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Buy & Sell Arrangements

Business Continuity: Buy & Sell Agreements
Many entrepreneurs spend a great deal of time and effort establishing and operating their biggest asset, their business. They may also consider their business to be a source of retirement capital or income for their families should they become unable to run the business due to illness or disability.

It is therefore very important for business owners to consider the following practical consequences of unexpected death or disability:-

  1. How long would it take to find a willing buyer?
  2. How would death or disability impact on staff, clients and creditors?
  3. How would it affect the continued existence of the business?
  4. How would it affect the owner’s dependents? Would they be in a position to run the business, considering their experience, skills and interest in the business?
  5. Would the dependents be financially secure?

The Solution

A ‘business continuity plan’ or a ‘buy-and-sell agreement’ is set up whereby the business owner finds suitable person/s, (potentially existing business partners), who understand and are interested in taking over ownership of the business. These parties then conclude a ‘Buy and Sell’ contract; the contract details the terms and conditions of the sale and under what circumstances.

Potential buyers could be current partners / co-owners, members of staff or even competitors. It’s therefore possible for a sole proprietor or sole-owner to enter into a buy and sell contract. – This agreement should be formally documented to avoid problems at the time of the sale.

Potential Issues

The contract provides a business with a detailed plan in order for it to continue operating if one of the owners/co-owners were to die or become permanently disabled. Without it the following issues could arise:

  • Potential buyers of the business may not be found at the required time.
  • Family members of the owner may inherit a share in the business but have no interest, or experience in the business; potentially prejudicing the success of the business or creating a dispute with existing co-owners.
  • The business interest may be sold below market value, negatively affecting the estate planning of the deceased seller.
  • Creditors and banks may be uncomfortable with the loss of a key person, which could negatively affect credit decisions and they could call in any loan facilities.
  • Large capital sums will be needed to purchase the deceased or disabled owner’s/sellers business interest at a time when the buyer(s) are unable to raise sufficient finance.

A ‘Buy and Sell’ agreement is a contract of sale and purchase and must contain certain essential terms and condition, as follows:-

  • Full details of the seller
  • Full details of the buyer
  • A description of the business interest to be sold and bought
  • The price of the business interest and how it will be financed
  • Under what circumstances the contract can be exercised.

Valuations

It is vital that the seller and buyer agree upfront and document the valuation basis of the business interest otherwise no contract will be finalised, it’s also important in order to avoid potential disputes in the future. This valuation method is then used to determine the purchase price at inception of the contract.

The Contract

The contract can specify how the purchase should be funded, the financing and purchase arrangements. – If the buyer has sufficient capital this can be used; or the buyer may wish to build up sufficient capital by way of savings or investments, – this option does hold some risk because one cannot know when a death or disability might occur.

The option with the least risk and expense is life insurance, whereby the buyer insures the seller for the full purchase price of the business. This can be done using an existing policy or a new policy; however e new policy is preferable due to beneficial estate duty and capital gains tax benefits. (An existing policy is usually only used if the seller is uninsurable due to illness or old age).

Implementation

If the maximum tax and estate duty benefits are to be obtained, the buyer/s should apply for a new insurance policy on the life of the seller. The buyer/s would then also be the premium payer/s, and the beneficiary of the proceeds. The existence of the contract for purchase and sale would provide sufficient proof of an ‘insurable interest’ and the valuation would quantify the amount of cover required.

Structure

In a typical ‘Buy & Sell’ contract the various business owners take out insurance policies on each other’s life. For example if three individuals are business partners and they wish to take out buy-and-sell insurance, the policies should be structured as follows:

          Mr A owns 50% of the business

  • Mr B & Mr C take out a policy equal to 50% of the value of the business, and pay premiums on the life of Mr A.

          Mr B owns 25% of the business

  • Mr A and Mr C take out a policy equal to 25% of the value of the business, and pay premiums on the life of Mr B.

          Mr C owns 25% of the business

  • Mr A & Mr B take out a policy equal to 25% of the value of the business, and pay premiums on the life of Mr C.

In terms of the above, B, C take out a policy on A’s life; A & C take out a policy on B’s life, etc. The policy owners are the premium payers, who are responsible to pay the portion of the premium that relates to their percentage ownership of the policy. If structured correctly, the policies will not attract estate duty in the estate of a deceased insured life.

Technical Aspects

Income Tax

The premium on a typical business continuity policy is not tax deductible. However the proceeds are then tax free and the exact purchase price is immediately available to the beneficiaries.

Estate Duty

Insurance policies are normally estate dutiable as ‘deemed property’ in the seller’s estate. However, they can qualify for an exemption if they comply with certain provisions of the Estate Duty Act. All three of the following requirements must be met in order to qualify:

  • The policy is taken out or acquired by a person who was a co-owner of a business with the deceased when he or she died, and
  • It is taken out or acquired for the purpose of acquiring the whole or part of the deceased’s share in the business, and
  • The premiums were not paid or borne by the insured life.