While the wealth protection needs of many clients tend to focus on paying off their mortgage and covering living expenses, for high-net-worth (HNW) clients, other priorities need to be considered. This article will highlight where additional advice needs may arise, with a focus on the business owner cohort. It’s an appropriate time to revisit these concepts, with recent data[1] revealing an increased demand for life insurance products, especially among HNW Australians.

Business owners

Assume you are about to meet with a prospective client, Victoria, who is aged 44. Victoria is married to Paul and they have three children, all of whom are in primary school. Victoria and her business partner, Sarah, are co-founders and 50-50 shareholders of a very successful consultancy practice.

As you understand it, Victoria is seeking your advice on the state of her financial affairs, and is particularly interested to understand:

1. The annual income her projected pool of retirement savings is expected to yield in retirement, based on the current trajectory; and
2. Whether her current levels of life insurance and income protection are adequate and necessary, given the $2 million mortgage debt currently sitting on the family balance sheet.

Further inquiries required

As the fact-finding process evolves, Victoria’s financial needs, circumstances and objectives will become clear and will drive the focus of your advice.

From a wealth protection perspective, it’s clear at this preliminary stage that the non-deductible debt is causing some anguish. Perhaps the current pandemic has led to heightened anxiety. Like many, Victoria may be concerned about the burden that such a large debt will have on her family, should she be unable to work.

Either way, there are other circumstances at play that need to be brought to the fore to completely understand Victoria’s financial situation, the scope of advice and consequential advice needs. Victoria does, however, appear capable of self-insuring the risk of a premature death or permanent disability. Some further lines of inquiry are therefore required.

The appropriateness of existing insurance cover

The sums insured and cost of retaining existing policies will need to be considered within the context of Victoria’s broader balance sheet.

Should these policies even be retained going forward? Apart from Victoria’s 50 per cent equity interest in the practice, are there other assets inclusive of her retirement savings that can be relied upon to expunge the mortgage debt upon a sudden death/disablement? Are there any other underlying objectives that need funding, in addition to covering the mortgage? Do Victoria and Paul require a pool of capital to fund private school tuition fees for the three children?

If, at first glance, existing policies are deemed surplus to requirements, and a self-insurance strategy is being contemplated, we need to consider the flow-on effects. As this is not a conventional ‘life insurance to repay mortgage debt’ scenario, some issues you might want to consider and questions you may wish to ask are:

• If the plan is to rely on a sale of Victoria’s shares in the business to extinguish the debt on her sudden death/disability, then that equity is absorbed into the family home.
• Will Paul’s income, together with projected returns from other investable capital (if any), be sufficient to fund projected living expenses?
• Will the value of the shares be sufficient to fully pay down the mortgage at that point in time? Is it reasonable to assume that the full value of Victoria’s shares can be liquidated within a timely and tax-effective manner?
• Will there be capital gains tax (CGT) levied on the sale, and if relevant, to what extent will the small business CGT concessions provide relief?
• What impact will Victoria’s unexpected departure from the practice have on the value of the shareholding prior to transfer? Is it reasonable to expect the value of any business goodwill will be retained following Victoria’s premature death?

On the other hand, the retention of these policies, either at existing or increased levels, while the mortgage prevails may be justified, not only on a cost-benefit basis but on the grounds that it provides Victoria and her family with peace of mind in the current environment. It could be used as a hedge against a future write-down in the value of her shares.

Indeed, the life insurance policy could liberate share sale proceeds from having to repay debt and allow claim proceeds to be used as seed capital for a future family fund. This may or may not be a priority for Victoria, but it is certainly worth exploring, especially if Victoria and Paul desire to educate their children within the private school system.

If existing insurance policies are to be retained, either in part or full, are they appropriate given Victoria’s circumstances and needs? If yes, then there may be no grounds to recommend a replacement. If, however, the disablement policy is housed within a group insurance scheme, or a retail super fund, then enquiries ought to be made about the comprehensiveness of the underlying policy and whether the features and benefits meet Victoria’s specific needs and objectives.

