Part of that process includes defining their vision of a secure financial future for their business if they, another owner or other key person were unexpectedly lost to the business.
There are many people’s financial futures to consider, including the departing person and their family, the ongoing partners and their families, and their staff and their families.
To help your clients create a business estate plan to look after all these people, a comprehensive process needs to be developed that takes into account many legal and financial issues, including the ownership of the business, its revenue and its debts. As a result, there should be less risk of outcomes such as:
- a departing owner, or their spouse or estate, taking legal action over a valuation or payout figure
- a departing owner’s spouse or child deciding – against the wishes of the continuing owners – to become an active hands-on partner of the business (rather than taking the payout)
- 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.
Clarifying ownership issues
As the accountant, you will help your clients and their business partners to formally agree on how their business will be valued – and what each partner’s share will be. Importantly, you will also help ensure that capital gains tax is minimised for the departing owner or their estate, and for the continuing owners.
Funding options also need to be explored which will allow the continuing owners to fairly compensate the departing owner or their estate. These options include the use of business capital, a new partner buying into the business, debt, and buy/sell insurance.
Where this specialised insurance is used, your clients will need advice on the most appropriate ownership structure for the insurance to ensure it allows for the business estate plan to be implemented efficiently.
Financial impact
The sudden loss of a key person can have an adverse effect on the sales and profits of the business and, until a suitable replacement is found, the business could be faced with recruitment costs, loss of clients, loss of revenue and profits, and negative impact on goodwill and credit rating.
Your clients will need to establish who are the key people in their business, and then estimate the financial cost to the business if each of them suffered a tragic event. If required, an appropriate insurance policy will need to be purchased on each key person for a sum insured equivalent to the estimated financial loss. It is the business that will own these insurance policies and pay the premiums, and it is the business that will receive the proceeds.
If your client or one of the other owners were to die, any loans or leases their business has may be immediately callable by the lender. A business estate plan can ensure that debt can be retired by the continuing owners, through either the use of business capital, a new partner buying into the business, finance, or an insurance policy.
Regular reviews needed
Once the business estate plan has been implemented, it will need to be reviewed regularly. This will ensure it continues to reflect your client’s vision of a secure financial future for them and their business, and will avoid the sorts of unpleasant surprises illustrated by the case study.
Case study
Mary, Wayne and John were co-owners of a successful business. John contracted a serious disease and died after a number of years. He left his share of the business to his wife, Betty.
Many years prior to John 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 John’s diagnosis, he was unable to obtain more life insurance.
Over the years, the business grew significantly to where John’s share was valued at $780,000. The partners had not reviewed the insurance policies to maintain the cover levels in line with the value of the business. This left Mary and Wayne with a $580,000 shortfall and presented them with a problem. They could not afford to buy out John’s share of the business, nor could they afford to obtain a loan for that purpose. This left them with a number of unpalatable options, including:
- Accepting Betty as a co-owner. The problem here is that Mary and Wayne do not get along with Betty – and the wife has no skills to help in the business. So Mary and Wayne would be doing all the work and giving one-third of the profits to Betty.
- Finding a third party to buy the business and use that money to pay out Betty. However, there aren’t any obvious takers that Mary and Wayne know already, so they would have to take on a new partner – unknown to them personally or professionally – possibly leaving Mary and Wayne vulnerable to someone they won’t get on with.
- Selling the business and paying out Betty from the proceeds. The problem here is that, without John, the value of the business is a lot less. It is not the best time to be selling. In any case, Mary and Wayne both love the business and don’t want to sell.
- Get Betty to agree to receive the initial $200,000 and then receive regular payments under a vendor-terms arrangement. The problem here is that Mary and Wayne are in effect in business with Betty until she is finally paid out. This also means that the business needs to generate Betty’s payment and pay it in addition to the existing costs of running the business.
What happened?
Mary and Wayne had numerous meetings with Betty and rather than the business folding, Betty’s lawyers agreed to the following:
- receive the $200,000 insurance payout as an initial payment
- receive $9000 a 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 Mary and Wayne could pay a final lump sum.
A better solution
It’s too late now, but Mary, Wayne and John should have put a buy/sell agreement in place from day one. They could have funded it with an insurance policy that covers trauma, death and total and permanent disability. Plus they could have obtained a valuation of the business from their accountant annually and adjusted the sums insured accordingly.
Then, on John’s death, Mary and Wayne could have paid Betty the agreed amount and then have owned the business outright.
Based on the following parameters: Mary age 44, Wayne age 42, John age 40; business valuation $2,340,000; cover required for death, TPD and trauma for $780,000 for each partner, the annual premiums for the insurance cover would have been: Mary $4691, Wayne $3692, John $2996. That’s a total of $11,379 or 0.49 per cent of turnover.
There are benefits also for the business’s accountant. As well as being paid at their normal hourly rate for the initial valuation, provision of financials and annual valuations, the practice would have been remunerated for either implementing the risk insurance or referring it to a financial adviser to implement. In addition, the accountant would have very appreciative and loyal clients, and would keep the business as a client.
