Business Succession Planning

Business succession planning considers the following questions:

• If X were to (die, disable, trauma), would the spouse become a business owner?

• If X were to (die, disable, trauma), would the spouse need capital or would he or she sell the pre-deceased business interest?

• Key objective of business succession planning

• Disposal agreement

• Funding agreement

• Structuring insurance as a funding mechanism

• Self ownership

• Cross ownership

• Trust ownership

Key objective of business succession planning

The Key objective of BSP is to ensure that the business survives significant changes such as death, total and permanent disability (TPD) or even bankruptcy.

A fundamental part of business succession planning is to establish a business agreement between the shareholders, partners or principles. It is important that the agreement outlined both disposal mechanisms and funding mechanisms.

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Disposal agreement

The disposal agreement can consider any range of issues and outcomes which the parties agree should trigger the sale of the business. The parties may agree to sell the business if any of the following occur:

• Death

• Disablement

• Conviction of a criminal offence

• Bankruptcy

The disposal agreement could be mandatory, with a contract setting out that if event X occurs, then Y must happen. By making the agreement mandatory it would force the disposal and subsequent purchase, such an outcome may not be wanted depending on the circumstances.

The main reason to avoid the use of mandatory contracts would be to avoid the Capital Gains Tax event of disposal. Mandatory contracts, create a CGT liability at the date of contract which may be years in the future.

The alternative to a mandatory contract is to use a "put and call options", which addresses both concerns of the mandatory contract. Such an option can provide flexibility, together with the same security of the mandatory agreement.

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Funding agreement

There are a variety of options accessible to fund the purchase of the departing owner's business interest. If resources and circumstances allow, the purchaser may have funds available personally or a re-structuring of the business may allow a debt funded solution.

A number of funding mechanisms are available where the event is death, total permanent disability, or one of specialized trauma events. Insurance for these covers provides certainty, with most policies providing a guarantee of future insurability subject to age limits.

The range of insurance policies which commonly apply as a source of funding include:

• Term insurance

• Trauma insurance

• Total and permanent disability insurance.

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Structuring insurance as a funding mechanism

Insurance can be an appropriate funding mechanism for a range of common events which may trigger business succession. There are two relevant parts to an insurance contract:

• The policy owner; and

• The policy beneficiary.

The owner of the policy can make changes with regards to policy amount, terms and beneficiary party. The beneficiary is the party to whom the proceeds of the policy will be paid. The owner and beneficiary may be the same individual.

It is possible and valuable to use the business succession agreement to establish the rights between the business partners. This may include limiting rights for assignment or transfer of ownership, or to change beneficiary.

There are three principal structures of insurance ownership:

1) self ownership;

2) cross ownership; and

3) trust ownership.

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Self ownership

With self ownership, the business owner will own the policy on their own life and will also be the beneficial owner.

Once there is receipt of the insurance proceeds to the new owner it is essential that the business succession agreement forces the disposal of the business interest to the other business owner. If this does not happen the estate may receive the insurance proceeds and retain ownership of the business. This may happen when an agreement is poorly drafted.

The key advantage of this structure is that the insurance proceeds are exempt from Capital Gains Tax. The exemptions apply mainly because the beneficial owner is the original owner.

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Cross ownership

In this popular structure, a policy is taken up on the life of each remaining business owner. Business succession merely provides for the disposal of the business interest.

The triggering event causes the remaining owner to receive the insurance proceeds directly, and then to purchase the departing owner's share of the business. The departing owner's share will be calculated at market value, so there may be a risk of being under or over insured.

For term policies, there is no Capital Gains Tax on disposal, unless the policy is transferred for money or other consideration. For trauma and Total Permanent Disability policies, the proceeds are exempt from Capital Gains Tax only if the policy owner is the insured, or a relative of the insured. For non-related business partners, cross ownership of a trauma policy will give rise to a Capital Gains Tax implication.

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Trust ownership

A trust is a type of policy ownership where the policies are held on trust for the beneficiaries. They are to be distributed for the benefit of the beneficiaries only where these is a corresponding obligation under the business succession agreement.

In a trust agreement there are the trustees and beneficiaries. The business owners should normally be the trustees and a class of beneficiaries. The beneficiaries can include business principles but may also be spouses, children and other parties.

There are two main advantages to having an insurance trust. Firstly, it allows flexibility as the policies are only held by one party - the trustee. The range and list of beneficiaries can change without causing a disposal, thus CGT for trauma and TPD policies upon the admission of a new partner is avoided. The second advantage is that by having a trustee there is additional protection that the proceeds will the distributed as per the plan.

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If you'd like more information or help with a business succession planning matter. Complete and submit the Express Enquiry form on the top right hand side of this page and we will contact you to discuss your enquiry or call us on 1300 QUINNS (1300 784 667) or on +61 2 9223 9166 to arrange an appointment.