Business Succession PlanningDolfinwise Super Strategies

Most people are familiar with the concept of personal Wills, but how many would consider the same issues for their business? For many business clients, their own business will be the source of much of their personal wealth, and therefore their rights in that business should be protected.

If correct documentation has not been put in place when a key partner exits a business, a number of unfavourable outcomes can occur. The exiting partner (or their estate) may not receive any value from the business. Alternatively inappropriate people may enter the business in their place. This can lead to management issues, and affect the future of the business.

Exits can be planned for. A buy/sell agreement is a legal document held between two or more parties, which allows one party to buy or sell to the other their rights in the business, should a defined event occur. Buy/sell agreements are commonly held between two or more owners of an existing business. These agreements control the exit of an owner, ensuring that the right person (such as the continuing business owner) receive the exiting partner's share of control in the business.

Buy/Sell and Critical Events agreements

Buy/sell agreements are entered into between business partners where the surviving partners are bound to buy out the other business partner's interest in the business should a specific or defined event occur.

Buy/sell agreements come into play as a result of a defined event. These events can be voluntary or involuntary. Voluntary events are those such as resignation, termination of employment, or expulsion from the business. Involuntary events are those such as death, total and permanent disability, or serious illness. The involuntary, or unplanned, events are actually easier to plan for than the voluntary, or planned, events. This is because the involuntary events can be covered by insurance such as life, total and permanent disablement or critical illness insurance. In these scenarios, the buy/sell agreement is essentially a funded succession agreement.

Events such as unexpected resignations or terminations are more difficult to plan for, as they cannot be covered by insurance, and must be funded in some other way.

To cover all these eventualities we recommend business clients have a document that supplements the shareholders/partnership agreement. We like to call this document a “critical events agreement”
A good critical events agreement cover both fundable events such as death, total and permanent disability, suffer a major illness and non-fundable events such as retirement, dismissal, resignation, loss of licence, going to jail, bankruptcy etc.

Structuring

Before entering into a critical events agreement, business holders should have a partnership/shareholder or management agreement in place, which covers the structure of their business and their responsibilities. This document acts as an anchor for the agreement. As part of the critical events agreement a funding agreement is required.
The funding agreement sets out the circumstances or events which would constitute the right to call upon an insurance policy or other form of funding. It sets out which company the policy is with, the level of funding, who owns the policy, and therefore who pays the premiums (and receives associated tax benefits).
Put and call options can be granted between two parties, allowing either party the right, but not the obligation, to either sell their own, or acquire the other's interest in the business when a defined event happens. Therefore an departing partner has the ability to put upon the remaining partner to buy their share in the business, or the continuing partner can call upon the exiting owner (or their beneficiaries) to sell their share in the business. A capital gains tax (CGT) event will not occur in a contingent agreement until the option is exercised, after a defined critical event has taken place.

Establishment

A lawyer generally drafts the critical events agreement, as it is a legal document, involving many aspects of succession law, corporations law, trust law, superannuation law and family law. As businesses operate in different ways the individual requirements in every case must be considered.
It's important that all the vital legal entities (and people) involved in the business are considered. A critical events agreement must identify:
Relevant owners,  relating interests, such as any asset holding vehicles,  any funding arrangements,  the relevant insurance policies and purposes of the policies, the valuation method for the business, any director guarantees, such as business owner guarantees or bank debts

Valuing a business

The valuation process, due to its complexity, is often the stumbling block in establishing critical events agreements.
The amount of insurance required will be anchored to the valuation of the business. How a business is valued will be different in every case, although businesses are generally valued according to their industry.
Consideration needs to be given to the future growth of the business as well. Having a formula or an agreed value in place is ideal, as this allows the business owners to assess the business' value at any given time, to ensure they have the right funding levels in place to buy out a departing owner's interest if need be.

Funding the agreements

Critical events can be fully funded, partially unfunded, or unfunded.

Unfunded events

If an event unfunded, and if the surviving partner is unable to fund the payout of the terminating partner, the parties involved will need to renegotiate the arrangements.

Partially funded events

An event can be 'partially unfunded'. For example, the value of the departing partner’s share of thebusiness calculated according to the agreement may exceed the insurance cover in place at the time.
Where an agreement is partially unfunded, there are a number of options for payment. For example:

	the unfunded amount could be paid by the continuing partner over a period of time allowing the continuing partner to make the payments, without adversely being too detrimental on the cash flow of the business.

