Dead business partners and a widow
Article by James Harman
The widow stood at the graveside as the coffin was slowly lowered. She looked across at her late husband’s business partner. “I’ll make that bastard pay double if he wants my husband’s half of the business,” she thought. The business partner caught the widow’s mournful eye. “I’ll offer her one tenth. She wouldn’t know what it is worth. Anyway, without me it is worth nothing”.
Did You Know?
That for 2 male business partners both aged 35, the probability that one will die or become totally and permanently disabled before aged 65 is 52%. For 4 partners the risk increases to 77% and with 6 partners 89%. Women on the other hand statistically make for a better risk. Business succession planning is not about selling personal life insurance, legal documents or detailed financial plans. It is about developing a strategic plan to ensure a smooth and trouble free hand over following a trauma event, disablement or death.
How is Business Succession Planning best achieved? Protecting your business and your family
Business owners think they do not need or are too busy to get around to creating their Business Succession Plan. The spouses generally don’t know the risk their business spouse is taking in not planning for disasters. Let me give you an example: Not so long ago I saw “John” in our office. John runs a small, successful real estate company with his business partner Keith. Shortly before I saw John, Keith had developed cancer and died. He left everything in his Will to his wife Nicole. Nicole inherited Keith’s interest in the real estate business. Nicole had never been involved with the business. Not only did Nicole not want to have anything to do with the business, she told John she would camp on his doorstep until he purchased Keith’s half of the business from her. In the meantime, she wanted Keith’s usual wage. She needed money to support herself and the children. John would have been happy to pay her half of the value of the business IF:
1. He knew what the business was worth;
2. Nicole agreed with the value (and wanted to sell); and
3. He could find the money to pay her To compound the problem the bank wanted additional security for the business’s overdraft. Was Nicole willing to go as a guarantor to the business overdraft to replace her husband? John was frantic. Would he have to sell the business (his life’s work) at a fire sale?
Why was this?
It is NOT well known that in the majority of any Banks fine print clauses on security for a Business loan, the death or disability of a guarantor or co-surety to a business is an “event” of default. This means that if any person, who is a party to a Bank’s security dies, becomes disabled or suffers a traumatic event, the Bank is able to seek repayment or renegotiate the loan facility. The answer here is proper Key Person Insurance (as distinct from insurance for a Business Succession Plan).
What is the answer?
John and Keith together with their Adviser, Accountant and Tax Lawyer could have prepared a Business Succession Plan. A Business Succession Plan is an agreement between the business partners to deal with a principal:
2. becoming disabled;
6. being convicted of a criminal offence;
7. becoming bankrupt, and;
8. taking unauthorised absences from the business Nicole could then have required John to purchase her half of the business for a predetermined price. Alternatively, John could have required Nicole to sell her half of the business for the same predetermined price.
How can you afford to pay the purchase price?
Even with a Business Succession Plan, to ensure the transfer of a business interest upon death, all problems are not solved. The remaining partners need money to buy out the deceased’s family. A number of funding mechanisms are available. The most successful funding method is a combination of life policy, trauma policy and total and permanent disability policy. We suggest you contact your financial planner to discuss the many products out there.
What about tax?
Yes, you have to be very careful to structure your Business Succession Plan so that you avoid unnecessary tax.
1. A properly prepared Business Succession Plan ensures that only nominal stamp duty is payable when you sign the Business Succession Plan.
2. Capital Gains Tax can be triggered on the “disposal” of the business (that is when Nicole sells to John). There are many avenues available to you to ensure the assets are transferred without the expense of capital gains tax provided you take the proper precautions before entering into the Business Succession Plan. Exemptions in The Income Tax Assessment Act (such as section 160ZZI) give further protection.
3. Some of the business assets can be income producing for the taxman (e.g. trading stock). Proper mechanisms can circumvent this problem.
How do I create a Business Succession Plan?
Put and Call options are the easiest to set up and explain. Let’s look at an example of how this works using John, Nicole & Keith. John gives Keith the “right” (option) to purchase Keith’s interest in the business following the occurrence of any of those specified events listed above and Keith gives me the same right. To make the arrangement even more secure, we each grant both “put and call options”.
The personal protection insurance for John is as follows:
Assume Keith has died; John may exercise the option to “call” upon Nicole, as the Widow, to sell Keith’s interest in the business to John at a predetermined price.
The protection for Nicole, the Administrator of Keith’s estate is as follows:
Alternatively, Nicole may have the option to “put” to John that he must buy Keith’s interest in the business.
The Put and Call Agreement
Arguably, the most tax effective way of structuring an agreement to embody your objectives is through an option agreement.
A senior Adviser, the business’s Accountant and a Tax Lawyer when acting in concert together can achieve proper tax effective Business Succession Plans for their clients.
About the Author
James Harman and Associates – personal life insurance, personal protection insurance, personal accident insurance specialists with over 25 years industry knowledge.