How to safeguard your business if the unexpected happens: Case Study
Jane, Peter and Jeff are co-owners of a successful business. Jeff contracted a serious disease and died soon after. He left his share of the business to his wife, Amy.
Many years prior to Jeff being diagnosed with the illness, the business had taken out $200,000 of life cover on each partner for use as business ownership protection. However, no buy/sell agreement was put in place. After Jeff’s diagnosis, he was unable to obtain more life insurance.
Over the years, the business had grown significantly where Jeff’s share was valued at $780,000 on his death. The partners had not reviewed the insurance policies to maintain the cover levels in line with the increasing value of the business. This left Jane & Peter with a $580,000 shortfall.
This left Jane & Peter with a number of unpalatable options, including:
• Accepting Jeff’s wife as a co-owner. The problem here is that Amy has no skills to help in the business. So Jane & Peter would be doing all the work and giving a third of the profits to Amy.
• Or Jane & Peter could find a third party to buy the business and use that money to pay out Jeff’s wife – but there aren’t any obvious takers that Jane & Peter know already. So they would have to take on a new partner who they don’t know – possibly leaving them vulnerable to someone they won’t get on with.
• Another option is to sell the business and pay out Jeff’s wife from the proceeds. The problem here is that, without Jeff, the value of the business is a lot less. It is not the best time to be selling. In any case, Jane & Peter both love the business and don’t want to sell.
• The final option is to get Amy to agree to receive the initial $200,000 and then receive regular payments under a vendor terms arrangement. The problem here is that Jane & Peter are effectively in business with Amy until she is finally paid out. This also means that the business needs to generate Amy’s payment and pay it in addition to the existing costs of running the business.
Jane & Peter had numerous meetings with Amy and, rather than let the business fold, Amy agreed to the following:
• Receive the $200,000 insurance payout
• Receive $9,000 per month, indexed each year for inflation for the next five years
• At the end of the five years, subject to a valuation of the business, the payments would continue or Jane & Peter could pay a final lump sum.
A better solution
It’s too late now, but Jane, Peter & Jeff should have put a buy/sell agreement in place from day one. They could have funded it with an insurance policy that covers death, and serious illness or disablement. Plus they could have obtained a valuation of the business from their accountant annually and adjusted the insurance sums insured accordingly. As a result, on Jeff’s death, Jane & Peter could have paid Jeff’s wife the agreed amount and Jane & Peter would then have owned the business outright.
The insurance cover required for death, TPD & trauma of $780,000 for each partner would cost each year:
Jane $3,563, Peter $2,846, Jeff $2,409. This is based on the following parameters:
• Jane age 42, Peter age 40, Jeff age 38.
• Business valuation: $2,340,000.
That’s a total of $8,818* or just 0.38% of the business’ turnover.
What is business estate planning?
Business estate planning is the process of arranging your business affairs now to help ensure there is no unnecessary deterioration or loss of continuity in your business should it lose you or one of the other owners or other key people through illness, injury or death. With appropriate business estate planning, there should be less risk of:
• A departing owner, or their spouse or estate, taking legal action over a valuation or pay‐out figure
• A departing owner’s spouse or child deciding – against the wishes of the continuing owners – to become an active partner of the business (rather than taking a pay‐out)
• The departing owner’s spouse or family taking their legal right to claim a share of the business profits without having to work in the business
• A departing owner’s spouse or estate selling their share of the business to a third party that may be unsatisfactory or unknown to the continuing owners
• The control of the business or its assets being frozen due to legal difficulties created by the departing owner, or their spouse or estate.
*Premiums are based on occupation code 2A – Managers & Business Executives. Premiums are average (at date of publication) for a non-smoker, with stepped premiums. Indexed benefits (i.e. cover is increased by indexed amount each year), trauma re-instatement benefit (i.e. your cover is re-instated after a claim) and business safeguard (i.e. ability to increase cover in line with business valuation). Source: Xplan Risk Research Manager 30 September 2015.
Disclaimer: This article is not legal advice and should not be relied on as such. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice relevant to your circumstances before making investment decisions. Where a particular financial product is mentioned you should consider the Product Disclosure Statement before making any decisions in relation to the product. Whilst every care has been taken in the preparation of this information, Australian Unity Personal Financial Services Ltd does not guarantee the accuracy or completeness of the information. Australian Unity Personal Financial Services Ltd does not guarantee any particular outcome or future performance. Australian Unity Personal Financial Services Ltd is a registered tax (financial) adviser. Any views expressed are those of the author and do not represent the views of Australian Unity Personal Financial Services Ltd. If you intend to rely on any tax advice in this document you should seek advice from a tax professional. Australian Unity Personal Financial Services Ltd ABN 26 098 725 145, AFSL & Australian Credit Licence No. 234459, 114 Albert Road, South Melbourne, VIC 3205. This document produced in October 2015. © Copyright 2015