Are your business clients aware of the pros and cons relating to how their business cover is owned?

Most insurers allow the following ownership structures for their policies:

• self-ownership by the insured person;
• ownership by another individual or individuals (cross-ownership);
• joint ownership by the insured person and another individual or individuals (generally by spouses or de facto partners for personal risk protection);
• ownership by a corporation (i.e., company); or
• ownership by the trustee of a trust.

All of the above can facilitate business succession and key person protection, but with varying results. This article will look at these structures, with a particular focus on business insurance trusts.

The three main business insurance concepts using lump-sum life insurance products are:

• buy/sell purpose cover (also known as shareholder protection or share purchase insurance);
• key person capital purpose cover (including business debt protection, guarantor protection and loan account protection); and
• key person revenue purpose cover.

Term life, total and permanent disablement (TPD) and trauma policies may all be used to fund the above purposes.

While there is generally no upper limit on term life cover, most insurers cap their TPD and trauma cover at $5 million and $2 million respectively. Some insurers offer a ‘reserve’ TPD benefit, which can provide up to $15 million cover (a combination of own occupation, any occupation and general TPD cover). Similarly, a reserve living benefit may be available with some insurers, providing up to $10 million cover (with amounts over $2 million restricted to specified severe medical events and with additional exclusions). This added flexibility can give business owners peace of mind if these higher limits accommodate their business requirements.

Note: An insurer will determine underwriting requirements based on the insured’s total level of cover, including both personal and business insurances. Clients and financial planners should consider how best to structure personal and business insurance needs concurrently to ensure the appropriate outcomes are reached for both needs. This includes assessing if high levels of business insurance lead to loadings or restrictions to non-deductible personal insurance cover.

Buy/sell purpose cover

The purpose of this cover is to fund, via life insurance, the transfer of the business interests of a departing business owner (or their estate) to the remaining business owner or owners, should one of the owners die, become totally and permanently disabled, or suffer a traumatic or terminal illness.

The funding may be for the full value of the transferable business interest; or if for various reasons this is not possible (due, for example, to sum insured limits or affordability), for the maximum possible amount. Any shortfall in the funding may be covered via an instalment repayment plan, vendor finance, a bank loan or other funding mechanisms.

Regardless of the insurance policy ownership structure, buy/sell cover requires the business owners to enter into a written buy/sell agreement to provide certainty around the value of the respective business interests and to ensure that the insurance proceeds are applied to the funding of the buyout. The buy/sell agreement may also include provisions for the resignation or retirement of the business proprietor.

This agreement should be drafted by a legal professional with expertise in business succession. The thrust of the buy/sell agreement is to ensure a smooth transition of the ownership of the business and to align related documents, such as the departing owner’s will and insurance policy, with the terms of the buy/sell agreement and to avoid unnecessary tax implications, particularly regarding potential capital gains tax (CGT) on life insurance policy proceeds.

The insurance and the agreement should be regularly reviewed to ensure the cover remains appropriate. This also includes agreement to cancel the contract if the purpose of the insurance is no longer required, such as a sale or restructure of the business.

Policy ownership of buy/sell insurance cover

The most common buy/sell insurance policy ownership structure is self-ownership, where each business owner holds an insurance policy on their own life. Upon a successful claim, the insurance proceeds are paid to the departing owner or their estate, which is credited as a full or partial payment for their business interest. Subsequently, the interest is transferred to the continuing owner/s via the terms of the buy/sell agreement.

This is a simple and easily understood structure, and enables the business owner to retain the policy for personal risk protection on leaving the business, if required. If there is no valid buy/sell agreement in place, the danger is that the departing owner or their estate can still ask for payment for their share of business equity, despite having received the insurance proceeds.

Tax and other ownership implications

For buy/sell and key person capital purpose cover, the general rule is that premiums are not tax-deductible and insurance proceeds are not assessable as income. The CGT treatment of TPD and trauma cover is governed by two sections of the Income Tax Assessment Act 1997 (ITAA97).