For example, the underlying definitions for a group insurance total and permanent disablement (TPD) policy may not be as generous as a retail-advised product, which tend to provide for a more favourable TPD ‘own occupation’ flexi-linked policy.

A group TPD definition may include a clause allowing the trustee to assess what work the insured person can reasonably perform, if they were to undertake further training. Some group TPD definitions may also look at what voluntary work the insured person has done, when assessing what paid work they could perform in the future. Likewise, insurance definitions and other parts of the contract may be changed at any time, upon agreement between the trustee of the super fund and the group insurer.

Weaving succession advice into the picture

So far, it’s apparent that various commercial, financial and personal factors will dictate whether the ensuing recommendation is to partially or fully retain Life and TPD insurance in order to cover the mortgage debt. It’s important to note that, irrespective of whether the existing Life and TPD cover is retained, inevitably, Victoria’s shares will be liquidated at some point in time.

If Life and TPD cover is deemed surplus to requirements and the shares in the business are being relied upon to pay down debt, the sale will probably be pursued shortly after Victoria’s death or disability. If insurance is instead retained, there may not be as much of a rush to sell down Victoria’s shares, although it’s reasonable to assume that Paul may want to ‘cash in’ the shares he inherits, or Sarah may look to assume full control of the practice, in the near future.

Just like an ordinary share transaction, if Paul moves to liquidate Victoria’s shares, there needs to a buyer. With no stock exchange to place an order on, who will that buyer be and how will it be funded?

This is often overlooked when clients hold meaningful equity interests within a private business. The asset might look favourable on the family balance sheet, but what is the ‘exit plan’ if a sale of these unlisted shares is being pursued following a sudden death or disablement?

Identifying the advice ‘need’

Before we even consider how this transaction is to be funded, at this early stage of the advice process, the focus should be on articulating to Victoria and Paul the importance of putting in place a plan that will safeguard the equity that she has cultivated in the practice over time.

Once you’ve conveyed this advice need, it either will or won’t be brought into the subject matter of the advice. Either way, it must be canvassed. If scoped in, then the discussion needs to turn to how this exit strategy will be funded.

This is where most of the complexities tend to emerge when exploring the topic of business succession. Although, it really doesn’t have to be all that complicated. The problem we’re trying to solve is simple: If Victoria predeceases Sarah, how will Sarah pay Paul, if Paul wants to cash in the shares he inherits? And vice versa, if Sarah predeceases Victoria, how will Victoria pay Sarah’s estate or beneficiaries if they want to cash in her shares? Even if it’s the surviving business owner that is initiating a buy-back of the equity, the same principles apply. We need to consider the funding mechanism.

Funding the transaction

There are a variety of ways to fund this transaction. Victoria might tell you that Sarah’s balance sheet will always be strong enough to self-fund the purchase of Victoria’s shares, if required. When it comes to HNW clients, this will be more common than not, and indeed, feasible. But there are some downsides that may or may not be a deal-breaker – potential CGT, introduction of market risk and so on.

Similarly, Victoria, in consultation with Sarah, may tell you that they would back themselves to secure finance at the relevant time, if required. Again, that’s more likely to be feasible for a HNW client and is certainly an option. But to what extent is it reasonable to rely on a future ability to obtain finance to fund this type of transaction?

Then there is the option of Life and TPD insurance, subject of course to underwriting and cost considerations. The idea is that Victoria personally owns Life and/or TPD policies on her life, with the sum insured pegged to the value of her shares and vice versa for Sarah. If Victoria passes away, claim proceeds would be paid (generally tax-free) to Paul.

