Death of the Testator. Therefore, a Mutual Will Strategy can only give effect to a transfer of Equity in the case of Death. It cannot give effect to a transfer in the case of Terminal Illness, TPD or Trauma. Therefore, a Mutual Will Strategy can only deal with one of several possible Succession Events.
Dependence on Will It is crucial to a Mutual Will Strategy that there be an effective Will. This creates scope for a number of commercial vulnerabilities for the Proprietors.
Will Never Signed The Proprietor must sign a Will containing the required Gift. If the Proprietor never signs a Will, the Strategy can be defeated by one Proprietor. In practice, the Proprietor who fails to sign the required Will is inevitably the first Proprietor to die. As a result, the Continuing Proprietors learn after the Death of the Outgoing Proprietor that there wasn’t an appropriate Will in place. Unfortunately, it is too late to remedy the failure after their death. Dead people can’t sign Wills. Dead people can’t make Gifts.
Revocation or Variation of Will Similarly, if the Proprietor signs a Will but later revokes or varies it, the Strategy can be defeated by one Proprietor.
Invalid Will If the Will is invalid, it will not take effect. The invalidity might revive an earlier Will that does not contain the required Gift. Alternatively, the Outgoing Proprietor might die intestate. This would defeat the Gift.
Challenge to Valid Will Even if the Will is valid, it can be challenged by disgruntled family members under Family Provision Legislation. Strictly speaking, if the Proprietor’s Estate only consisted of the Equity (worth $400K) and the Insurance Proceeds (another $400K), the total Estate should be worth $800K. The role of the Will is to distribute these assets and funds in an appropriate manner, having regard to the needs of the potential Beneficiaries. In this example, a Mutual Will Strategy would require half of the Estate to be gifted to a person who was a business partner, not a family member or other appropriate Beneficiary. It is highly possible that this Gift would be challenged by a Beneficiary who felt that their needs had not been adequately addressed by the Will.
Enforceability of the Obligation to Make a Gift It is possible for a Testator to legally bind themselves to make a Gift in their Will. If they fail to comply with their legal obligation, the aggrieved party can sue the Executor of the Estate and enforce the obligation against the Estate. These legal proceedings might have to take into account the Testator’s obligations under the Family Provision Legislation. However, if it was established that the Insurance Cover was only obtained on the condition that the Equity would be gifted to the Continuing Proprietors, it might be possible to argue that, in the above example, the Estate would have only been worth $400K. Therefore, it might be appropriate to gift the equity to a Non-Family Member. In other words, but for the Insurance Cover, the Estate would only have been worth $400K and this would have been the only amount that would have been available for distribution to the Family Members. Legal proceedings of this type could cost hundreds of thousands of dollars. Therefore, it has to be asked: what is the principal motivation of adopting a Mutual Will Strategy.
Reduced Legal Fees? As already mentioned, a Mutual Will Strategy has a neutral impact on the premium cost of the Cover. The only potential cost saving is the cost of preparation of a Business Succession Agreement. Thus, it needs to be recognised that the real, underlying motive of a Mutual Will Strategy is to avoid or minimise the Legal Fees with respect to a Business Succession Agreement. This fails to take into account:
Mutual Will Agreement The Courts have been confronted by many arguments in many different personal and family contexts that a Will should be varied by the Court to give effect to an obligation to make a Gift. However, in order to do so, the Courts have insisted on evidence of a proper legal obligation to make the Gift. Usually, these cases have concerned Family Members. However, because a Mutual Will Strategy requires the Gift of part of the Estate to a Non-Family Member, it would be important to clearly document the obligation in a legally binding Mutual Will Agreement. In other words, to obtain commercial certainty with respect to the arrangements, it would be necessary to pay for a Legal Agreement other than a standard Business Succession Agreement. This type of Agreement is not a frequent requirement of most Commercial or Estate Planning Lawyers and is likely to cost more than a standard Business Succession Agreement. Thus, to obtain commercial certainty, a Mutual Will Strategy is likely to increase Legal Fees rather than reduce them.
Terms of Gift in Will It would be tempting to draft the Will so that it made an unconditional Gift of the Equity to the Continuing Proprietors. However, the substance of the commercial arrangement must effectively be that the Gift will only be made if the Insurance Proceeds are equivalent to the value of the Equity or Gift. If the Insurance Proceeds were less than the value of the equity, what would the arrangement be? No Gift? Or a Gift regardless of the value of the Equity? Similarly, what if the Policy lapsed before the death of the Proprietor? Would the Gift still take effect? Or would it be conditional upon the existence of the Cover? You can see why a properly documented Mutual Will Strategy might cost more than a standard Business Succession Agreement.
Capital Gains Tax Issues When the Continuing Proprietors acquire the Outgoing Proprietor’s Equity, their Cost Base for CGT purposes would normally be the Pre-Agreed Sale Price. If they acquired the Equity for $400K and immediately on-sold it for $400K, then there would be no Capital Gain and therefore no CGT liability. In contrast, when a Beneficiary acquires an asset by way of a Gift pursuant to a Will, they are not treated in the same manner as a Purchaser for value. They normally “inherit” the Cost Base of the Deceased Outgoing Proprietor. As a result, if the Cost Base was $1 per share, then an on-sale for $400K would result in a Capital Gain of $400K and a CGT liability with respect to $400K.
Vendor’s CGT Liability A Gift pursuant to a Will does not result in a CGT liability for the Deceased Outgoing Proprietor. If there had been a Sale, then there might have been a CGT liability (subject to any available exemptions). However, in the case of a CGT liability incurred at the time of Death, it would be possible to insure the CGT liability, so that it was funded by Insurance Proceeds. For example, if the CGT with respect to a $400K Sale Price was $100K, then it could be funded at the premium cost of $400K of Cover.
Purchasers' CGT Liability In contrast, a Gift to the Continuing Proprietors would have an adverse CGT impact on the Continuing Proprietors. The Outgoing Proprietor might have no CGT liability at the time of Gift. However, instead, the Continuing Proprietors would inherit the Outgoing Proprietor’s Cost Base and therefore their CGT liability. As with most CGT issues, the reduction of the Vendor’s CGT liability effectively increases the Purchasers’ CGT liability. In other words, CGT cannot be avoided; it can only be passed on to the Purchasers.
Summary A Mutual Will Strategy:
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