The first section, 118-300, which provides a CGT exemption on the death or terminal illness of the insured person, if the insurance proceeds are paid to the original owner of the policy or paid to someone other than the original owner, but who did not pay any money or give any other consideration for the acquisition of the rights or interest of the policy.

The second section, 118-37, provides an exemption for TPD and trauma proceeds if the person who is beneficially entitled to the insurance proceeds is the insured person, their spouse or a defined relative of the insured. Self-ownership of policies satisfies these exemptions, as does the receipt of these proceeds indirectly via certain trust structures.

Due to the CGT implications for TPD and trauma proceeds, a cross-ownership structure does not hold appeal, in circumstances where an owner is unrelated to the other owner/s and has either a fractional or direct interest in the life policies of the other owner/s.

Company or ownership of buy/sell cover is generally undesirable because it does not satisfy CGT exemptions for TPD and trauma proceeds. It is also tax inefficient, as it results in the remaining owner/s owning all the equity in the business, but not getting any increased cost base for acquiring the interest of the departing party.

Using a business insurance trust

A business insurance trust is a special purpose trust specifically created for holding life insurance for business and, if required, personal purposes. Under this structure, legal (nominal) and beneficial ownership is split between the trustee of the insurance trust (generally the existing business entity in its capacity as trustee) and the insured person (the beneficial owner). Because the insured person is the beneficial owner of the policy under the ‘roof’ of the insurance trust, this ownership structure obtains a CGT exemption for both death and non-death (TPD and trauma) benefits.

As we shall see below, the insurance trust also has several commercial advantages and efficiencies.

Insurance inside super

Historically, superannuation fund ownership of buy/sell insurance has been popular among some financial planners because insurance premiums can be funded by pre-tax or tax-deductible super contributions, subject to prevailing concessional contribution caps.

However, it would be prudent for business clients using buy/sell arrangements in retail risk-only super funds to apply for a private ruling to clarify their situation, considering the current position of the Australian Taxation Office (ATO). Financial planners may wish to assist their clients with obtaining such a ruling.

The ATO clarified its position in an interpretive decision from 2015. While it’s not a binding public ruling, the ATO’s decision can be viewed as a practical guideline. In ATO ID 2015/10, the ATO addressed the issue of holding buy/sell insurance inside a self-managed superannuation fund (SMSF). The SMSF had purchased life insurance of the life of a member, with the sum insured based on an agreed market value of the member’s shareholding in the company, which he owned together with his brother.

The ATO ruled that the SMSF trustee’s purchase of the life policy contravened both the sole purpose test under section 62 and section 65 (1)(b) of the Superannuation Industry (Supervision) Act 1993 (SIS Act), which covers the provision of financial assistance by an SMSF to a member or their relative. Breaching these provisions can lead to an SMSF being non-compliant, with significant monetary penalties being imposed on the SMSF trustee.

Policy ownership of key person capital purpose cover

Generally, the loss of a key person who is also a business owner adversely affects the capital value of a business. To mitigate this risk, a business can hold a term life, TPD and/or trauma policy for a capital purpose.

Insurance for a key person can be used to maintain the capital value and therefore, stabilise the business. The loss of a key person may impact goodwill and a business’ credit standing. Insurance can ensure that the business can repay or reduce business debt, particularly where the departing person was also a guarantor for business loans or where there are outstanding loan accounts owing to them.

The logical ownership structure for key person capital cover is business entity ownership. It enables a business to discharge its debts, both external and internal, and to maintain stability. With most private sector businesses in Australia having a company structure (over 41 per cent of all businesses)^[1], the tax treatment of company-owned insurance policy is an important consideration.

While the proceeds of term life insurance would be received tax-free by a company if owned from inception, TPD and trauma proceeds would incur a tax liability at the company rate of 30 per cent. This means that, for example, a net TPD requirement of $1 million would need grossing up the policy sum insured to $1,428,571.