Funded agreements

Life insurance is the traditional and most popular way to fund critical events  agreements. This is an area where it is particularly important for the legal representative to work with the financial adviser, who has the insurance expertise.There are many different options regarding the ownership of the insurance policies. Critical illness insurance is also increasingly being used, as people recognise that they may suffer an illness and not die, but may no longer want to be part of the business.

If one of the parties cannot obtain life insurance, this doesn't mean thel agreement can't go ahead, it just means there will be different terms and conditions. It's important to find the most effective person/entity  to own the insurance policy in regards to the payment of premiums.

Self-ownership

The current trend is for insurance policies to be self-owned. This allows for greater flexibility in the personal estate planning and asset protection processes of the partners or shareholders, and is considered to be tax-effective and practical. Each relevant principal in the business holds a policy over their own life.
If the owner dies and the insurance policy is called upon, the insurance proceeds will commonly flow through the policy-holder's personal estate into a testamentary trust contained in the Will of the relevant partner. This potentially has significant tax benefits for the beneficiaries, and is an effective asset protection tool. There are also benefits from a CGT point of view. However, when it comes to CGT, the individual's circumstances must be taken into account - for example, whether the client can roll the proceeds into a super fund, or even into a new business to take advantage of the small business concessions.

Self-ownership of policies also allows for more flexibility in relation to the addition of key staff or partners joining the business; all that's required is for the incoming partner to buy a policy on his own life.

Cross-ownership and through a Discretionary Trust

Cross-ownership of insurance policies is worth considering where there are just a few partners in a business. If a partner dies, the agreement will kick in and the remaining partners will use the insurance proceeds to pay out the departing partner's interest. When a policy is cross-owned, there may be CGT on the policy proceeds.
If there are more than a few partners in a business, it may be necessary to insert a discretionary trust which can hold the insurance policy, pay the premiums on behalf of the beneficiaries, and receive the benefits of any insurance policy, should one of the defined events occur. If the policies are owned by a trust, then the vendor is the trust, and the normal tax implications relating to insurance payouts will apply.

Superannuation funding

Using super to hold insurance policies for a critical events agreements is becoming increasingly prevalent, especially because of the removal of Reasonable Benefit Limits.

From a tax perspective, policy-holders can buy the policy through super by topping up Superannuation Guarantee (SG) contributions, and the business and the fund receive a tax deduction for the insurance. Only premiums for life and TPD insurance policies will be deductible for the fund - trauma insurance policy premiums are not deductible.
If the life insurance proceeds are paid to a tax dependant or to a terminally ill member the proceeds are tax free.
However, those holding buy/sell agreements within SMSFs must be careful that they don't jeopardise the complying status of the fund.

Issues of using Super include:

	Payments of taxable components to non-dependants will be subject to tax at either 16.5% or 31.5%;
	The member may not satisfy the definition of permanent disability in Superannuation Industry Supervision legislation and thus may not receive the TPD insurance proceeds  paid to the Trustee of the fund;
	TPD insurance proceeds are taxed as a lump sum superannuation benefit although the benefit may include an increased tax-free component;
	A trauma insurance claim may not be paid out as the permanent incapacity definition or any other condition of release may not be satisfied;
	Contributions used to pay insurance premiums count towards superannuation caps.

• Tax considerations

• 
  Where there is a transfer of equity as a result of the actioning of a critical events agreement, CGTmay be triggered. It is important when structuring these documents to do so in such a way that will be beneficial for all the parties concerned.
  
  TPD and Trauma policies

Each of the partners must also maintain their own personal succession plan through their Wills and other testamentary trust instruments. The business buy/sell agreements must also be integrated with the client's own personal estate planning requirements. It's vital that the individual partner or shareholder's executor should know of the arrangements surrounding a buy/sell agreement. The occurrence of the defined event may trigger a time-frame for the exercise of options, within which the executor may need to call upon, or give, the option. This is a significant role, as there are often strict time frames defined in buy/sell agreements. The most common mistake made regarding buy/sell agreements is a failure to review them regularly. As businesses are constantly changing, these documents need to be kept up-to-date and relevant.