Buy and Sell agreements

A buy and sell arrangement, supported by a buy and sell agreement and life insurance, will ensure that on the death of a business owner, the business can continue to operate with as little disruption as possible for the surviving business owner/s, as well as ensuring that the estate of the deceased business owner receives fair value for his/her business interest, as well as settlement of his credit loan account. Interestingly, there seems to be a trend for business owners to transfer their business interest into a trust. Note that where a business interest is held in a trust (or a corporate entity, such as a company) the reality is that even though the trust or corporate entity can continue to hold the business interest in perpetuity, there is often only one of the trustees/shareholders who is directly involved in the business, who influences the success of the business and upon whose death, and therefore, in all likelihood, the trust or entity would no longer wish to continue to hold its interest in the business, as it would not make commercial sense to do so.

Why is it important from the surviving business owners’ perspective to have a buy and sell arrangement in place?

  • The survivor/s would want to buy the deceased’s interest in the business, but may not have the money readily available to do so. They may need to raise finance, and if they are fortunate enough to be able to do so, interest will be charged on the capital, meaning that over the term they will in fact pay a lot more than the original purchase price for the business interest
  • If they are unable to raise the finance then the late co-owner’s spouse or dependants may step into his/her shoes in the business and become a co-owner with the survivors. In many instances this may be highly undesirable.
  • If the spouse (or dependants) does become a co-owner, they may not have the necessary knowledge, skill or expertise to be of value in running the business, and will simply be a drain on the business.
  • The survivors may have to pay a “salary” to someone who is not actively contributing to the business, in order to buy that person out of the business over a period of time. This could impact on the long term viability of the business.
  • If the trust/corporate entity had to continue to hold the business interest, without making a true contribution to the running of the business, it would still be entitled to share in the profits of the business. This could have a negative impact on the profitability and viability of the business in the long term
  • If the deceased co-owner has a credit loan account, this must be settled on his/her death. If there is insufficient liquidity in the business this could pose a very serious problem.

Why is it important from the deceased business owners’ perspective to have a buy and sell arrangement in place?

  • The potential capital growth (in terms of the value of the investment in the business) will be left in the hands of the surviving co-owners ability and willingness to continue to run the business profitably, which may not be in the best interest of the trust beneficiaries, who may not have the ability or inclination to be actively involved in the day to day running of the business. The value of the business may well decline and the trust beneficiaries’ entitlement would decline accordingly.
  • On death the surviving spouse and/or dependents will have to negotiate a price for the interest in the business, and may not receive a value which in the deceased’s estimation is a fair value.
  • The surviving spouse and/or dependants may be compelled to become co-owners of the business. They may not have the ability or the desire to fill your shoes and this would thus be a burden to them.
  • The surviving spouse and/or dependants may have to receive the value for their share in the business over a number of years, paid in instalments. If the business does not continue to operate successfully, they will never receive the true value of the deceased’s share in the business, as reflected at the date of death. Their destiny will be tied to that of the business, over which they will have no control.

The structure of the buy and sell arrangement:

The parties enter into a legally binding buy and sell agreement, in terms of which the survivors will be obligated to buy and the deceased estate (or disabled co-owner), or trust/corporate entity, will be obligated to sell his/her/its interest in the business if s/he or the named trustee/director dies or becomes disabled. The current value of the business must be determined by the business’s auditors or accountants and life insurance should be taken out for that value. The parties will own life insurance policies, and pay for them, on each other’s lives or on the life/lives of the relevant trustees/directors, so that they will immediately have the funding necessary to purchase the business interest if one of the co-owners or trustees/directors dies or becomes disabled.

Payment of premiums:

It is important, from an estate duty perspective, that the life assured does not pay a single premium in respect of the policy on his/her own life. The owners of the policy should pay their share of the premium, pro-rata. Payment of the premiums may come from the businesses bank account, but should either be debited to the individual’s loan account, or debited against the individual’s salary. While technically the business may now pay the premiums directly, this payment does not qualify as a tax deduction and may have other tax implications and so is not ideal or recommended.

The Income tax consequences:

The premiums paid for the life cover are not tax deductible, therefore the proceeds will pay out free of income tax. As long as the policies have not been ceded by the original owner/s to any new owner/s there will be no capital gains tax payable either.

Estate duty consequences:

The proceeds of the life insurance policy will not attract estate, provided that the following requirements are met:

  • The partners/shareholders/members do not pay the premiums on the policies in their own lives
  • At the date of the death of the life assured, the parties to the agreement are still partners/shareholders/members
  • The policy was taken out for the purpose of enabling the partners/shareholders/members to acquire the whole or part of the deceased’s interest in the business

These requirements can be met where a trust or corporate entity is an owner on a life insurance policy, and where the life insured is a business co owner who is a natural person (and not a trust or corporate entity).

However, where the life insured is the trustee of a trust or director of a corporate entity, then the requirements cannot be met and the proceeds of the life insurance policy will potentially attract estate duty. This potential estate duty must be accounted for and the cover effected should be increased to ensure a sufficient after-tax lump sum to purchase the deceased’s business interest.

Steps to implement a business assurance arrangement:

  • Establish the value of the business. It is recommend that the business’s accountants or auditors conduct the valuation in order to ensure that the value is accurate
  • Establish the value of any credit loan accounts, if they are to be included in the buy and sell arrangement
  • Effect life cover and/or disability cover required in order to purchase the respective businessinterest in the business.
  • It is important to take account of the business owners marital regime as well as trust deeds etc into account when making a proposal in respect of the buy and sell arrangement.
  • All the necessary documents to obtain the life insurance with the relevant life office must be completed.
  • A formal buy and sell agreement must be drawn up and signed. It is critical that the parties do enter into the buy and sell agreement, as they need both the signed agreement and life insurance in order to have a binding and effective buy and sell arrangement.