The A-Z of Buy and Sell Insurance

10/3/2008 2:16:35 PM

We started with the last editorial to look into the different elements of business insurance. We discussed the concept of key person insurance and the advantages for a business to have this kind of insurance. With this editorial I want to stand still at Buy-and-sell agreements and how insurance is incorporated to ensure contingency for a business.

What happens if one of the partners of a partnership or a member of a closed corporation or a shareholder of a company should die or become disabled. Very often the surviving owners do not want the deceased’s spouse or family involved in the day to day activities of the business or the owners may want to ensure that at death their families will receive a fair value for their stake in the business. This is where buy and sell agreements and insurance comes in.

Let us use an example. Let us say a closed corporation exists with 3 members, member A, B and C. To simplify lets say each has a third interest in the business. How the buy and sell would be structured is the members will decide that at death or in case of disability the interest of the member who is affected would be sold to the remaining two members in relation to their interest. In this case let us say member A dies. Since each member owns a third of the interest it would mean that each of the remaining members would buy 50% of the 33.3% share that is available.

Normally an insurance policy would be used to finance this transaction. When a buy and sell agreement is drawn up each member would take out a life insurance policy on the life of the other member or members. In our example it would mean that member A and B would take out an insurance policy on the life of member C. Member B and C would take out a life insurance policy on the life of member A and member A and C would take out insurance on member B’s life. In case of one of the members’ death the life insurance would payout an amount to each of the other two members which would be used to buy the business interest from the deceased members’ estate.

The principles on which buy and sell is based are the following:

• Each member has an obligation to sell his/her interest at death and/or disability

• A formula must be determined for determining the value and therefore the selling price of a members interest

• The members/owners must agree to taking out life insurance to finance the structure.

Premiums of buy and sell insurance are not normally tax deductible and there are strict rules that must be complied with for the proceeds of the policy to be free of any estate duty.

These rules are as follows:

• The policy must be taken out by a person who, at date of the deceased’s death, was a member/partner or shareholder in the business in which the deceased also held an interest

• The policy was taken out with the purpose of acquiring the deceased’s interest in the business

• The deceased paid no premiums on the policy. This is very important because often the owners’ allows the business to pay the premiums. If the premiums are paid through the bank account of the business the owners must ensure that the premiums are allocated to their own drawings/income and not paid by the business as a perk.

It is also very important that members or partners don’t merely cede existing life insurance policies to finance the buy and sell agreement since a ceded policy is seen as a second hand policy and will attract capital gains tax and will not qualify for the exemption of estate duties.

There are definitely many benefits to a buy and sell agreement some of which are:

• Your beneficiaries or dependants, receive a market related value for their inherited share of the business

• Sufficient capital is available to purchase the shares and

• The existence/contingency of the business is assured.

It must be emphasized that the buy and sell agreement is a contract that has many legalities and this must be drawn up by an expert. The second important aspect is to make sure that the policies conform to the rules.

It is advisable to obtain the services of a qualified advisor when this kind of structure is set in place.

Well that all for now. Till next time!