The death of a fellow shareholder in a business is a distressing period. Sure – the period of grief may not have been intense as say, the death of your child, but it is still an extremely distressing period.

So getting the documentation, funding and tax aspects of the business are critical for its success.

It is also important to note that you would not have gone into business together unless, at some stage, you enjoyed and respected each other enough to work together.

The stress and grief on the death of a business partner are only increased if the business crisis management plan, or succession plan, isn’t sorted.

Consider the following (extreme) example

Sue and Evie run an insurance sales business together. However, on Sue’s death, the business succession is not fully thought out. Sue’s estate goes to her husband Alex. Evie offer’s to buy the business from Alex. Alex refuses. He thinks the idea of owning a financial advice business is really exciting. He lets Sue know that she Sue can be paid a market salary and the dividends from now on will be split 50:50. Without Evie half of the client’s leave the practice. The business struggles with the reduced clients and the same rent. Evie remains obsessed about Alex owning half of “her” business. Eventually, Sue quits and the business is wound up.

The above example can be altered for a range of different scenario’s. What is Evie doesn’t want to buy out Alex? What if Evie cannot afford to do so?

Enter the world of an insurance as a financing mechanism

The use of insurance is a key part of many succession plans. The insurance can pay a sum of money to a fellow shareholder such that they have money to finance the buyout process.

It is important to note that the use of insurance is simply one of the ways to finance the arrangement. Some families can finance the buyout themselves. Sometimes the business has no, or very little, value.

So what are the tax impacts?

Section 118-300Tax Act provides a Capital Gains Tax exemption for life insurance proceeds. So if you have a life insurance policy the proceeds are paid to you and you incur no tax.

The CGT exemption only applies if the person is the original beneficial owner and paid for the policy.

A disposal by a person who is not the original beneficial owner still qualifies for exemption under section 118-300 if the person provided no consideration in acquiring those rights.

The term “original beneficial owner” is not defined and has no accepted legal meaning.

In Tax Determination TD94/31, the Commissioner states that the original beneficial owner is the first person who:

at the time the policy is effected, holds the rights or interest; and
 possesses all the normal incidents of beneficial ownership, e.g. is entitled to the
 benefits of the policy proceeds and has the power of management and control over the policy as well as the power to transfer, grant as security, surrender or otherwise dispose of the policy.

Are the premiums tax deductible?

There is clearly no doubt that insurance premiums are for a capital purpose (the payment of a lump sum on death) so the premiums for the underlying insurance policies are not tax deductible.

It then follows that if the premiums are not tax deducted, the policy proceeds received are not assessable income but this is not always the case (see trauma policies).

If premiums are paid by the business on behalf of the proprietors then there is an expense payment fringe benefit and FBT is payable. Alternatively, if premiums are paid by the private company consideration may need to be given to Div 7A ITAA (the deemed dividend rules) alternatively premiums could be paid from the loan account.

The tax deductibility of insurance premiums can be circumvented by structuring the individual policies through a superannuation fund. However, we typically find that, while this is a great theory concept, the restrictive $25,000 concessional superannuation contribution threshold effectively restricts the ability of two independent shareholders to attend to this type of structuring option.

What about trauma policies?

The purpose of trauma insurance is to provide a capital amount to the insured in the event of a specified medical condition occurring also termed critical illness.

Tax deductibility of premiums

If the policy does not replace earnings lost by the taxpayer (as is the case for the Business Succession Plan) then the Commissioner considers that the benefits payable under trauma policies do not constitute assessable income. So on the basis of FC of T v DP Smith, 81 ATC 4114, a deduction is not allowable (Taxation Determination TD 95/39 and TD 95/41). Note Trauma premiums payable under’trauma’ insurance policies are not allowable deductions but CGT can apply to trauma proceeds

The effect of Capital Gains Tax and Section 118-37 contains a number of exemptions from the CGT provisions. Section 118-37 exempts any sum received by way of compensation or damages for any wrong or “injury” suffered by the taxpayer “to his or her person”, or “in his or her profession or vocation”. “Injury” is not limited to physical injury.

The Commissioner accepts that a specified illness in a trauma insurance policy is an “injury” for the purposes of section 118-37 (Taxation Determination TD95/43). The exemption under subsection 118-15 applies if the taxpayer who obtained the proceeds under trauma insurance policy is either the person insured under the policy or the spouse of the person insured under the policy: Taxation Determination TD 95/43. The Commissioner considers that compensation received by a trustee in his or her capacity as trustee is not exempt from CGT liability: Taxation Ruling TR 95/35. but there is TD 14 that the same treatment will apply if the payment is made to a trustee for a taxpayer who has been injured.

Events that cannot be insured

The tax impact on the application of insurance policies as part of the process of financing the buyout of a shareholder on their death is a critical element in the structuring and planning of a business transition. However, these policies are great at financing a definable, insurable event.

If your business partner simply gets tired and no longer wants to be part of the business you have a greater problem. You simply cannot insure against an event that is based on attitude, or based on the non-performance of a shareholder.

In this instance, a crisis management plan can address key events like the termination of a director and payout ratio’s associated with valuing a person’s exit.

At Westcourt we deal with these issues almost daily. Because we are not selling insurance policies, we are more open to different ways to deal with the exist of a shareholder that is not simply focused on the purchase of an insurance policy.

The collaborative approach of a business advisor, tax advisor, legal advice and insurance consultant is key to getting a business succession plan together. A one-stop shop is too conflicted to manage all parts.

Once this document is in place the next step is a staff engagement program so that staff are aware of, and capable of, applying strategies to help in the event of the death of a shareholder. Again, the crisis management plan only works if it is an active living document. Because if a major crisis happens you might find that all the staff just quit. So drafting it, and then reinforcing the strategy is critical to continuity of the business.

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