Policy ownership of key person revenue cover

The loss of revenue, and therefore profitability, following the loss of a key person to an insurable event, can have a devastating impact on a business. This person could be a business owner or an arms-length employee with specialist skills, technical knowledge, or influential contacts who is responsible for a substantial share of the revenue of the business. Often, the key people in the business are the owners themselves, who have complementary skills and knowledge of the business.

Key person cover for revenue purposes provides a lump sum to the business for the replacement of the revenue lost following the exit of this person. As discussed above, it’s normally established in the form of a term life, TPD and/​or trauma insurance policy.

Key person revenue insurance not only covers a loss of revenue but also replacement costs, including the recruitment, relocation and training of a replacement key person, until a suitable replacement is effective and contributing substantially to the bottom line. It may be that the key person cannot be replaced by one person or that existing employees would need to be upskilled, over time, to produce similar outcomes as the departing key person.

As opposed to buy/sell and key person capital purpose cover, key person revenue premiums are tax-deductible and assessable as income to the business, provided certain criteria are satisfied. The main ones are: the term life, TPD or trauma policy must be owned by the business entity on the life of the key person; the purpose of effecting and maintaining the policy must be of a revenue nature (and preferably documented as such); and the need for the business to continue, following the loss of the key person (which would preclude deductibility for most sole proprietor or single director businesses if they held this cover on themselves).

Case study: comparing ownership structures

Phyllis, Jane, Mark and Wyatt are directors of a successful multimedia company. Their respective family trusts each own 25 per cent of the company, which is valued at $2.8 million. The company has an $800,000 bank loan and each shareholder has injected $100,000 of their own capital into the business. The directors all wish to obtain full insurance cover for their business and personal needs.

Their net requirements are summarised below in Table 1. For business cover, they only require term life and TPD. (We assume they require the same personal cover, and are taking trauma cover for personal protection only.)

Table 1

The usual policy recommendation (not using a business insurance trust) for the above scenario would be as follows in Table 2:

Table 2

Grossed up for CGT on TPD (and term life if linked to TPD cover).

The above recommendation would require four policies, as the business interest is owned by the family trust trustees. As company owned TPD would be subject to CGT, the key person capital sum insured would need to be grossed from $1,050,000 to $1.5 million. Table 3 below shows the cover and premiums that would normally be set up for one director – let’s say, Jane.

Table 3

Let’s look at what could happen at claim time: assume Jane suffers a TPD event, makes a successful claim on her policy, and is required to depart the business in line with the buy/sell agreement.

Under the usual policy structure where the company owns key person cover and Jane holds TPD cover, the insurer would pay to the company $1.5 million key person capital and $400,000 key person revenue proceeds. After deducting 30 per cent ($450,000) to cover CGT, the company would discharge the bank loan, pay out the loan account owing to Jane and retain $150,000 for lost goodwill. It would use the $400,000 to replace lost revenue and to fund a replacement key person.

Jane’s family trust would receive $530,000 of TPD benefit for its equity in the business, to cover the CGT liability on the sale of the equity, and to cover legal and accounting costs and stamp duty. Jane would receive a TPD benefit of $700,000 as personal cover. Any remaining company owned policies on Jane could be transferred into Jane’s personal name; however, there is a chance that the transfer would be for consideration and would have CGT consequences.

Contrast this with what would happen under the insurance trust structure.

As discussed above, under an insurance trust, legal and beneficial ownership of insurance is split between the trustee (legal owner) and the insured (beneficial owner). Through a trust agreement, insurance proceeds can be distributed to a range of recipients. Further, various business and personal purpose insurance cover can be aggregated into one policy for each insured person. Under this ownership structure, a CGT exemption applies for both death and non-death (TPD and trauma) benefits.

Therefore, if we apply the insurance trust structure to this case study, there would only be one policy per insured person, housing all business and personal insurance requirements. The insured would have the flexibility to recalibrate sums insured to align with clients’ changing requirements (e.g., reduce key person capital levels of cover and increase buy/sell components as business debt is reduced) without altering the overall sum insured.

