Taking out buy/sell insurance can give business partners peace of mind in the event of disablement or death of one of the parties. Peter Townsend examines how holding this type of cover within an SMSF can be of even greater benefit.
Tom and Jerry own a business together. They could be partners in a partnership, shareholders in a company or unit holders in a trust.
Regardless of the type of structure used, they each could face a serious problem if anything untoward happened to either of them.
If Tom dies or becomes totally and permanently disabled (TPD), how could he ensure his interest in the business would be properly and expediently liquidated to provide much needed funds for his family?
And how could Jerry continue in the business without having to be in partnership with Tom’s wife or worse, having to sell the business to liquidate Tom’s share for Tom’s family?
The answer is a buy/sell arrangement.
What is a buy/sell arrangement?
Buy/sell arrangements are agreements that set the ground rules between co-owners of a business as to what is to happen if a co-owner dies or becomes TPD. Fundamentally they deal with when and how the other co-owners will acquire the interests of the outgoing or disabled co-owner in the business.
Both sides win, with the activated arrangement ensuring fair value for the outgoing co-owner and agreement being reached as to how the funds for the purchase by the continuing co-owner are to be provided. Buy/sell does not cover trauma or key man issues, which relate to operational issues for the business, not ownership.
There are two aspects to a buy/sell arrangement: transfer and funding. Both must be dealt with carefully to avoid unwanted tax and state duty implications.
The transfer issues relate to the trigger events, valuation of the business, payment terms, release from personal guarantees, the procedures and timing for transfer of Tom’s interest in the business and the deferral of capital gains tax until there are proceeds to enable payment. Trigger events include death, TPD, permanent incapacity and terminal illness.
Although continuing co-owners can fund the purchase of the outgoing co-owner’s share using their existing personal cash and assets, borrowing from their bank, using profits of the business over time or by finding a new co-owner to buy in, all of these have uncertainty and the most popular funding method is to use the proceeds from a life insurance policy.
The issues are then who owns the policy, who pays the premium, what is the tax treatment of the policy proceeds and how will those proceeds get transferred to the outgoing co-owner or their family?
While advice can be sought from all these standpoints, the purpose of this article is to look at the SMSF alternative.
What is the best structure for holding buy/sell insurance?
Unfortunately the answer to this question is still “it depends”. But we can narrow down the choices:
- self-insurance is better than cross-insurance;
- ownership by the jointly-owned company or trust is not recommended;
- ownership by the co-owner’s SMSF could be very advantageous for the right co-owner;
- a separate insurance trust is useful where there are a substantial number of co-owners or where a single policy has a variety of covers, some of which could be held by one vehicle (for example, the SMSF), while others were held either personally or by the business.
Holding buy/sell insurance inside an SMSF
To assess whether a life policy to support a buy/sell arrangement should be held by the co-owner’s SMSF, consider the advantages and disadvantages set out in the accompanying table.
If the SMSF is chosen as the vehicle to hold the life policy, care needs to be taken to ensure compliance issues are covered off.
The SMSF trust deed
The trust deed of the SMSF would need to contain provisions that empower the trustee of the fund to:
- insure the life of a member;
- pay the necessary premiums;
- pay the proceeds of such a life policy into the member’s account in the fund;
- insure the fund’s obligation to pay such a benefit to members, and;
- pay the necessary premiums.
There are a number of regulatory issues arising out of the Superannuation Industry (Supervision) (SIS) Act 1993 relating to the use of an SMSF to hold the policy.
In-house assets test
A life policy is expressly excluded from being an in-house asset. So long as the life policy satisfies the statutory definition of life policy in the Life Insurance Act 1995 (which is wider than life policy as per common law definition), then the in-house asset rule would not be breached.
Sole purpose test
If there is no detriment to the fund and there is an advantage to the fund from participating in the arrangement, then the sole purpose test would not be breached. Alternatively, it can be argued the life policy is designed to provide the death cover on death of the member and the TPD cover to provide the retirement benefits (brought on by incapacity) so there is no breach of the sole purpose test.