As Paul receives a lump sum amount that corresponds with the prevailing value of Victoria’s shares, he can relinquish legal ownership of the shares to Sarah. Sarah is relieved from having to pay consideration for acquiring Victoria’s shares, as Paul is deemed to have received this, by virtue of the claim proceeds received from Victoria’s life insurance policy. Sarah then ends up as sole shareholder of the practice. All of this is usually formalised in a legally enforceable document, commonly referred to as a buy/sell agreement.

If life insurance is being used to fund the buy/sell agreement, then as an alternative, the policies could be housed within the superannuation environment. It means that an additional layer of complexity is involved, namely the introduction of super and taxation law considerations that wouldn’t necessarily apply if the cover is self-owned by the business owners. Extra planning is also required if the intention is to house the insurance cover within a self-managed super fund. In these cases, expert technical advice should be obtained.

There are other ways of structuring the ownership of buy/sell insurance policies, but that discussion is beyond the scope of this article. Yet, self-ownership is usually a preferred starting point – primarily due to its simplicity, flexibility and tax effectiveness.

Summary

More and more clients are seeking out life insurance advice following the COVID-19 outbreak. For self-employed clients, be sure to factor an involuntary early exit from the business. Many in this cohort will have meaningful equity interests sitting on the balance sheet, therefore, there is a need to talk to them about safeguarding these assets to ensure they or their beneficiaries receive fair value if and when the interests need to be suddenly liquidated.

Benjamin Martin, Senior Manager – Product Technical, Life Insurance, BT.

Footnote

1. GlobalData’s 2020 Global Wealth Managers Survey shows that 88 per cent of wealth managers reported increased demand for life insurance products in Australia as a result of the COVID-19 pandemic – the highest proportion among the 19 countries surveyed.

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QUESTIONS

To answer the following questions, go to the Learn tab at moneyandlife.com.au/professionals

1. Relying on the sale of assets to pay down debt following a premature death may result in which of the following?

a. The transfer of equity from an investable (income-producing) asset to a lumpy illiquid (non-income producing) asset.

b. A capital gains tax liability being crystallised on sale of the asset.

c. The introduction of market risk into the equation.

d. All of the above.

2. Retaining life and disability insurance to specifically protect the mortgage debt on the family balance sheet:

a. is not advisable, as life insurance policies are subject to capital gains tax, if owned personally.

b. could trigger double stamp duty.

c. eases the pressure on the family to sell assets in order to extinguish the debt, which means these assets can be retained to fund ongoing living expenses.

d. depends on whether a binding death benefit nomination exists and is valid.

3. George, aged 55, is self-employed and he has a meaningful equity interest in his business, as evidenced by his 50 per cent shareholding. Which of the following could be a genuine concern in the event that George was to suddenly pass away or become disabled?

a. The impact, if any, on the business goodwill and consequential value of George’s shares.

b. Superannuation contribution caps and fringe benefits tax.

c. The company pays capital gains tax on a termination payment.

d. The company is forced to immediately buy back George’s 50 per cent shareholding

4. Vivien, aged 45, is keen to explore the use of a self-owned life insurance policy to fund a buy/sell agreement. She queries the flow of funds in the event of her premature death – in particular, she is confused about who ends up with the insurance proceeds in the first instance and what then happens to her shares. Which of the following statements correctly describes the flow of funds/shares under a conventional self-owned buy/sell insurance policy?

a. The surviving business partner is paid the benefit claim proceeds, then calls for the transfer of Vivian’s shares from her estate.

b. Vivian’s estate, or nominated beneficiary on the life insurance policy, receives the benefit claim proceeds, which then enables the shares to be relinquished to the surviving business partner, pursuant to the buy/sell agreement.

c. The company is paid the benefit claim proceeds, then initiates a buy-back of the shares from Vivian’s estate.

d. The company is paid the benefit claim proceeds, then transfers the shares to the super fund.

5. A buy/sell insurance policy can never be owned within a business owner’s superannuation fund, as that will result in a breach of the sole purpose test. True or false?

a. True

b. False