The entire $2.68 million TPD benefit would be paid to the trustee of the insurance trust. The trustee would then distribute the proceeds in a secure manner to the appropriate recipients. Note that the trustee will control distribution of the insurance proceeds in accordance with the trust agreement, so the physical control of those proceeds is in the hands of a custodian that has a contractual or fiduciary obligation to comply with the directions of the beneficial owner in the trust agreement.

The key person revenue proceeds ($400,000) would be paid to the company. Jane’s family trust would receive the buy/sell and associated proceeds ($530,000). Jane would receive her personal insurance benefit ($700,000), as well as payment for the loan amount owing to her ($100,000).

As for the key person capital cover, the repayment of the business debt (including loan accounts) can be achieved by a payment from the trustee to the continuing owners, who now own 100 per cent of the business between them. They can then lend the insurance proceeds to the company, which can then repay the bank and Jane’s loan account. (This would be a paper entry only, as the proceeds would physically be repaid to the financial institution and the departing owner.) In effect, this creates new loan accounts owing to the continuing owners in substitution for the external bank debt, as well as Jane’s loan account.

This means that the remaining owners will have created a loan account of $300,000, each in their favour. The existence of these loan accounts allows the future cash flow of the company to be paid to the continuing owners as tax-free repayments of principal.

Summary

The use of business insurance trusts has several commercial advantages over conventional structures. The advantages include potentially substantial cost savings via volume discounts by having one policy per insured and the opportunity to create substitute loan accounts; and further savings might be available with respect to both death and non-death insurance benefits, as no CGT is payable when the benefits are paid by a trustee to the recipients under an insurance trust structure.

Setting up a complete succession plan using an insurance trust, including a buy/sell agreement, typically costs around $3,000-$5,000 in legal fees, so not much more than for a standalone buy/sell agreement.

Financial planners should consider insurance trusts in discussions with their business succession clients and their accountants. If clients proceed with this structure, planners should involve lawyers specialising in insurance trusts to ensure their recommendation meets their clients’ best interests.

Alex Koodrin, Senior Product Manager, Advised Life Insurance, BT

Footnote
1. Australian Bureau of Statistics (ABS): Counts of Australian Businesses, including Entries and Exits (July 2017-June 2021).

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QUESTIONS

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

1. A technology company is using an insurance trust to hold all life insurance policies on its directors. In the event of a death claim for key person capital cover, how could the money flow from the insurer to the lender for the repayment of a business loan?

1. The trustee receives the proceeds from the insurer, pays the owners, who can then lend the insurance proceeds to the business, which can repay the lender.
2. After receiving the proceeds from the insurer, the trustee pays the lender directly.
3. The insurer pays the lender.
4. Either a or b.

2. A manufacturing company owns a TPD policy to pay out its $500,000 business loan in the event of the total and permanent disablement of one of the directors. What is the grossed-up sum insured required to pay out this loan after accounting for the CGT liability?

1. $600,000.
2. $650,000.
3. $714,286.
4. None of the above

3. The CGT treatment of TPD and trauma cover is governed by the Income Tax Assessment Act 1997. Which ownership structures satisfy the CGT exemptions under this legislation?

1. Self-ownership of policies.
2. Ownership of the policies by the spouse of the business owner .
3. Ownership via certain trust structures.
4. All of the above.

4. Which is the only business insurance concept where life insurance premiums are potentially tax deductible and assessable as income to the business?

1. Key person revenue purpose cover.
2. Buy/sell purpose cover.
3. Key person capital purpose cover.
4. None of the above.

5. What are the advantages of using a business insurance trust?

1. They satisfy CGT exemptions for term life, TPD and trauma insurance proceeds.
2. The ability to recalibrate sums insured to align with the clients’ changing requirements.
3. The option of creating tax-free loan accounts on the discharge of debt.
4. All of the above.