Best interests duty
Section 52(2)(c) of the SIS Act requires the trustee to covenant to ensure the trustee’s duties and powers are performed and exercised in the best interests of the beneficiaries. In holding the life policy supporting the buy/sell arrangements, if there is no detriment to the fund and there is an advantage to the fund from participating in the arrangement, then the best interests duty would be met.
Financial assistance prohibition
Section 65 of the SIS Act prohibits a trustee of a super fund from giving any financial assistance to a member or relative of a member. Payment of the premium may at first glance appear to be the provision of financial assistance from the fund to the life insured. However, it is the fund that benefits from the policy proceeds, not the life insured directly. Any benefit the life insured receives in respect of the policy proceeds comes to them through the fund and must be permitted by the SIS Act as a lawful release. Similarly, any payment of policy proceeds to a relative of a member must be a permitted release, in which event section 65 is not breached.
Matching payment of policy proceeds with access under the super fund
The payment of benefits to a member from a super fund is governed by the payment standards and conditions of release prescribed in the SIS Act. Death is a clear release condition. However, to access the proceeds of a TPD policy held inside super, a client under 55 will typically be required to satisfy the permanent incapacity condition of release. Problems arise when the terms of the insurance cover are not aligned with those statutory release conditions. Recent announcements by the Australian Taxation Office (ATO) indicate it does not believe it is appropriate to hold any cover except death, TPD and income protection inside superannuation.
Matching policy definition with super release entitlement
The mismatch between a TPD policy definition and the statutory permanent incapacity definition means that when a claim is made, there is a possibility the insurance proceeds may be trapped in the fund unless/until the client meets a condition of release, such as relevant incapacity or retirement.
For clients who want an ‘own occupation’ policy the answer may be to hold that part of the cover that matches the permanent incapacity definition inside super and the balance of the cover outside super.
The same mismatches can occur in respect of disability insurance, but are perhaps not as heinous as premiums are likely to be deductible whether inside or outside super on general deductibility grounds. Access issues would still apply if a mismatch existed.
Additional compliance issues and other considerations apply to split cover, which has also been affected by an announcement in the last federal budget that may inadvertently make split cover easier. In any case, split cover will only be available by using the right type of policy and advisers need to consider the choice of policy carefully.
Deductibility of premium
The current state of pronouncements from the ATO means premiums for ‘any occupation’ TPD cover are typically fully deductible but premiums for ‘own occupation’ TPD are not. That is because ‘own occupation’ proceeds are paid even though the co-owner/member is capable of working at some role, engaged in gainful employment, and therefore not entitled to their superannuation. On the other hand, any payment under a policy covering ‘any occupation’ is made because the co-owner/member is not capable of working at all and is almost certainly therefore entitled to access their superannuation.
It also needs to be considered whether the premium is paid from the member’s account or generally from investment proceeds. Only the former may truly qualify for a deduction. The position regarding the latter is arguable but not definitive.
The pros and cons of holding life insurance inside an SMSF:
- The life policy is owned by the co-owners.
- Concessional contributions to the fund can be used to pay for deductible premium resulting in effectively no contributions tax.
- If paid to the SMSF, the proceeds of the life policy would then be available in a ‘low tax’ and ultimately a ‘no tax’ environment.
- Once a trigger event occurs the policy proceeds are paid to the SMSF and the co-owner/estate transfers the interest to the continuing owner for a nominal purchase price.
- Premiums on the life policy can be funded through the superannuation guarantee charge (that is, pre-tax dollars).
- Proceeds are substantially quarantined from the outgoing co-owner’s debts and other legal liabilities.
- Even if excess contributions tax paid, the benefits of the proceeds inside super may still be worthwhile.
- Access to the proceeds once paid is restricted by the superannuation law.
- More documentation is required than normal and if the client has no SMSF, then the fund would need to be set up with considerably more documentation and expense.
- Preservation issues can apply – for example, accessing proceeds from super arising from ‘own occupation’ TPD.
- The co-owner/member will need to consider having a death benefit nomination in place to direct the ultimate recipient of the life policy proceeds along with their other superannuation death benefits.
- There are restrictions on who can receive death benefits from a super fund.
- Some beneficiaries will pay tax on what they receive from the super fund.
- The fund deed must allow the process and the various different administrative aspects.
- Contributions to pay for premiums may exceed cap thereby attracting tax on excess contributions.